Thursday, March 12, 2015

You Can't Always Win (Mitigating Losses)

You can't "win" in every financial transaction, and in fact, trying to win every time is one sure way to lose.

Well, we finally got an offer from a developer for the condominium project.   It is an interesting offer, about 61% over market value at the present time, with no real estate agent fees.  So, instead of getting $120,000 for a one-bedroom condo, we could get $172,000.   Not bad.

However, there are some who bought their units at the height of the Real Estate Bubble, and the amount they receive would be less than what that paid.   One fellow complains that he paid $275,000 for his 2-bedroom unit, owes $220,000 for it, and the buyout price is only $247,000.   Why should he sell?   Why not just "hang on" and wait for market values to come back?

It is an interesting comment as many small investors feel the same way about everything they invest in.   I know I used to.   I bought stocks and "rode them all the way down" because I felt that no transaction I was involved in should ever, ever be a loss, even if I had to wait 10 years, or indeed forever, to get my money back.

It is an immature way of looking at investing, in retrospect.  Not every transaction you make will be profitable.   And sometimes you have to "cut your losses" and move on.

Our vacation home in NY is a case in point.   We paid about $340,000 for it, put another $150,000 into it with improvements, and then sold it for $400,000, walking away from about $110,000.   Should we have "held on" until it was worth what we had into it?   No, and let me explain why.

First of all, when it comes to houses, the improvements you put into them are often worth nothing in resale.   If you add a pool, new kitchen, bath, or addition to a house, don't expect to "get your money back" in resale value.   Even if you sold the house the next day the most you could expect is to get 50 cents on the dollar back.   You can't spend a dollar on a new kitchen and expect to get back a dollar, much less a buck-fifty.

Improvements are just that - things you do to make the place more to your liking.   And that is one reason I realized that it is a lot cheaper to buy the house you want, than to buy a house you don't want and try to make it into something.  Or just learn to leave well enough alone and live with what you have.   You can go broke throwing money at houses.

But getting back to the investment side, in order to "break even" we would have to have held onto the house until it appreciated by $100,000.   At current market rates, prices are going up in that area by only negligible amounts  1-2% a year.   It is a depressed area, and few people have the money to buy $400,000 homes.  So you are looking at a decade or more before you "break even" on the house.   Is it worth it to "hold on" to a house so you can say you "won"?

Well, no, not really, and in fact, not at all.   By selling off that house, I could put the money into other investments, which net more than 1-2% a year.   In fact, I used the money to pay off the mortgage on my other home, which means a savings of about 5.6% a year in interest not paid (that was a competitive rate at the time).   I come out ahead by far by selling, rather than trying to "hang on" and break even.

Of course, with houses, you have other expenses - repairs, utilities, taxes, etc.   Plain investments are slightly different - but not by much.

Say, for example, you buy 1000 shares of ACME corp for $5 a share.   It goes down to $4 a share, and you've lost $1000.   "No problem!" you say, "I'm in it for the long haul, and ACME is a sound company and the share price is going up slowly over time!  I'll hang on until I've made my money back!"

And that is true, the share price is going up, but that is only because inflation, if nothing else, increases share prices over time.   At the 1-2% increase in price, you'll have to hang onto ACME for decades, before you "make your money back" and break even.

The real issue is that you overpaid for the Acme Stock, not that the share price as "gone down in value".   You read an article in the press about Acme, and everyone else did, too, and the share price spiked, and that was when you bought.   Bad mistake.  Compounding this would be hanging on - perhaps.

Now, if you sold the ACME stock and looked around to see what you would want to buy, and the most attractive stock out there was ACME, because it paid a good dividend and was going up in value, well then you might want to hang onto ACME.   You overpaid for it, but if you sold it, it is what you would buy, at today's prices.   The only reason to sell, might be to take a loss on your taxes (and then re-buy it).

However, if there are other stocks out there that are clearly out-performing ACME, then maybe a better idea is to cut your losses (and take that deduction) and sell ACME and invest in WILGROCO which is going up 7% a year and pays a great dividend.

And yes, this is an "opportunity cost" argument, but here we are talking about investments - which make you money - not cars or other purchases, which are just expenses that cost you money.   Opportunity Cost arguments make sense in business and investing.  They make no sense on the sales floor of a car dealer.

So, getting back to our Condo owner, should he vote to sell to the developer or vote "nay"?   The point may be moot.  If over 80% of the owners vote "YES" then the deal goes through.  And yes, that might be "unfair" to some owners who are getting less than what they paid, or indeed, less than what they owe on their units.   Of course, of the latter, would you say that was "unfair" if what they owed was due to a cash-our re-fi they used to buy a new car and pay off credit card debt?   Debt is debt, it is not attached to things, but to you.

It is also one reason I say to "never buy a condo!" as you have no control over your own destiny.   Well, put more succinctly, you have no complete control as you do when owning a free-standing house (even then, the County can take your home and put in a freeway).  Never overpay for a condo - they are really not worth much.  You are paying for the rights to pay condo fees and special assessments, and the right to occupy.  If it is cheaper to rent, rent.

And that is the problem for our young friend.   He overpaid for his condo.   With the mortgage, condo fees and special assessments, taxes, and insurance, he is paying far more per month to own his unit than it would to rent the same unit.   And this was true at the time he bought it.  He is paying, by my estimate, well over $2000 a month not counting special assessments to own a condo that rents for about $1550 a month today, and even less at the time he bought it.

He made a very poor investment in purchasing the place.   A smarter person might have rented the same unit, and then bought it for a song in 2010.   When prices are crazy and unaffordable, a correction is always inevitable.  When consumers stop buying, prices plummet.  Supply and Demand.  The only things this law doesn't apply to are real needs, like food and water.

Would he be better off keeping the condo and waiting for it to appreciate back to his purchase price?  I think not.   Housing prices have leveled off somewhat.   These units are cheap, for the DC market, but only because of their condition, the high condo fee (Mine is $558 a month, or what I pay to live in my HOUSE in Georgia) and the constant special assessments.  And as I noted, they just raised the property taxes by 29% in one year (!!)

Yes, other condos cost more money - but they are in better shape, have a view of the city (as high-rises) and have amenities like underground parking.

And yes, it will be a challenge for some owners to find equivalent condos for the price they are being bought out at.   There are condos to be had at equivalent (or lower) prices, but few of them are adjacent a Metro station.   It will be interesting to see how this plays out.  No doubt their will be a weepy piece in the local paper about poor Bertha Lovejoy, and how she is being "forced out of her home" due to "greedy developers."

But the other side of the coin is this:  These units are 60 years old and falling apart.   A lot of the units are rented as section-8.  About half are owned by investors, and if that number exceeds 50%, FHA approved loans will no longer be available - which could cause a tail-spin in prices.   And if 80% of the place ends up being owned by investors (or a developer) then the buyout would be at market prices not 61% above market prices. 

We all want to be winners, even when we've made bad choices.   And I have done this in the past, with stocks, and yes, even Real Estate.   "Hang on!  It will turn around!"   That's what I said about my GM stock and you know how that panned out.   Lost every damn penny.  If I had sold early on, I would have lost only half.

And there are other stocks that I "hung onto" that did finally turn around, after years in the red.   Some I hung onto because, after the initial loss, they started climbing back at 5-6% and paid a dividend.  Selling those stocks - only to re-buy them - made no sense (you can't claim a tax deductible loss in an IRA).  Still others, well, I should have sold and invested in something more reasonable.    "Hanging on" for ten years to get your money back makes no sense at all.

Of course, a lot of this is based on perception of the market and future values.   Maybe these condos will shoot up in value overnight.   Maybe, but then again, maybe not.

Say you bought my condo for the "market value" of $120,000 (A Real Estate agent made a presentation on market values at the Condo meeting, and this was the value given).   You put down $20,000 and finance $100,000 at 4% (good luck with that, for a condo) for a monthly payment of $477.42

The condo fee is $558.   Annual taxes are ow $1200 a year.   Insurance is now $224.  There are no utilities.  This comes to about $1123.86 a month to own this condo.   The current rent is $1250, which is slightly more than this.   You may get a small tax deduction for the mortgage interest, but probably not a lot, for someone in that tax bracket.  And of course, this is not counting the Special Assessments, which have averaged about $3000 a year for the last few years.

If we do this math at $172,000, with a mortgage of $716.12 on $150,000, we have a monthly overhead of $1362.57, which is clearly more than the unit can rent for at the present time (by about 10%).

Fascinating calculation - note how a small increase in monthly cost equates to a huge increase in sales price.   This is one reason why condos fluctuate in value so radically compared to the rest of the market.   Since the condo fee is about the same as the monthly mortgage payment, the sales price doesn't affect the overall monthly cost as much.   Fascinating.

For the two-bedroom unit, you can see the numbers get a lot worse, as the prices are far, far higher (about $220,000), but the rents are only marginally higher (about $1500 a month).

I suppose it is a wash, in some regards.   Rents in the DC market have been going up, as they have in a lot of places.   I suppose rental values could increase somewhat over time.   On the other hand, if special assessments increase or the condo fee increases, or the units no longer qualify for FHA financing, or it turns into a section-8 ghetto, well, prices could actually fall.

But we'll see what happens.   There will be a vote, and if 80% vote for the proposal, well, they drive a bulldozer through it all.   If only 79% vote, well, it is highly unlikely that any developer will make a subsequent offer anytime soon.

The point is, when you make an investment - be it real estate, stocks, bonds or whatever, and the investment goes down in value, "hanging on" so you can emotionally "win" with that investment, could be a very poor option in every sense of the word.   Sometimes it is best to cut your losses and move on, and use your capital to invest in something more promising.

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