Sunday, April 15, 2012

Twelve Lessons from the Real Estate Boom (revised)

Twelve Lessons from the Real Estate Boom 

How I Made a Million Bucks in Real Estate - and Kept It!

(Well, OK, I spent some of it...)

The news media is rife today with stories about how "everyone" lost money in the Real Estate Market. For the most part, most of the data they present is misleading or flat-out wrong.   Getting financial advice from the news media is probably about the worst place to get it, as they tend to hype fear and panic.

For example, in the recent market downturn, the media hypes how "everyone" lost money in the stock market. I recently was reviewing one of my 401(k) funds and while it was "down" from last year, it was still worth twice what I had invested into it. If I looked at is as investment today, it has made 10-15% per year since I bought it.  Not a bad rate of return.

But the media counts this as a "loss" because it is not worth what it was a year ago. For an investor, taking such a view is a principle mistake.

It reminds me, in a way, of a homeowner on the television who was complaining about how much money he "lost" on his home.  He bought a home in a volatile region in California, and it doubled in value.  After the bubble burst, it went back down to about what he paid for it.   He whined that he had "lost" all that phantom equity in his home! In reality, the home is worth what he paid for it, and he lost nothing. If he wanted to "cash in" at the height of the market, he should have.

The problem most investors have is that they don't understand markets, money, or even basic mathematics (the big three M's) and they cling to odd ideas such as our homeowner friend or our friends in the media, who call the loss of phantom gains a "loss" when in fact the investor may still be ahead.   Bad news sells, so people tend to believe this.

If you are well-grounded and have a view of reality that is consistent with reality, investing is not hard. All you have to do is act rationally in an irrational market.   I made over a million dollars in Real Estate this way - and kept it.  It was not hard.  You can do the same thing in almost any market. Let me show you how I did it and the rules that apply.

I bought my first home when I was 22.   But I made little money on that, although it was a good tax deduction and gave me a place to live while I was in college.  In 1989, I bought my first "real" home in the Washington DC market, at the height of the bubble.  The house did not decline in value much, we could have sold it for more than we owed on it (although lost our down payment).  It was essentially flat in value for many years after that.

I learned that buying at the peak of a panic bubble is never a good idea.  But I was glad I bought a free-standing house, on two deeded lots, and not the Condo my Realtor said was "more affordable" and "luxurious".   My friends who bought brand-new condos in that era went broke.

LESSON #1: Learn from your mistakes and try not to repeat them. The lesson of the 1989 Real Estate Bubble was there for everyone to learn from - and apply - in 2009. Few remembered the earlier bubble or thought it was applicable 20 years later.

Real Estate stayed flat throughout the 1990's. Prices did not go up much, and people were "scared" of investing in Real Estate, as many of them (or their friends) had lost everything in the bubble. So demand for Real Estate dropped.

I had opened my own practice by then. Every day on the way to my rented office ($2000 a month) I drove by a row house in the historic district of Alexandria, Virginia that had a "for sale" sign on it - advertising it as office space. On a whim, I called the Broker, and was surprised to see that this building had been recently remodeled as beautiful office space, but was clearly neglected and abandoned for the last two years.

I did the math and made an offer. The market was dead back then - no one was buying. I asked them to take a second note as a down payment. We arranged financing through a local, family-run bank. To my surprise, they took the offer. A month later, after signing some papers, they handed me the keys to the place. I had bought the property for $210,000 or about half the asking price, with nothing down. The monthly carrying cost was about the same as I was paying in office space rent. It seemed like a no-brainer at the time, and it was. Yet others shied away, why?

LESSON #2: Identify real opportunities in the market that others are missing. Do the math, does it add up? Are people shying away from an investment due to psychological reasons? Opportunities are rarely well-advertised or touted in the media or "popular".

Things went well. The market was still dead. On a whim, I went to look at a foreclosure property one day. This was in 1995, and houses were still being foreclosed upon and re-sold as a result of the 1989 "bubble" (Real Estate recovers SLOWLY from bubbles, so be prepared to wait out this market a long time!).

We didn't get that property, but were able to make a good connection with the Realtor. We found a local bank and made friends with a VP, who refinanced our office building to combine the two notes into one, at a lower rate, and take out enough cash to buy a foreclosed duplex for $95,000. Again, the house was in great shape, just having been remodeled (which had bankrupted the previous owner). We finished the remodeling project ourselves (sweat equity) and rented it at a positive cash flow.

My friends told me I was insane to invest in Real Estate - "You'll lose your shirt!" they said, "Remember 1989!". But I wasn't buying properties at 1989 prices, with negative cash-flows, high interest rate adjustable notes and the other garbage that went on then (and again, two decades later). I cranked the numbers and saw that for the going rents, I could have a positive cash flow in these properties, get a great tax deduction, and make a little money in equity appreciation. It was another no-brainer.

I asked my friends what they were investing in at that point (1995) and they said "Dot Com Stocks! It's the next big thing! You should get out of Real Estate and get into Dot Com!" Well, you know how that worked out.

LESSON #3: Avoid the popular trends or whatever is being touted as the "next big thing" whether it is stocks, bonds, Real Estate, Gold, or whatever. By the time something is on the evening news or touted on a financial program, it is probably too late to invest in it.

We bought one more property, a condominium, for $38,000 to rent to a friend of ours who was having trouble with their landlord. The seller was desperate to sell the place, for less than she paid for it. Again, at the time, people were paranoid that the properties were plummeting in value and they should "get out" before they plummeted further.

In reality, the steep plummet was due to the fact that the property was overpriced a year ago. The condo sold for $35,000 when new, jumped up to $85,000 in 1989, and then dropped back to the high 30's in the 1990's.   People seeing this steep drop in the graph tended to project a further loss, which turns out to be a typically human thing to do - that is usually wrong.

But the property still has SOME residual value. It would not drop to ZERO in value. And what was that value? Well, again, you calculate the rental income, the taxes, the mortgage interest rate, the insurance, the upkeep, and you can figure out, to the dollar, what it is "worth" - how much mortgage the place will support and still generate a positive cash flow.

In retrospect, it is ridiculous that those units sold for so little - the price of a new car, today. But for nearly a year, many were on the market at those prices - and were unsold for months at a time.   I sometimes think I should have bought more, but being conservative, I did not want to go overboard on Real Estate and also be struggling to manage so many properties at the same time. With a house, an office, a duplex and a condo, I already had a lot of refrigerators, stoves, toilets, roofs, and hot water heaters to maintain, worry about, and pay for.

If the Real Estate Market had gone the other way (which, as we will see, was a function of interest rates), I could have lost it all. I made the right decision at the time.

LESSON #4: Don't Over-Do It. A good investment is a good thing. But putting all your eggs in one basket is never a good idea, even if 10 years later you'd wish you did (we cannot predict the future).

In the early 2000's, something weird started to happen. I expected my Real Estate investments to increase in value by modest amounts - perhaps 15-20% over a few years. But prices started to jump. People lost money in the stock market (the "dot com" bubble had burst) and were looking for "safe havens" to invest in. Real Estate, being tangible, looked like a good bet.

And prices were pretty low. Moreover, interest rates were dropping, so now an investment property could support a larger mortgage and still make a positive cash flow. Interest rates directly control housing prices - never forget that. Other factors are important as well - Taxes and Insurance, as we shall see.

Many folks saw these dramatic rise in prices and did the same exact (wrong) thing they did when prices had dropped a few years earlier - they projected the trend further. Just as they saw prices dropping in Real Estate in 1989 and (wrongly) assumed they would continue to drop, they saw prices rising in the 2000's and (wrongly) assumed they would continue to rise at the same rate, indefinitely.

LESSON #5: You Can't Project Trends - In fact, oftentimes outcomes are the opposite of trends. When an investment shoots up suddenly in price, it is far more likely to DROP in value than go higher. If an investment plummets in value, there is a good chance it is set to recover shortly. See, for example, my article on why buying gold is a bad idea right now.

We saw this rapid increase in prices and got nervous. At first, the increases were supportable by the lower interest rates. Properties could still be bought a positive or neutral cash flow. But then odd things started happening. Although interest rates were fairly low, many folks started opting for odd-ball mortgages with low introductory rates, so they could "flip" properties. And many folks bought properties with a negative cash flow, on the premise that they could "make" money by selling the property in a year or two.

We all know how that worked out.

LESSON #6: When an investment area starts getting crowded with people who are looking for huge, short-term gains, it is probably time to head for the door. The short-term gain people can make a lot of money this way - and lose it as well. People looking for the "big kill" in an investment tend to destabilize the market - or are a sign a market is destabilizing. It is basic control theory - and undampened system tends to have wild swings in values.

We sold the duplex at nearly the peak in the market. The prices were now nearly triple (and would eventually reach quadruple, before it all went wrong) what we had paid a few years earlier. Of course, some might say we should have "hung on" another year and gotten more money for the place, but timing the market is a very tricky thing.

We made a lot of money on that investment. Looking at the gain "we could have made" is a self-defeating exercise and often is the type of thinking that causes people to hang onto an investment too long and lose everything.

LESSON #7: Get Out While the Getting is Good: If you can take a huge gain in an investment, then do it. Hanging onto a stock that shoots up in value, on the premise that it will go even higher, is a sure recipe for riding it all the way back down to the bottom. If you can double your money in ANYTHING, then cash out at least a portion of the investment to secure your gain. Holding on for the "peak" is nearly impossible to do.

Using Starker deferred exchange, we used the gain from that transaction to buy two condominiums in Florida. While the DC market was hot, the Florida market was insane. Prices were jumping like mad. We bought for a fairly reasonable price and enjoyed the condos for a few years.

But investing the Florida market was problematic. People were acting very wild-eyed and crazy, and saying very odd things to themselves. I am not sure that drugs were not involved, given the actions of some of the people. Trying to buy Real Estate there was hard to do, as many folks simply out-bid you at crazy prices.

Compounding this was the high taxes and insurance involved. Due to Florida's well-meaning but toxic "homesteading" laws, many people paid little in Real Estate taxes. Since there was no State Income Tax, nearly all revenue was derived from Property Taxes. As a result, new buyers were taxed at nearly face value, to make up for the millions of older people paying only a small percentage of their real tax values.

After a couple of hurricanes, flood and hurricane insurance also went through the roof. Homeowners insurance, in a State notorious for its Personal Injury lawyers, was also very high.

Taking the cost of Flood, Wind, Homeowners insurance, plus property taxes, and you could easily be spending $1000 to $2000 a month before you even address the underlying mortgage.

And then there are Condo fees. While Florida law is supposed to protect against such things, many investors would shout down condo boards and try to slash condo fees to the bone. As a result, maintenance gets deferred, and there are no reserves for the Association. When a major repair is needed, Condo owners end up getting assessed $10,000 to $20,000 for repairs. The investors, in the meantime, have sold out, their prices being artificially boosted by unrealistically low condo fees.

We through about buying more Florida Real Estate, but this "perfect storm" of overinflated prices, high insurance, high taxes, and high condo assessments was brewing on the horizon. In addition, we found Florida to be crowded, noisy and dirty. The State was subject to so much in-migration that it was getting out of hand. We decided to sell, and did so nearly at the peak of the market.

LESSON #8: Other costs associated with Real Estate, including Taxes and Insurance, can decrease the value of the investment, as they decrease the amount of money available to support a mortgage on a property.

While this is slightly out of order, at about the same time, an investor literally knocked on the door of our personal home and offered us more than three times what we paid for it, if we would leave in 30 days, so he could knock it down and build two houses on the property. Without batting an eye, we said "YES". It was the best decision we ever made.

LESSON #9: BUY FREESTANDING REAL ESTATE - When you buy a Condo, you are only buying the right to occupy a part of a building. But when you buy free-standing Real Estate, you are buying the underlying land, which can be worth more than the improvements. In our case, two deeded lots in Fairfax County were worth more than the house itself - far more.

Most of our neighbors sold as well. Some said they didn't want to sell, as they were "emotionally attached" to their properties. One lady, a widow, took that stance, initially (listening to bad advice from another neighbor). But I asked her, did she think her house would ever be worth as much again in her lifetime? The next day, a pipe burst in her 60-year-old home and that sealed the deal. She was taking the $700,000 and going to live "happily every after" rather than staying in a decaying older home, "to make a point".

LESSON #10: Emotions have no place in investing. If the County wants to build a freeway through your home, saying you will "never sell" is idiotic. Get the best price you can (make a profit) and move on. Turning down "once in a lifetime" deals out of sentimentality is just idiotic.

We bought a home on Jekyll Island, Georgia, and now have a vacation home in New York. Both were reasonably priced and in markets that did not see the rapid rise in prices during the 2000's. And not surprisingly, both have held their values fairly well. We sold the office building at the near-peak of the market, but still have the Virginia condo. While the condo is not worth the $200,000 it would have fetched at the "peak" of the market, it is still worth over $100,000, which is far more than the $38,000 we paid for it.

LESSON #11: Real Estate can still be a good investment - as a traditional investment for the "long haul". While the boom/bust cycle has occurred yet again, this does not mean that Real Estate is now worthless. We are back to the "normal" market of a few years ago.

With regard to Lesson #11, the same can be applied to those "Dot Com" stocks. When the bubble burst, many people panic-sold and got out. While most of those stocks were "dogs", there were a few that ended up being viable Internet companies. Smart investors at the time took advantage of the panic (emotional reactions of others) and bought a few diamonds in the rough. At times like that, the best bargains may be found. In some Real Estate markets, the same is true today.

As in the 1990's, I expect that Real Estate will not increase dramatically in value over the next decade. We will see minor increases across the board. Pain will continue to occur in the hyped-up markets of Nevada and Florida, as more and more foreclosed properties reach the market. But eventually, prices will drop to the point where people say "Wait a minute, this is a freaking bargain!". It has already happened in parts of Florida, where houses selling for over half a million a few years back, are being sold at auction for less than a hundred grand. Once again, Florida is becoming the affordable retirement State for people from the North.

My prediction is that it will be 2015 before the market fully recovers and we see the foreclosures dampen down and prices start to rise on a regular basis. Of course, maybe by then, people will have forgotten 2009 and start doing crazy things again. Let's hope not!

LESSON #12: SEE LESSON #1!!!!!

UPDATE:  April 2012:   Since I wrote this blog, we sold the vacation home.  Why?  Well, while it was possible to own several properties at once, on a fairly modest income, it was possible only to do so when they were rented out.  The rents support the properties.

Your personal residence does not generate income, but is an expense, as is a vacation home.  I learned Lesson #13 in assuming I could afford the cash-flow on two homes, even if one was not mortgaged.  Property taxes, utilities, insurance, upkeep, and the like, can cost thousands of dollars a year (about $10,000 for my primary residence).

In retrospect, we should have seasonally RENTED both properties when not occupied.  One had an "in-law" apartment that could easily have been rented to a college student when we were not there.  This would have paid the property taxes, easily.

Lesson #14 - never over-improve a property!  We adding over $100,000 in improvements to one home, when the market clearly wouldn't support it.   We sold that property, took a $100,000 loss and learned a painful lesson!

Lesson #15 - never confuse brilliance with just getting lucky.   Perhaps, given our success in the Real Estate market, we thought we were immune from difficulties.   However, this was not the case.  But, on the positive side, we took action, got out, and are now debt-free.   And still have that million bucks, too.

The secret now is lesson #1 - don't make the same mistakes over and over again.   A house is a place to live, and throwing money into it in "upgrades" and remodels is just tossing money away.   Unless something is broken or worn out, learn to appreciate your house the way it is.