Tag Archives: money

House or Home? 7 Case Studies …

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The real advantage of my 7 Millionaires …. In Training! ‘grand experiment’ for the rest of us is that it provides some great ‘real life’ case studies of the topics that we talk about on this site.

For example, we talk a lot about your house, as – for most people – it’s your largest single purchase  …. assuming that you don’t intend to actually get rich and go off and buy yourself some REAL investments 😉

Here is where each of the 7MITs are at with their current housing; if any of these case studies interest you, click on the link to read their full post and be sure to scroll down and read all the comments:

Scott talks about both his current home (he has kept his previous home as a rental) and compares his current dual income to the 25% Income Rule – although, there is a question about his wife’s income to be answered.

Ryan isn’t sure whether he bought the ‘bargain’ home that he thought he was getting; should he pay down the mortgage to compensate? Read the post – and the comments – then let us know (either here or there) what you think?

Jeff is a Navy Pilot, so it should come as no surprise that he: (a) moves a lot, and (b) gets some housing assistance. Jeff is seeking to capitalize on his unique situation by flipping his current home … why don’t you add your comments to those that are already on his post?

Mark has a home that he wants to keep as a rental. Is he making the right move … and, is he using the right metrics to help him make the right decision? Also, in the comments, we examine whether Jeff’s (yep, back to the Navy Pilot) house is a home or an investment.

Josh is the ‘free accommodation at home’ guy … sigh! I (slightly) remember those days. But, does Josh have a housing decision to make (he has been give the task of managing his grannie’s flat)? Read his post (and the comments … feel free to add one of your own) and YOU decide!

Lee asks the critical question: house or home? We also have (read my comment) a totally new version of the Old Age Pension to offer Lee …

Diane lays an interesting ‘life situation’ on us: when do Life Partners combine assets and liabilities and when don’t they? Also, if finances are separated, how do you calculate where you are REALLY at financially? It can (and should) be done, but how? Diane has taken the same ‘live at home with parents’ path as Josh (for now) … what advice can you add?

If you are still deciding how much house YOU can afford – and, want to learn more about the 25% Income Rule and the 20% Equity Rule – start with this post, and work backwards through the links.

Tempting deal … bad deal!

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picture-1My last (not ever, but for a while) Reader Poll showed that most of you thought that my hypothetical real-estate transaction was a good deal, provided that it didn’t tie up your money for too long.

Thomas, who has all the hallmarks of becoming a great real-estate investor, liked the strong returns on cash invested:

I don’t have to invest the full 100k. I can finance most of it, secured by the real estate. So, let’s say I can finance 80% of it, which means I “only” need to come up with 20k myself. If I can finance it at 5%, the interest on the 80k would be $4k a year, which would leave me with $3500 left over each year. $3.5k annually for an investment of 20k is a return of 17.5% per year. In addition, any appreciation is also yours, so unless you need to average a very high annual compound rate, this sounds like a great deal.

I, too, think it’s a pretty tempting deal, but NOT for the reasons that many of you gave for liking it in the first place …

… to summarize; here’s what I like about the deal:

– very well-established commercial strip-mall in a great area

– fully rented, with long leases

– currently returning 9%, less contingencies … so, estimated yearly distribution is $7,500

So, on an investment of $100k, I get a 7.5% – 9% return each year … presumably, there’s some sort of ‘ratchet clause’ in the lease to ensure that rents at least keep pace with CPI and/or market. I would NOT invest until I knew the answer to this question, but it’s a reasonable assumption to give an ‘in principle’ OK to the deal … with the cost of funds at sub-6% these days (and, I can lock in for 5 to 10 years on a commercial loan), this is beginning to look quite good. The capital appreciation almost becomes a ‘bonus’ …

So, here’s what I don’t like about the deal:

– It’s a general partnership … luckily I am the general Partner and get to control the property, but the rest of you don’t 🙂

– There is a rental/return guarantee

Whoa … I DON’T like a guarantee??!! … what’s up with that?!

To me, the guarantee is  a risk – not an opportunity – because the real returns should meet or exceed the guarantee at all stages, anyway, except in two cases:

1. The value of market-place rents decline (a recession can cause deflation; tenants may leave or go broke and we may need to cut rents to retain new tenants),

2. Costs can go over budget (vacancies could cause protracted loss of income; hidden structural issues could cause major repair costs; etc.)

3. Both could happen at the same time

Rick agrees, sounding the following warning:

It really sounds too good to be true- if a lot of these businesses go out of business can the $9K/year really be guaranteed? Could you really find another buyer in the current economic environment?

If only one of these things happen, we may be able to dig into our contingency fund to ‘ride it out’ (remember, we retain roughly 1.5% on net income each year as a ‘contingency’), but if a number of things happen at once, such as in the current economic and real-estate ‘perfect storm’, then the fund may run ‘dry’ …

… if this were our only investment, we would simply not take much/any rent out of the deal until we covered these costs and rebuilt our fund (if the situation becomes dire, we may need to put more money in or even sell out … but, this should be extreme).

However, because this is a partnership with a guarantee, the General Partner (me) has to maintain a minimum 7.5% return to the partners (you); which only leaves me a few choices:

1. Dig even further into the contingency fund, or

2. Ask you ALL to agree to vary the contract and take less money this year OR sell the project (are you ALL going to agree?), or

3. Borrow more money to pay the guarantee and/or cover the costs (increasing the expenses on the project even more), or

4. Wait for the bank, a supplier, or an investor to foreclose (because we pay you and slow down the bank and/or suppliers, or we pay the bank and one of you initiates proceedings because we fail to pay you as ‘guaranteed’).

In all of these cases, the flaw is that the ‘guarantee’ is funded by the project itself and forces the General Partner to make decisions that he would NOT make if ‘the project’ didn’t have to pay the guarantee …

I like to think that the ‘managers’ on any project or business that I am involved in are always making the best commercial decisions, not acting artificially to enforce some sort of ‘forced distribution’ …

…. kind of like the board of directors of a business focusing on maintaining a certain level of dividend for investors, rather than growing the business’ long-term earnings (a.k.a. profits).

Can you now see that dividends and profits (businesses) or guarantees and net income (real-estate) are NOT the same thing?

So, for this project, if I were an outside investor, I would make a decision on the project and insist that there were NO guarantees … simple. Unfortunately, most investors don’t think past their noses (“what’s my return?”), hence the ‘guarantee’.

As to me, unless I was the General Partner and there was no guarantee, I would NOT invest …

What do you think?

Real Cashflow, Fake Cashflow

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cashflow

This is the first installment of a four part series on what I describe as the three types of cashflow (as it relates to Real-Estate) … feel free to weigh in!

________________________________

I think, by now, most of our readers no longer subscribe to the “buy property for the tax deductions and future appreciation” scams of the 90’s and 2,000’s that resulted in one of the biggest property busts that the USA has ever seen.

But, I fear a new mantra – not quite as dangerous, but one that can squash your future returns (hence, financial dreams) like a kink in a fireman’s hose [AJC: that’s probably the worst simile that I have ever written] …

… it’s the ‘positive cashflow’ mantra.

You see, there are three types of positive cashflow, when it comes to Real Estate … and, I’m not sure that you will read about this anywhere else, but here it comes:

1. Tax Cashflow

2. Fake Cashflow

3. Real Cashflow

… only one of which we are really looking for, although, any great property purchase will probably exhibit characteristics of all three.

First, though, let’s review the typical property; the one that doesn’t produce any cashflow at all and loses you money … it’s negatively geared!

Negative Cashflow

A property produces rents – hey, even your home produces a ‘rent’ … it’s just that you don’t bother to pay it to yourself, but you should 😉 – and those rents are offset by costs: e.g.

– Mortgage Interest

– Repairs and Maintenance

– Vacancies

– Provisions

And, there are many others …

… interestingly, the last two aren’t strictly a ‘cost’ but a lost opportunity to earn rent – it amounts to the same thing: more cash going out than going in.

If the property has more expenses going out than money coming in from rents it is said to be Negatively Geared; this simply means that you are losing money!

So, why do you do this? Well, the promoters of such property – and, there are many such ‘promoters’ (e.g. builders, developers, real-estate agents, etc.) – will say that you do it for the FUTURE APPRECIATION …

… definitely lose a little bit of money today for the chance to make a LOT of money in the future.

There’s a word for that: gambling. I prefer poker; you may prefer lotteries; let others gamble on this kind of real-estate.

In the next installment in this special 4-part series on real-estate, I will cover the first kind of ‘positive cashflow’ real-estate: Tax Cashflow.

Playing the Efficient Market Theorist for a fool …

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I love it when a scientific study – that cost goodness-knows-how-much – produces a result that is, well, kind’a stating the obvious …

Take this paper as an example; it finds that Warren Buffett’s success with stocks is not due to luck or taking higher risks, rather – surprise, surprise (!) – it’s due to superior stock picking skills:

The stock portfolio of Berkshire Hathaway, comprising primarily of stocks of large-cap companies, has beaten the S&P 500 index in 20 out of 24 years for the time period 1980-2003. In addition, the average annual return of Berkshire Hathaway’s stock portfolio exceeds the average annual return of the S&P 500 by 12.24% over this time period.

We examined various potential explanations for Berkshire Hathaway’s investment performance. We first explored the explanation that Berkshire Hathaway’s performance may be due to pure luck. We find that while beating the market in 20 out of 24 years is possible due to luck at a 5% significance level, incorporating the magnitude by which Berkshire beats the market makes the “luck” explanation unlikely.

After employing sophisticated adjustments for risk, we find that Berkshire’s high returns can not be explained by high risk.

Ruling out the major alternate explanations to Berkshire’s investment performance leaves us with the potential explanation that Warren Buffett is an investor with superior stock-picking skills that allows him to identify undervalued securities and thus obtain risk-adjusted positive abnormal returns.

Well, d’ah …

So, let me tell you – and, I’ll accept a $1 Mill. federal government grant to write the obvious up as a paper, if you like – that Warren Buffett makes his money essentially in two ways:

As Businesses

Contrary to popular belief that Warren Buffett is a vulture who swoops in when there is carnage all around to pick up businesses at bargain prices, Warren actually patiently waits to buy sound businesses at fair prices.

These are usually private/family businesses that need to be sold for reasons other than the soundness of the business itself … for example, the largest family business in Australia was split up to avoid squabbling by the ‘next generation’ … succession is usually the major issue facing such private/family businesses. Warren did not buy this Aussie business, but you get my point …

Warren, to the best of my knowledge, rarely bargains on the price of a business and has even been known to overpay; for example, when the Sees family wanted $30 Million for the Sees Candy business, Warren nearly walked away, thinking it was worth only $25 Million …

… Warren is glad that he bought it anyway, as the business returned Warren’s $30 Million in only a few, short years and is worth over $1 billion today.

You see, a business grows and produces continuing cashflows – even if you never sell (and, Warren NEVER sells!), so the price you pay is secondary, IF the business produces outstanding returns. That’s why Warren says:

It’s far better to buy a wonderful company at a fair price than a fair company at a wonderful price.

In Defiance

So, Warren Buffett wears two hats, with his first hat (surprisingly) being business owner … but, it’s his second hat as the World’s Greatest Stock Investor seems to be the most fascinating to most people.

Well, I’ll let you in on a ‘secret’ … there is no great secret here, at all: Warren simply makes a ton of money by proving that the so-called Efficient Market Theorists are fools … time and time again!

Given that luck and all the other explanations have been rigorously and scientifically ruled out, what the study has ‘proved’ – at great expense, I might add – is not that Warren Buffett is right …

… but, that Efficient Market Theory is wrong!

Now, THAT is a breakthrough of gargantuan proportions, and tomorrow, I’ll tell you how you can exploit it 😉

How not to be a dull boy …

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When I worked I was dull and when I retired I became insufferable … it’s official!

But, there is a way out: it’s called the Work/Life Balance and we all want it, but none of us really have any idea how to get it 🙂

Which brings me back to a conversation I had with a friend of mine after showing him our new house a few nights ago (extensive renovations will be underway, soon):

My friend, a doctor – an internist, family doctor, or general practitioner as he would variously be called depending on which country you are in – confided that he originally wanted to become a surgeon.

But, he stopped his studies – after many years of trying, failing, then retrying to make the ‘cut’ when his wife suggested that he draw a pie chart of how he was spending his time.

Here’s his chart:

all-work1

Typical working student; most of his day taken up with work, then study with very little left for sleep and virtually no R&R (rest and recreation: that’s where ‘family’ comes in) …

… she then asked him to draw a similar chart of how he would LIKE his typical day to look, and this is what he drew:

no-play

It doesn’t take a genius – or a budding surgeon – to realize that what he really wanted was a BALANCED LIFE: work, sleep, family.

My friend almost immediately gave up his surgery aspirations with absolutely NO REGRETS and now runs a successful suburban practice that gives him a life where he can help people, his family, and himself in almost equal quantities.

This leads me to think: why do we live the first pie chart, if not to get to the second? Perhaps, money is not really the object, after all …

… or, maybe you need to live the first for a defined period (your Date) in order to achieve a preset amount (your Number) so that you can live the life you really need (your Life’s Purpose)?

Now I better go and take some of my own advice … 😉 [AJC: Really, I just added this sentence: I have to go for a walk to the letterbox with my wife … whoo hoo!]

A new way to look at your home …

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There is a new way to look at your home, and if you do it, you will never make a financial misstep again – at least when it comes to the biggest personal purchase that you are ever likely to take …

… but, I warn you: your wife may not like it 😛

You see, we tend to describe our homes as an ‘investment’ but the reality is far different: we buy emotionally and we justify rationally.

The truth is: we [most of us] want a home … then we want a bigger one … always, just a little/lot more than we can actually afford. And, to be totally truthful … I not only succumb to this line of thinking myself, I actually encourage you to do the same!

I subscribe to the old-fashioned notion that you should buy your own home – even if it means breaking my rules to get into the home in the first place – as a way of ‘forced savings’ …

… but, once you are in your first home, I then want you to rationally examine the true current resale value of your home, and the equity that you have in it (i.e. what the home is curently worth against what you currently owe), at least ONCE EACH YEAR, to ensure:

(a) that you don’t upgrade until you can afford the payments, and

(b) that you put any excess equity to work for you.

But, these rules are only ‘proxies’ for what you should be doing, if you could be trusted to manage your money rationally, instead of emotionally …

… if you could be trusted to treat your home – at, least from a financial aspect – as a house:

You should charge yourself rent!

This is the only way to ‘prove’ that your house is an investment. It lets you know two things:

Am I living beyond my means?

To find out, simply ask yourself these two questions:

(a) How much rent could you get on your house if you rented it out? Ask a Realtor or two … scour the listings in your local paper … look it up on rent.com … do this properly!

(b) What rent can you afford to pay, according to the 25% Income Rule?

If (a) is more than (b) then you have a problem … you are living beyond your means: either increase your means (e.g. get a second job; charge your children board; etc.) or decrease your living (e.g move out; rent out a room; etc.).

Am I investing wisely?

This one is easy; if you charge yourself rent, you can see if your property is positive cashflow or negative cashflow …

You have some ‘advantages’:

– You have a great tenant

– Your tenant has a great landlord

– You get to tax deduct your mortgage

– There’s no tax to pay on the ‘rental income’ … it’s all in your head, remember? 😉

To find out if you really are investing wisely, simply ask yourself these two questions:

(a) How much return on my money (i.e. equity currently in the house) could you get if you sold the house and reinvested the equity elsewhere?

(b) What rent would you have to pay (remember that you want to take the lower of your current rent or what the 25% Income Rule allows) if you lived elsewhere?

If (a) is more than (b) then you have a problem … you are investing badly: either sell your house or see if pulling out some equity and investing helps.

If the answers don’t please you, and you are unwilling to make the necessary changes, then the 20% Equity Rule and 25% Income Rule are still there to stop you from getting into too much financial trouble … make sure you obey them! 🙂

Good deal or bad deal?

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No, this is NOT another ‘Howie Mandel-style’ game show … I’m done with that series (aside from a couple of wrap-up posts, still to come)!

But, this will be my last reader Poll for a while, so I want you to sit down for 3 minutes and make a commercial decision with imperfect information:

Time for a fun ‘hypothetical’ … I’m not really asking you to invest with me [AJC: I want you to learn to invest with somebody far more capable: yourself!] …

I would like you, and a number of other people, to join me in a real estate project [remember: this is hypothetical].

It will be very low risk, because it’s a very well-established commercial strip-mall in a great area, pretty much fully rented with lots of good tenants with long leases left to run and for the last 10 years has produced a reasonable – perhaps not stellar, but certainly highly respectable – profit with very low maintenance costs, tenant turnover, etc., etc.

No catches, here, really … it will be a general partnership, I will be the managing partner and you can join the group of passive investors already committed.

So, let’s look at the deal a little:

Your share of the investment will cost $100,000 and for that you get 10% of the $1,000,000 project (incl. financing/closing costs) … it’s a very inexpensive strip mall 😉

We expect reasonable capital appreciation over the life of the project (up to 10 years, although you can sell out anytime before then, and we will guarantee both a buyer and then-current market price for your share).

The property will return about $9,000 a year (net operating income per 10% share), but we think it’s best to keep aside some as a contingency against vacancies, maintenance, etc., etc.)

So, we will guarantee you (secured by the project itself) $7,500 income each year for at least the next 10 years indexed to 7.5% of the current value of the building (but, NO LESS than the $7,500 p.a. guarantee) v the $3,000 or 3% that a bank will currently give you, and which does not grow. Of course, you may have others ideas in mind for the money, but I hope you will invest with us … after all, here, your income is guaranteed!

In summary: an ultra-low-risk ‘bricks and mortar’ investment returning a MINIMUM 7.5% p.a. on your original investment (increasing in line with property value increase) … you will get your money back, just from the guaranteed distributions that the project will pay you, over 13 years and you STILL get 10% of any appreciation in the building!

Deal or no deal?

How fast is frugality?

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save-v-invest

I love it when I read interesting posts on the personal finance blogs and other forums … take Mighty Bargain Hunter‘s view that frugality is the fastest way to a better bottom line:

It shouldn’t be the only way you’re improving your bottom line, but it does give results, fast.

For someone who already has their finances under good control, some money-saving activities are simply too little payback for too much time … [but] what about the people who aren’t as well off?  Maybe they’re making $40k or $50k, but have a lot less saved up than they probably should for their age.  This is the situation for which packing your lunch, buying generic, buying used, skipping Starbucks, and clipping coupons will help.

And it helps immediately.  The week you take lunch to work at $2 a day instead of hitting Subway at $5 a day, you’ve improved your bottom line by $15.  Boom.  Or brew your coffee in the morning instead of hitting Starbucks.  $10 per week.  Boom.  Instant gratification.

Building up income streams takes longer, especially the kind of income streams you want (passive ones) … higher income may be better in the long run, but that’s the long run.

Frugality is here and now.

Businesses have taken this view for a long time now … they call it cost-cutting 🙂

Usually a business that is spending its time cutting costs is a business that you should selling out of, not buying into …

… it’s current finances may begin to look great, but its future may be bloody awful (that’s why it’s busy cutting costs!).

On the other hand, a GREAT business invests in their future (sales and marketing, product development, R&D, production, etc.) while managing their costs.

So, let’s put it to the test: how fast is frugality?

Well, to find out, I put four scenarios into the Magic Excel Blender and here’s what it spat out:

Save: If you earned $100,000 a year and cut corners so that you could save 20% to stick in your mattress, at the end of 20 years, you’d have $400k stashed away.

Invest: If you only managed to save 10% a year and spent your time investing the proceeds wisely (@ 8% p.a.) you’d end up with $460k in (say) stocks.

Save + Invest: But, if you did the sensible thing and invested your savings instead of stashing it under your mattress (in other words, save 20% then invest it @ 8% … hardly rocket science), you’d end up with more than $920,000 after 20 years, and still have dividends each year to live off … a much better result for only a little extra work together with some belt-tightening.

MM101: However, if you did the really sensible thing, and built up your income (so that you can afford to reinvest the dividends), saved well (at least 20%, but only of your original level of income), and invested both the dividends and the savings wisely (@ 8% p.a.) after 20 years you’d have over $2.5 million.

Frugality may be quick (in that we can afford to pay a bill; pay down a pressing loan), but will never make us rich …

… that’s why we take a multi-faceted view to personal finance:

Making Money 101 – to ensure that our costs are under control and free up some cash to help us invest in MM201

Making Money 201 – to grow our income by investing what little cash we may have (to begin) wisely and maintaining sound MM101 ‘habits’ to ensure that we have ever-growing streams of investment income, keeping our growing personal ‘needs’ (read: expenses) in check, so that we can eventually reach our Number

Making Money 301 – to manage our Number (i.e. our nest-egg) so that it lasts as long as we do, while living the life that we have designed for ourselves, not the life that others have resigned us to.