Finshing Jim's Model and starting Pablo's

Last post we talked about figuring out how Jim's one house was going to grow in value over 20 years. We got up to year 15, where he only owed just over $1,000 on his house, which was now worth $365,000 and generated more than $2,000 a month in rental revenue.

Today let's talk about what's happening in year 16, when Jim starts saving for rental home #2, and let's see what happens from then until year 20, when our model will stop.

Going into year 16 we make a couple of manual modifications to our model. We have to modify the equity that we're taking to no longer account for our debt (because there no longer will be any), and we have to modify our income (which stands for annual income after expenses). Instead of subtracting the annual mortgage payments ($14,483) we only need to subtract $1,174, which is the amount left in our mortgage.

At the end of year 16 the house is now earning $25,950 a year after property taxes and insurance. In addition Jim now has $24,961 in his bank account. But since houses are now worth $377,000 in his area and we want to put 10% down, we're going to wait another year before buying.

In Year 17 the picture changes. We now have $50,000 in the bank, and with houses costing $388,00 Jim is going to go ahead and buy one. We then create a second set of columns for the second house and expand upon them.


The result is that at the end of 20 years Jim has a annual income (after property taxes, mortgage payments and insurance) of nearly $35,000. At the rate things are going, he will pay off the second house in less than 5 more years (year 25) at which point he'll have an annual income of more than $70,000 (after property taxes and insurance). If Jim is 30 years old, then he can look forward to having nearly a full salary each year just from his business, not even beginning to count the savings he hopefully has put aside for retirement through his day job.

Now this result needs some very important explanations. One critical assumption here is that there are no repairs needed on a property (which is practically impossible). The second is that he has no vacancies (much more plausible, but still difficult).

So our final result for Jim is that after 20 years:
Houses: 2
Annual mortgage liability: $26,000
Annual income after mortgages/taxes/insurance: $35,000
Equity: $590,000

Now on to Pablo. Without having done the math here, I'd like to make the hypothesis that Pablo is going to be worth a tremendous amount more, but also be on the hook for an amazingly large amount of money each year. Remember that while Jim was pouring his returns into paying down existing mortgages, Pablo is going to be saving his returns until he can purchase a new rental property.

The math is going to be the same, except that we are going to have to include a new column for Pablo that holds his savings. I'll leave the calculations out of the article, since it's essentially the same as Jim, just more numerous. After year 7, Pablo has saved up $33,752, while houses in his area are worth $297,691. Therefore he now more than a 10% down payment and can go shopping for another house.


So we begin the dance with two homes, and again Pablo will be saving up for his third home. Predictably, this home take far less time to save for, and Pablo can now purchase his third home in only 4 more years. So in year 12, his account sheet might look something like this, right before he buys a third house:


This will keep compounding, so let's just cut to the big finish.

drum roll please.....

In year 20, Pablo's company looks like this:
Houses: 6
Annual mortgage liability: $132,102
Annual income after mortgages/taxes/insurance: $42,254
Equity: $902,459

By running some simple numbers we can conclude that Jim enjoyed an annualized return of 13.5% on his investment and Pablo earned a very impressive 16% return. And that was assuming a rather conservative annualized appreciation of 3% a year. And this was only on the original $47,000. Neither Jim nor Pablo put any of their own money into their business after the initial infusion.

So we can come to the final answer that after 20 years, Pablo's more reckless style of investing has pushing his annual return up by 2.5% (which is a very significant number) but at the cost of quintupling his risk (507% the annual liability of Jim). Obviously, most investors want to play it somewhere in the middle. The more leveraged you are (meaning a larger number of mortgages) the faster your money grows, but that money will have to be paid back whether or not you manage to collect rent.

I just want to make a few small notes to conclude:

• Neither Jim nor Pablo put any of the money aside in case of emergencies and or vacancies. This was very foolish of both of them. One possible modification to the model could be saving 10% of their annual rental income for emergencies. Which is the inspiration for the picture at the top of the post.
  
• Both Jim and Pablo will end up multi-millionaires by the time they retire IF they continue to save from their employment income and invest it either in other house or stocks (or hopefully both). They'd be fools not to continue to save aggressively.
  
• While Pablo's model pushes hard for equity growth, it's easy to see how Jim's model is great for cashflow. One possibility is melding the two models. Start by expanding aggressively (but not beyond your means) and then eventually switch over to Jim's system and pay off your mortgages one at a time. That could provide some serious income.
  
• Bear in mind that even if you disregard risk, Pablo is also managing 3 times as many houses as Jim. That's a lot of work and a lot of time. Jim's method might have been less lucrative, but it's also much more manageable by a busy investor. Keeping two houses occupied and their tenant's happy is by no means a full-time job, but it's gets harder with each unit you add to the mix.
  

The makings of a model

In this series we've been discussing how to use a little math and a lot of Excel to help you make better decisions in your investment activities. Landlord Schmandlord posts one of the landlord's great questions "Is it better to pay off each house, or buy when you have enough for a new down payment?" We've chosen to attempt to answer the question with two hypothetical people, Jim and Pablo.

Jim is our conservative investor. He plans on piping all of his excess cash flow into paying down his mortgage on his first rental property before purchasing a second. You can see a list of our complete set of assumptions here. Let's look at how we might go about calculating Jim's possible return...

Start by opening a new spreadsheet. Let's reserve the top two rows for the numbers our assumptions have gotten us. In fact, lets go ahead and put in our assumptions in the top two rows right now.

Let's go ahead and enter in the starting cost of our first home as well. We've decided to pay $235,000, and since we're giving Jim a 20% down payment, that means he's put $47,000 down on it. Now some of the math we'll do here (because it's fun) and some of the math we'll have done for us (to show that the answers you seek can often be found via the internet with a minimum of work done by you). The next step is to calculate our monthly payment. To do this we can simply go to any of a million mortgage calculators on the internet, through I prefer Bankrate.com. The monthly payment on our mortgage is $1206.89.

So now it time to do a little spreadsheet magic. So now that we have our assumptions, now we want to model his performance year after year. Let's start by figuring out his totals at the beginning of our test period. At the beginning (or Year 0), Jim owes $188,000 (the cost of the home - the down payment, or C4 - C5). He has $47,000 in equity.

His net income is equal to his gross income - his costs. We can calculate his gross income by multiplying his monthly rent by 12 (L1 * 12), for a total income of $18,000. His costs are his mortgage and his taxes and fees. His mortgage is a fixed amount so we can calculate that he will be paying $14,483 a year(D5), and his taxes are equal to .005 of the cost of his house (which we can calculate by adding his equity and his debt, or C7 + D7).

By putting that all together we figure out that the formula for his first year of income is equal to:
=(L1 * 12) - (D5 + .005 * (C7 + D7)) for an income of $2,342.

That's how much he's going to make after taxes, insurance and mortgage payments are made. To figure out his totals in Year 1 is going to take some slightly more complicated math. First let's start with his debt. The amount of Debt he owes at the end of year 1 is is equal to the debt he owed 1 year ago minus whatever principal he paid off. To calculate the amount of principal he paid off through his mortgage we're going to use a simple formula (which isn't perfect, but it's close enough). Last year he owed $188,000 and paid 6.65% interest on that (D7 * I2) for a total of $12,502. Therefore $1,981 was left over in his mortgage payments to pay off principal (D5 - (D7 * I2)). But we can't stop there. Jim is also going to be piping in the $2342 he earned from rent (F7).

So the formula we can use to determine the amount he owes at the end of his first year is:
=D7 - ((D5 - (D7 * I2)) + F7)

Now let's look at his equity. To figure out what our equity in the house is worth we follow a simple formula. Figure out what the house is worth, and then subtract what we owe. To figure out what the house is worth we use a slightly more complicated formula than we've been using so far:
(value of the house) = (starting value) * (1.0 + appreciation rate)^(number of years)

or in other words: =C4*((I1+1.0)^(B8)). To get to the equity in the house from there, we can simply subtract the Debt we have (D8).

Now we have to figure out what our rental income will be. While the mortgage payments have stayed the same, our rent and our taxes have increased slightly. We can calculate how much the rent has changed by using the same formula we used for the value of the home, but changing the starting value to starting rent, and the appreciation rate to the rent growth rate. To get the taxes value we use the same formula as before ( .005 * (equity + debt)).

That leaves us with a rental income formula of:
=((L1*12)*((L2 + 1)^(B8)) - ((C8+D8)*O1) - D5)

If you don't understand any of this go back and try again. The formulas look daunting, but if you take out a pen and paper and write out the word version of the formulas, then substitute the values, it should become clearer. So far we've been using math that anyone should be able to use (the only tricky part is explaining the formula to figure out the value of the home in a given year. Just take my word on that one.)

At this point we can extrapolate the formulas we've used for the end of year 1 for the end of year 2 (replacing year 0 numbers with year 1 numbers). We can quickly figure out the rental income, equity and debt of Jim in this model for any year...


We can see that by the end of year 15, Jim is making $11,730 a year in rental income and only owes another $1,174 on his rental home. It's getting late, and while the math and spreadsheet calculations I've been doing haven't been very trying, writing about them can be. So I'll leave off here with plenty of information to digest. Next time we'll see what happens in year 16 when Jim pays off his first mortgage and starts saving up for a down payment on a second rental home.

I'm finally married

I won't bore you with the details, but I finally said "I do" on Saturday the 16th. Both my new bride and I had a blast (though we're both still completely wiped out, but even so it's nice to get back to our more regular routines.

The post I had intended to write prior to the wedding was in response to a blog post I had read the week prior to that. Again by the infamous Casey (of '$2 million in debt by 24' fame), I was simply stunned by what I had read. As a real estate investor AND a new husband, let me give you some general advice about how to reconcile the two.

[...] right before the wedding, she found out that I was really “broke as a joke”. I even bought the ring on a credit card and went into debt for the marriage expenses. She came into the relationship with no debt and excellent credit expecting stability and married into a financial storm without really knowing it.

My sister got engaged and never really considered something like pre-marital counseling because to her it had religious connotations that she wasn't comfortable with. After she got married one of her friends was proposed to and told my sister that she and her fiance were attending some pre-martial counseling. Very curious, my sister asked "what exactly do they do at your counseling sessions?" Her friend told her that they were talking about sharing the workload at home (chores and such), going over finances, and opening up about all the things you don't typically talk about in polite company (your credit cards, salaries, and past). Stunned, my sister asked "Don't engaged people normally talk about that anyways?"

As Casey has pointed out to us, the answer is no. But there is really no excuse for that, as a married couple you should both be completely aware of each other's situation. Months before we had the ceremony, I sat my wife down, told her were all of my bank accounts were, gave her the addresses to all of the properties I have an ownership interest in and broke down the finances for each of them. She probably doesn't remember much in the way of specifics, but I showed here where I kept my books.

If I were struck by lightning on my wedding night and killed (which thankfully I wasn't), I'm confident that between my partner (Biff) and my wife, my estate would be properly taken care of. And that's really what it's about, making sure that her decision to get married is a fully informed one, and making certain that she'd be able to continue if I was incapacitated.

This has to be an even greater concern for solo investors. What if you were put into a coma for a month, would your spouse be able to keep your investments afloat during that time? Maybe he/she doesn't have the knack for investing/landlording and couldn't run your company for the next 10 years, but does your spouse know what houses you own, how many and where they are?

I told her not to worry about it. I have it under control.

These are words that I believe should never be uttered between husband and wife, except in trivial matters. I say that because the two are a partnership and whenever one has something to worry about, both have something to worry about. And even if you do take the lead in a situation, your spouse should be fully informed of that situation at all times. The notion of "Don't worry about it" harks back to a time when one spouse would dominate the other, and thus hold all the power and all the responsibility.

I’ve set some high expectations. No wonder she is feeling disappointed. I owe it to her to make it right.

What every husband owes his wife, and every wife owes her husband is to simply be themselves. The only expectation of you is to treat your spouse with honesty, respect and courtesy. After that, all burdens are shared equally by both of you. Any person who is disappointed in their marriage because the wealth isn't as great as they thought it would be is simply a fool to begin with.

And of course all of this comes around full circle. Being in real estate investing isn't like stocks, it's more like owning a small business. As such, it's easy to exaggerate wealth (and many people I know do) in order to impress people. But if the person you are trying to impress is your fiance, then maybe you're investing for the wrong reasons.

The good investors I've met don't invest to impress people and woo women, they do it for future security and, sometimes, for fun. And as good investors, they make sure that their investments are placed in a position to be well handled should ill tidings befall them. And as good spouses, they are equally concerned that their significant others should be able to handle their estates should the worst happen.

I'm extremely excited to start my new life with my new wife. She fully knows all of the risks I take by investing (especially in this choppy market) and she also knows all of the potential rewards. But win or lose, we'll go through it together and share the burdens or the riches equally. It's going to be a lot of fun.

P.S. Someone wrote a comment that said "If you want to get rich, don't marry". Actually he's wrong. The real rule is, "If you want to get rich, marry happily, don't get a divorce, and don't have kids". Married couples without children really collect the cash. Any potential taxation negatives are more then made up by lower averaged living expenses and financial accountability. But bear in mind that while finance should be a consideration when deciding on marriage and kids, they should obviously not be the only consideration.

Building a Model for Real Estate

In my last post I discussed the most crucial, most criticized and most remembered part of putting together a mathematical model: the assumptions. Today we are going to open up Excel (or some other spreadsheet program) and begin the fun work of making the model work.

But first I want to go back really quickly and respond to a comment made in my last post. While I supported most of my assumptions with historical evidence, I didn't provide links to one crucial assumption, the rate I expect house prices to appreciate. I claimed that historically housing prices were relatively close (within a percent or two) of inflation. The simplest evidence of home prices against inflation can be found in the US. Census Bureau:

Median US Home Price: Adjusted to 2000 Dollars

1940	1950	1960	1970	1980	1990	2000
$30,600	$44,600	$58,600	$65,300	$93,400	$101,100	$119,600

Extracting from that data you can determine that the annualized rate of return (adjusted for inflation) on a house bought in 1950 (and sold in 2000) is 1.99%, the annual return for a house bought in 1960 was 1.8%, for a house bought in 1970 is 2.04%. Most calculations regarding home data tends to omit the 1940's because of the effect World War 2 had on skewing housing statistics. So you can see that it's safe bet that housing since World War 2 has has a somewhat stable return over long periods of time of around 2%.

We're going to forget the original scenario of Jim and Pablo for a minute (which is quite complicated) and instead take a look at this scenario. When I quoted my number of 3% I hadn't really done any calculations to justify it, other than looking at a chart or two. But it's a great example of how we could use a model to figure out where housing currently is (according to historical trends) and what will happen to it over the next 20 years.

So all of the data that we extract came from 2000 or before (which makes sense because it came from the Census, who won't collect more data until 2010). So the current bubble isn't part of our records. Let's see where it fits, and how to do an extremely simple model of home prices. Since it's currently the year 2006, doing calculations using 2000 dollars doesn't make much sense, so first let's update our figures to 2006 dollars. The formula to do this is simple:

2006 value = 2000 value * (2001 inflation) * (2002 inflation) * (2003 inflation)....

We can grab the inflation numbers from the US Bureau of Labor Statistics (the inflation rate is the % change, located in the far right column). In other words, the median home price in 2000, adjusted for 2002 dollars is equal to:

$119,700 * 1.028 (inflation in 2001 was 2.8%) * 1.016 (the rate of inflation in 2002 was 1.6%) = $125,020

Extrapolating this up to 2006 dollars means that adjusted to today's dollars, the median home in 2000 was worth $135,700. If you are still trying to understand why we are adjusting for inflation, just remember that the value of a dollar changes over time. Changing from 2000 dollars to 2006 dollars may not seem significant, but a movie ticket that cost $0.25 in 1924 would cost $6.40 in 2006 (it must be a matinee). The bottom line is that your dollar isn't worth as much today as it was 5 years ago, so hopefully you have more dollars lying around.

Open up a spread sheet and choose a random square over to the right side of the sheet and insert a 1.02 there. That's our rate of return (adjusted for inflation). Then starting a column on the left side put our number of $135,700 (you can also put the year, 2000, to make it easier to keep track).

Right below the home value, we want to create a little formula that takes our 2000 value, and multiplies it by 1.02 (to account for our 2% appreciation, adjusted for inflation). If you do this right, you should see a value very close to $138,414 in that box. Then for 2002, we want to multiply our 2001 figure by 1.02 again. And so on, until we get to 2006.

In the above photo you can see in the fx box (at the top) the formula I have for square B4. What this tells us is that according to the model we just made, the median US home right now should be worth about $152,820. With the current median price of a US home at about $217,900, we can see that our model thinks that the US home market is currently over-priced by about 27%. (In other words, if the median home fell by 27% tomorrow, the market would be extremely close to our model.

Now it's time to point out the potential flaw in our model. The first was discussed at great length in our last post, the assumptions. Because this model is extremely simple, we only have one real assumption, that US home prices will appreciate at about 2% over inflation. If that's wrong, the entire basis of our model is off. Whether or not it's a reasonable assumption to make is left in your hands to decide.

So where is it going in the future? We can mock up a simple model for this as well. Let's assume that the average rate of inflation from 2000 to 2020 in 3% and that homes will average a 2% gain over that. Therefore homes will increase in value by 5% a year. We can go back to our spreadsheet, update the percent gain and then extrapolate the model to the year 2020:

In addition we can make ourselves the nice little chart that we saw up at the top of the post. So using our model we can predict the following:

Median US Home Price: Modelled

2000	2006	2010	2015	2020
$119,600	$160,275	$194,815	$248,639	$317,334

With the current median price of a US home at about $217,900, we can see that to reach a predicted value of about $317,600 in 2020, we'll be looking at growth of 2.77% each year (that's 2.77% flat out, not on top of inflation). That's actually pretty damn close to my original estimate of 3% a year.

Now about annualized returns, this doesn't mean that housing will go about by close to 2.77% this year and close to 2.77% next year and so on. The yearly fluctuations can be tremendous. Let's pretend that you hold a stock that you bought for $100. It gets some good press and gains 100% that year (ending at $200). The following year one of their products goes bad and they lose 25% (bringing it back to $150). Over the two year you held the stock, you gain 50%, which is an annual gain of about 22.5%. (note that it's not 25%. Due to the effects of compounding interest you can't just divide the total gain by the number of years you held it).

Housing is the same way as stocks. One year it may do well, the next it may not. We can get to our annualized gain of 2.77% over the next 14 years in many ways. Maybe it will climb 8% in 2007, maybe it will fall 30%. The model we constructed simply suggests that if you buy a house today and sell it in 2020 it will have appreciated by just less than 3% a year.

One final flaw to point out, this model uses national data which is nearly useless in real estate investing. Every local real estate market is different and every one could have it's own model made. While I would expect the US average to somewhat follow this model, it's practically impossible to invest in the US real estate average. If I think that stocks as a whole are going up by 20% in the next 2 years, I can invest on that theory by buying shares of an S&P 500
index fund. I cannot do the same with real estate.

That's both good and bad news. Some markets, like Phoenix, Washington DC and most of California are probably going to perform far worse than this model over the next14 years because they were pushing the national median up. Other places, such as most of the South and Midwest, could very likely outperform this model.

You could make a similar model yourself by looking up sale histories or appraisal histories in your town (both are public knowledge, and usually on the web at the county assessor's office) and determine if your market is currently above the predicted values or below.

So that's an extremely simple model. The next post I'm am probably going to talk about bit about marriage and money (since I am getting married a week from Saturday), and then I'll get back to dealing with our original question of who performs better, Jim or Pablo?

Ciao,
The Landlord

Doing the Math, How to Reinvest Your Gains

Landlord Schmandlord wrote a blog post on the 1st about whether it is better to pay off an existing mortgage with your profits, or reinvest in a new home. He makes some solid claims in there about getting higher returns and greater tax advantages by reinvesting your profits into a new property, and then ends his post with a call to "What do you guys think?" I've never been the short to back down from a challenge, so being a very techincal sort of person, I decided to go ahead and model his two scenarios and do the math to see which plan is better and by how much. And as I sat down and considered how I'd approach this, I realized that it's a great opportunity to share with you how I go about making models. Using only Excel and an internet connection, I'm going to walk you through how I go about trying to answer questions like these.

To be honest, I'm a bit of a geek and modelling is one of the more fun aspects of investing (at least for me). Questions like this are what I invest for. Afterall, it's extremely applicable (should I work on only one house at a time?) but the answer isn't immeaditely clear. For those of us that are less mathematically inclined, I'll try to give good layman explinations of everything I do, and what each figure means. My goal is for you to walk away after reading this and feel like you have a good understanding of how to approach a similar problem in the future (maybe when looking at buying a new investment property later on).

We're going to compare two scenarios, Jim and Pablo. Jim is going to buy a house and use all the profits from that house to pay off the mortgage. Once his mortgage is paid off, he'll save up for another down payment and do the same thing with a second house. Pablo, on the other hand, will save his profits from his first house until he has enough to make a down payment on a second. He'll then buy his second and save for his third. His mortgages will be paid strictly according to schedule. We'll project their networths 20 years from the start date and see who made it out on top.

The first thing we need to talk about are assumptions. There are many variables involved in real estate, things that we don't have a solid answer to until they actually happen (what will Jim's mortgage rate be? How much will it cost Pablo to fix a leaky roof? 10 years from now, what will rents be?). Since we can't claim to know the answers to these questions, we'll just build estimates into our model. Some of our assumptions will be as follows (with the important figures highlighted in red):

• Our mortgages will all be secured at 6.65%. According to Freddie Mac, the average mortgage secured last week was 6.14%. But we don't want to pay points (the average borrower paid 0.4) and a non-owner-occupied property usually gets a slightly higher rate.
• Our first house (for each) will be bought at $235,000. The median home price for Q3 in the US was $232,300.
• Our rents will start out at $1,500 per month. As I wrote in an earlier post about pricing, a common goal is to get rent to equal 1% of the value of the property, but that typically isn't possible with single family homes.
• The value of the homes will increase by an average of 3% a year over the next 20 years. Yes this is probably on the conservative side, but not by too much. Traditionally real estate appreciates at a pace just ahead of inflation, and we are coming down from one of the biggest bubbles of all-time.
• Rents will increase by 3% a year as well. For obvious reasons, rents go up when prices go up, and can come back down when prices come down.
• Annual taxes, insurance and association fees will equal 0.5% of the current value of the home (taxes will go up, even with a fixed rate mortgage).
• Jim and Pablo will only buy a house when they think it can produce a positive cashflow. Under our model that will mean a down payment of 10%.
• Jim and Pablo will each start out with 1 house, 20% down. The reason they start with 20% down is to help speed up the model and exaggerate the differences between the two, and do so while making very realistic starting conditions.
  

This is turning into a far longer article than I had originally anticipated, so I think I'll leave off here and pick it up again later.

But I'd like to take a second to talk about assumptions. Most everyone has heard that good old saying, "Assumptions make an ASS out of U and ME" (if you don't get it, just write the bolded letter down on a piece of paper).

Anyone who has every done mathematical proofs in college can attest to the fact that assumptions are everything. Many a mathematician has been told "your proof is untouchable... but I disgree with your assumptions." For example, I can mathematical prove the number of angel that can dance on the head of a pin, if I make an assumption about the size of an angel. The math I do may be perfect, but if the assumption is wrong all my work is for naught.

Maybe a more hard hitting example might be that infamous flipper Casey Serin. His business model (whether he realizes it or not) was validated in his head by the assumption that real estate prices would continue to climb. When that assumption failed, his entire "business" came crashing down around him, now he's on the hook for over $2 million. In fact you can take any business model and validate it or destroy it simply by changing the assumptions.

Assumptions are pretty scary stuff, they can destroy a business. So where are we supposed to get assumptions from? Well, like most "expert opinions", assumptions are simply guesses. Will real estate return an annualized 3% over the next 20 years? No one will know that until 2026.

So when choosing your assumptions, consider two things carefully.
What is the historical average? Housing has historically increased at a rate just over inflation. Unless you have some solid evidence that suggests that the historical trend will change, stay close to the trend.

Be pessimistic. In most things I want people to be optomistic. I'm a huge fan of the theory of self-fulfilling prophecies, that the act of believing something greatly increases it's chances of occuring. For example a student who honestly believes he's going to fail a class is always going to underperform an equal student who think he could do well (if you hadn't noticed the connection yet, the picture at the top is of Oedipus, a very famous self-fulfilling prophecy). But while I think that every entreprenuer needs to be hopelessly optomistic about their ventures, when making models I propose the opposite. Because if your model can withstand the worst conditions you forsee, then when things actually go well you'll be in fantastic shape.

Currently, in most of my models, I assume a annualized 3% appreciation from real estate over the next 15 years or so, which I believe is a fairly conservative estimate (depending on your area. Vegas and Phoenix might be lucky to average a annualized 3% return over 15 years). Over a shorter timeline, I'm much more pessimistic. Since the area I own in didn't over-inflate as much as the major cities, I tend to look at near 0% appreciation for the next 3-4 years (as a worst case scenario).

I'll continue this tomorrow when we go about setting up Excel to try to model Jim's busines


Updated: I just reached a major milestone. This was the first post I've written that contained no misspellings! Spellcheck just gave me the big thumb's up!

On Get Rich Quick Gurus....

I read a fabulous article the other day that I had to share. The title of the article is The Fallacy of Success and it was written in 1909. As you read it (or just the few passages I will comment on here) think of the dozens of late-night infomercials you've seen that will teach you to make millions in the next 1-5 years through No Money Down!

The author openly mocks "Success" authors, with a fictitious quote from a book about how to succeed at cards:

"In playing cards it is very necessary to avoid the mistake (commonly made by maudlin humanitarians and Free Traders) of permitting your opponent to win the game. You must have grit and snap and go in to win. The days of idealism and superstition are over. We live in a time of science and hard common sense, and it has now been definitely proved that in any game where two are playing IF ONE DOES NOT WIN THE OTHER WILL."

He follows that up with the quip, "It is all very stirring, of course; but I confess that if I were playing cards I would rather have some decent little book which told me the rules of the game." Then he continues on to recount an actual article he found in a popular magazine (probably akin to People today, or US Weekly). The article claims to describe the Instinct that Makes People Rich. It begins by recounting the story of Cornelius Vanderbilt, an American railroad tycoon and ends by telling us that "The precise opportunities that fell to him do not occur to us. [...] we can follow his general methods; we can seize those opportunities that are given us, and give ourselves a very fair chance of attaining riches". Of this extremely vague advice, Chesterton remarks:

In such strange utterances we see quite clearly what is really at the bottom of all these articles and books. It is not mere business; it is not even mere cynicism. It is mysticism; the horrible mysticism of money. The writer of that passage did not really have the remotest notion of how Vanderbilt made his money, or of how anybody else is to make his. He does, indeed, conclude his remarks by advocating some scheme; but it has nothing in the world to do with Vanderbilt. He merely wished to prostrate himself before the mystery of a millionaire.

When Chesterton wrote this in 1909 he obviously could not have known about Robert Allen, Carleton Sheets, Robert Kiyosaki or any of the other self-proclaimed "gurus" would start marketing their systems on late night cable. So the only possible conclusion is that marketers like these are nothing new. They are simply passing along the same advice that's been sold for over 100 years (and probably much longer.

An astute reader will note an uncommon similarity between the closing of the article ("we can seize those opportunities that are given us, and give ourselves a very fair chance of attaining riches") and the article I wrote on the lucky rich ("then watch for profitable opportunities and seize them"). Both make vague references to these mystic opportunities that occur which you can grab and wealth will be yours. However there's a difference between their madness and mine.

I will willingly admit that I have no idea what those opportunities are like. I'm vague about those opportunities because I lack the ability to describe them better. I know these opportunities exist because of how others (like Bill Gates or Steve Jobs) have seized them, but that hardly makes me an expert.

The entire purpose of my previous article was to dissuade readers from relying on the dream of the lucky rich to fuel their future. While I don't know about how to create hundreds of millions of dollars in wealth in the next 10 years, I do know how to create $1 million in wealth over the next 20 (currently on track to break my first million in my mid 30's, without any windfalls or inheritances).

Are you aiming to join the wealthy elite with net-worths over $50 million? Best of luck, I know it's possible to get there and I'll cheer you on all the way, but don't ask me for guidance. The best I can do is help you try to build that $2-$5 million safety net... You know... Just in case that huge deal doesn't go through...

How will you become rich?

Surveys are a funny thing. They are often cited (especially on news networks like CNN, who think that the release of a new poll is, for some unknown reason, newsworthy). The scientific flaws that confront polls are daunting. For one thing, polls cannot tell you what a person thinks, only what he's willing to admit out loud. Secondly, the phrasing used in a poll can alter the results in drastic ways.

Think back to the 2004 presidential election when Bush won in a close election. The major story for the following months was "moral values" and how that issue won the election for Bush. The power of this "moral values" voter bloc was indicative of a major swing in American society, and a result of the growing divide between the "Red" states and the "Blue" states.

There was just one small problem... This "moral values" demographic was simply a creation of the pollsters. Were moral values an equally powerful voting motive in 2000? Or 1996? We'll never know, because no one ever asked those voters if "moral values" were a major instrument in deciding their vote. This exceptional article illustrates far better than I the myth of the "moral values" voter.

So if you took a survey of real estate investors and asked them why they do what they do, I'm certainly you'd have a group of outliers who claimed to invest for "societal benefit" or "future management experience" or other nonsense. But the vast majority of real estate investor would probably honestly answer your question and tell you that they do it for financial gain.

That's the dream isn't it? The beach side mansion, the personal jet, the lavish trips to Europe, the beautiful cloths and huge parties. We may not expect all of these things, but they are certainly part of the dream that drives us. We are investing in real estate to get rich, or as close to rich as we possibly can.

The rich in America can be divided into two groups, the patient rich and the lucky rich. I'm sure that there is going to be a lot of scoffing at my division, much less the names I've assigned the two groups, but be patient and bear with me as I explain.

By now books like The Millionaire Next Door have publicized the idea of the patient rich to the point where I don't feel the need to over explain the concept. These are the people who save patiently their entire lives. They live below their means, save everything that they can, and invest their saving for the long-term. Getting rich in this way is not difficult (anyone with an income can do it with enough discipline), but it takes a frustrating amount of time to achieve, and after living such a disciplined lifestyle for so long, it's unlikely that when you break the 7 or 8 digit barrier you are going to run out and drink $500 champagne every night.

So it's the lucky rich that I want to talk about. This group involves a diverse groups of people ranging from Tom Cruise to Donald Trump to Kobe Bryant to Bill Gates. Already I hear the protests, "but [insert rich person's name here] works hard for his/her money. He/she earns every penny paid to him/her". That's almost certainly true. I've never met a wealthy man who didn't work extremely hard for his money. But I've also met many not-wealthy people who work equally hard for their money. What's the difference?

Let's look at Tom Cruise for a minute. Though acting sounds very glamorous, I've heard stories about the grueling lifestyles that many successful actors face. They work 18 hour days, often have to gain or lose large amounts of weight in short periods of time, and can spend months living in trailers away from home. The most successful actors are often perfectionists to the point of obsession. It's easy to see why they earn millions of dollars a film instead of the high school dropout who is waiting tables in L.A. But there are many very hard working aspiring actors in L.A. as well who are still earning almost nothing. Why is Tom Cruise a millionaire and they are earning below average salaries?

Bill Gates created a software company that has made him the wealthiest man in the world. I've known and read about dozens of people who also created software companies. Some of them are multi-millionaires now, some are broke, and some are still working hard every day for a relatively average salary. Obviously some of the broke entrepreneurs were fools and looking for a short cut to wealth, but many of them were every bit as hard working as the success stories. What's the difference between them?

The difference is luck. If you are a fan of any sport you can probably identify with this ages old adage for the NFL, "it takes skill to get to the playoffs, but luck to win a Superbowl." The idea behind that saying is that a good coach and a good general manager can put together a team which is generally successful and will win a majority of its games. That means that the team will typically be successful during the regular season (when success is measured by the results of 16 independant games), when they can have some bad luck, lose a game early, and still do very well. However, once you get into the playoffs, one small mistake can cost you the game and end your run. At this point luck plays such a powerful role that one bad officiating call (which wouldn't even be your fault) could undo all of your work.

The quintessential example of this would be the Indianapolis Colts. For the last 4-5 years they been one of the absolute best teams in football. Their success in the regular season shows what a great job their office has done is assembling a tremendous team, arguably one of the best ever in the NFL. But they have yet to even go to a Superbowl.

On the other hand we have the New England Patriots, also an example of how a good manager can assemble an excellent team, although their regular season records haven't been as good as the Colts. But with a remarkable string of good luck (including the now-infamous "tuck rule") they've won the championship three times in the last 5 years.

So obviously I'm just saying that it all comes down to luck, right? So why bother even trying? Not so fast my friend! The difference between the Colts and the Patriots may just be luck, but the difference between the Arizona Cardinals and the Patriots is much more. (If you are tiring of the football analogy, bear with me, this is the last one. I promise!) While the Patriots have won three Superbowls, Arizona, like the Colts, has won zero. But unlike the Colts they've never even had a chance. Arizona, plagued with poor management, hasn't even made it to the playoffs. The difference between the Colts and the Cardinals is that every December (when luck kicks in) the Colts have a shot to go home with the title. The Cardinals are guaranteed to be watching the game at home.

The parallels to business are obvious. The difference between Donald Trump and some other real estate investors is simply that The Donald got lucky on some of his bigger deals (remember, he's had almost as many deals go bad as have gone well). The other investors might be working just as hard as him, and have just as much knowledge as him, but they haven't had the luck to get over the hump. On the other hand, the difference between The Donald and Casey Serin, is that The Donald worked hard to acquire the knowledge necessary to succeed and then worked hard to apply it. Casey, on the other hand, is living in a pipe dream where he can go to a weekend seminar and start earning millions every year. Casey would like to skip the "work hard and watch for your break" step and just get lucky from the get-go. After all, since every deal turns a profit, the more deals the better, right?

So learn your lesson from the NFL. Every owner wants to win the Superbowl. Some owners (ok, I lied, here's another NFL analogy) like Daniel Snyder, owner of my beloved Redskins, try to buy an all-star cast that will shoot straight to the championship. So far that approach has failed miserably (one playoff appearance in 7 years). Other owners like Bob Kraft, owner of the Patriots, just build a good solid team and take advantage of the opportunities that are presented them.

In real estate investing the goal might be to own a Manhattan block. But if your approach is to try to buy 17 houses in your first year and trade to the block in your second, you're not only going to fail but that failure will crush you. If instead your approach is to build up a solid business piece by piece, then watch for profitable opportunities and seize them, you'll be on much more solid ground. And even if you never see your big break that gets you into the wealthiest of investors, you are still likely to do very well.

I'd be remiss not to point out that the lucky rich and the patient rich are not correlated. If Tom Cruise hadn't gotten his big break in Legend would he still be wealthy? No one but him knows for certain, but I'll take a shot and wager that most Hollywood stars wouldn't end up with wealth without their million dollar contracts.

But there are many software entrepreneurs who are already well on their way to great wealth before Microsoft or Google swoop in with multi-million dollar acquisition offers. They work hard and build up a solid business with fair income, and then save a fair amount of that income for the future (since owning your own company is quite risky). Then when Yahoo or eBay make their rich offers, these entrepreneurs just transition from patient rich to lucky rich.

Patient wealth come from how you handle the money you have, lucky wealth comes from being in a position to have large sums of money paid to you. Both patient wealth and lucky wealth require discipline and hard work, but only patient wealth is guaranteed. It's exciting and fun to go after lucky wealth, and I encourage people to go for it. But be smart and hedge your bets, you can play the safe game at the same time that you play the lottery. If you are into real estate investing, put yourself into your ambition and work hard to make the most you can. But also save at least 10% of all your income and invest it in vehicles that you don't directly control (such as stocks or bonds).

It may not be as sexy, but it never hurts to be on two roads to wealth at the same time.

Breaking a lease

I've written about how to write a lease. I've discussed some of the wild notions associated with leases and breaking them. So I suppose I shouldn't have been surprised when I recently discovered that one of the biggest ways people find my blog is by searching an engine with some variation of the terms "breaking lease". So since I don't have a large quantity of time to blog today, I thought to pontificate upon the terms of a lease and it's legal ramifications.

It seems (based upon the search terms) that there is a lot of confusion on how leases work. Most people seem to have the misconception that leases are covered by general law, and the courts have mandated certain terms and conditions, as well as penalties. In fact, many people who find their way to my blog are curious about the penalty associated with breaking a lease.

What is a lease?

While there are some laws that cover aspects of the landlord/tenant relationship (almost exclusively at the state level) those laws are usually aimed more towards the safety of the tenant, discrimination and eviction procedures. The lease itself is barely mentioned, for example Virginia laws mostly just remark that a signed lease must be provided to the tenant and it can't be changed without every one's consent.

Leases themselves are managed under a branch of law called Contractual Law. A contract, simply put, is an agreement between two people to exchange something, usually exchanging money for some sort of good or service. A great example of this is a mortgage agreement. When you get a mortgage (or any sort of loan) you sign a contract that pretty much states that the bank will give you a large sum of money right now, and you are to pay back an even larger sum, but over a long period of time.

The terms of the lease are strictly between the two parties. For example you could sign a contract to pay Uncle Joe $20,000 to paint your Honda Accord. It might not be a very fair contract (unless Uncle Joe is world-renowned), but if you sign it you've agreed to it. Any goods and services can be exchanged, best shown by this couple's prenuptial agreement in which she must cook 3 breakfasts a week and he must take her to London for her 60th birthday "keeping in mind that London is an expensive city, period".

OK, but what happens when a lease is broken?

Technically speaking a lease cannot be broken. Since a lease is a binding contract, you must fulfill your end of the bargain, regardless of whether you are a tenant or a landlord. If you go to court with a reasonable rental agreement, the judge will almost certain rule that the terms of the lease be enforced.

Most leases have a buy-out clause built into them that allows one party of the other to prematurely end the lease by following a series of steps. These steps most often include paying some sort of premium to the other party, but could also include producing special paperwork (such as a tenant providing an offer letter from a company more than 50 miles distant). This buy-out clause is what we refer to when we speak about "breaking a lease", but it's a perfectly legal method to end that lease early.

It's important to note that lease do not have to have buy-out clauses built into them. If there isn't a buy-out clause in the lease, and the other party is not willing to negotiate then you must fulfill your end of the bargain. Let's pretend that you own a house and rent it out to a nice family who signed a 24 month lease. Two months later you receive an unsolicited purchase offer for a large sum of money. You review your lease and discover that while the tenants can buy their way out, there's no such provision for you. The family is perfectly happy with the home and has no intentions of moving. Depending on the circumstances of the case, it's very likely that the family can force you to legally abide by the terms of your agreement, and not sell.

Whether you are a landlord or a tenant, it's very important to carefully review a rental agreement and understand how the buyout clause is defined. In Biff and I's lease we have chosen to set the buy-out clause (labeled as Early Termination) as follows:

Tenant may choose to terminate the Agreement before the natural expiration of the Agreement. To exercise this option, Tenant must submit his intentions, in writing, to Landlord at least thirty (30) days before termination and must pay a penalty equal to a single monthly installment in addition to their final months rent. In paying this penalty, the Agreement will be terminated and the Landlord will not hold the Tenant accountable for any of the monthly installments remaining in the term of this Agreement.

Basically in crafting this agreement, Biff and I have guaranteed ourselves 60 days to find a replacement tenant (30 days notice, plus an extra payment with covers another 30 days). This is good for both parties in that it allows a tenant to leave without too much trouble, and it gives us plenty of time to find a replacement. Of course, in keeping with what was mentioned directly above, we've also included a way by which we can terminate early as well.

The Landlord may choose to terminate the Agreement before the natural expiration of the Agreement. To exercise this option, the Landlord must submit his intentions, in writing, to the Landlord at least forty-five days before the date of termination. The Tenant has the option of moving out at any time before the date of termination. The Tenant is responsible for paying all rents due up until the date he moves out. On the date of the move out the Landlord must refund an amount equal to one (1) monthly installment to the Tenant.

If Bill Gates moves to Virginia tomorrow and wants to buy one of our houses for $5 million, then we have a way by which the deal can be completed. Look at the wording again, this clause means that Biff and I can terminate the lease for any reason at all, and the tenants can't object as long as we follow the steps set forth in the lease (giving them 45 days notice and refunding a month's rent).

Alternatively, bear in mind that any contract can be changed at any time as long as all parties agree on the change. In the above example with the landlord reciving a large offer on his house, he could possibly offer money to his tenants. If they agree to it, and sign an agreement to that effect, the earlier lease is then nullified.

As a tenant that same laws apply. You can negotiate your way out of any lease as long as you can convince the landlord. Unfortunately it is typically impossible to neogtiate with a large management firm, in the same way that you usually can't barter with Walmart. However if you are dealing with a small landlord, he might be willingly to allow you out of the lease if you can sweeten the deal enough for him. One possibility could be offering to locate a replacement tenant that meets his criteria.

However, if either party refuses to negotiate, the lease remains.

So I'm taking the lease to court...

So if all else fails and you are trying to escape a lease (or enforce a lease) in civil court, there are several things you need to know about contract law. The first is that you must bring a copy of your lease signed by both parties. If you plan your argument based upon the terms of the lease (such as trying to get a deadbeat tenant to pay up) and you don't have a copy handy the judge will most likely throw out your case. The same goes for tenants, you must have your own signed copy of the lease to present to the judge.

Once the judge has a copy of the lease, it's most likely going to be enforced. If you are trying to escape the terms of the lease, there are a few common defense that are used:

• Lack of Capacity - One of the rules of a contract is that both parties must be capable of understanding and fulfilling their side of the contract. There are many ways to dispute capacity, some of the more common including mental illness, such as Alzheimer's, (proving a lack of understanding of the contract) and bankruptcy (proving a lack of ability to fulfill the contract). Special consideration can be awarded to people (either tenants or landlords) who can claim financial hardship.
• Unconscionability - Simply put this word means that one party used a superior bargaining position to force unfair conditions upon the other party. For example if a landlord rented his unit out to a couple who spoke little English and used their poor understanding to add tremendous fees and dues. Unconscionability is not a guarentee that a contract will be voided, and the court often has great leeway in how it deals with such claims; from voiding the contract to simply amending it.
• Illegality - A contract can be voided if it is ruled to be illegal. For example, Virginia state law clearly defines the maximum amounts that a landlord is allowed to collect for a security deposit. If a landlord collects too much, then that clause is illegal. As I mentioned in "Breaking Down a Lease", one illegal clause can potentially void an entire contract. The best way to prevent a complete dismissal is to add in a clause of Severability.

This is a fancy legal word that means if some part of this lease is invalid for some reason (like a judge throwing out a no-liability clause) the rest of the document is still considered valid, instead of the entire document just getting thrown out.

• Misrepresentation - The misrepresentation argument is used when one party has lied or stated falsehoods before the contract was signed. A tenant could use this argument if the landlord planned some major renovation work before signing a lease, but didn't disclose that fact to the tenants. Alternatively a landlord could use it if a tenant lied on their application, for example with regard to income or number of potential inhabitants.

You'll note that nowhere on this list is "convenience" or "it's not fair" (ok, "it's not fair" kinda made it on the list, in extreme circumstances). Signing a binding contract is a serious matter and shouldn't be taken lightly. I strongly urge all landlords to write their own leases by hand so that they fully understand every clause of it (even if you base your lease heavily off of a template), and I strongly urge all tenants to actually read a lease before signing it.

Never make a promise that you don't fully understand, and never sign a substantial contract (like a lease) without carefully reading it over. Too many horror stories (like the poor guy I wrote about whose lease had a buy-out clause of three months rent (at the very bottom of the article)) could have been avoided if people simply took the time to understand what they were getting themselves into.

We Buy Houses

In my favorite book, Zen and the Art of Motorcycle Maintenance, Pirsig describes a process he calls analytic description. Such a process "discusses things in terms of their underlying form". He then gives us an example by describing a motorcycle:

A motorcycle may be divided for purposes of classical rational analysis by means of its component assemblies and by means of its functions.

If divided by means of its component assemblies, its most basic division is into a power assembly and a running assembly.

The power assembly may be divided into the engine and the power-delivery system. The engine will be taken up first.

The engine consists of a housing containing a power train, a fuel-air system, an ignition system, a feedback system and a lubrication system....

And so on... This is a classical approach to understanding something. You take it, you divide it up into pieces. Then you divide those pieces into more pieces, and keep going until you feel you can divide no longer. The "it" in this process can be a thing, a role, an idea, or even a process itself. Scientifically the goal of such a practice is to accurately describe the components of whole. Philosophically the process can be used to "Look Closer" and force yourself to see things that your mind has been filtering out.

For example, the goal of real estate investing it creating value. Value can be realized either at the time of purchase or the time of sale.

At the time of purchase value can be realized by purchasing undervalued property, which can be divided into buying from a "motivated seller", buying in a soon-to-be-improved area where prices will climb, and buying a distressed home.

Buying from a "motivated seller" can further be divided into buying a foreclosure from a bank, buying at an auction and buying from a seller in financial trouble.

Of course, once, we've finished dealing with all the subsets of motivated sellers, we have to go back up to describing the process of buying in a soon-to-be-improved area, and eventually we need to go all the way up to the top and describe the means by which value can be realized in selling. I hope you can start to see the interest in such an exercise, because I'd like to stop here and discuss one of the "motivated sellers" I described.

One of the time honored business models for buying discounted homes has been the "We Buy Homes" model. You've all seen the signs on the side of the road, variations of "We Buy Homes in a very short time and pay cash!"

The purpose of such a business model is to find sellers in dire financial straits who are either currently facing foreclosure, of will likely be so soon. Then you can swoop in and offer to pay cash for their home (usually at a 70-80% discount, from what I hear). Why would a seller ever agree to that?

Let's imagine for a second that you are a hard working American. You bought your house 10 years ago (say for $100,000) and have seen properties rising all around you. Unfortunately a medical disaster has crippled your finances and the creditors have come calling. You don't have enough money to make your house payments. The bank is threatening to foreclose. The rising property taxes is only making the situation worse.

Then a buyer comes knocking on your door and offers you $200,000 for your house. Other houses in the neighborhood are selling for $250,000. If you accept their offer you will walk away with $100,000 cash (more since you have paid down some principle on your mortgage through the 10 years).

Now the situation is not quite as dire as you think. If the bank forecloses on your home, they will then sell it (first through a realtor, and then at auction), and after they've paid all creditors who have a lien against your home (which it typically just them and any second mortgages), they have to turn over the balance to you. However, it's uncertain on when the home will be sold, what fees will be paid to Realtors/auctioneers, AND there will be a foreclosure on your credit report for the next 7 years.

So by taking the buyer's offer you are trading the possibility at some extra money (depending on the offer, it could be a considerable sum), for the certainty of money now and the prevention of a foreclosure on your credit report. For many people this is a very fair deal, often people in these circumstances have far too much uncertainty in their lives already and could use help in resolving a couple of their issues.

The business models is certainly a sound one, but it relies on a few conditions that are going to be harder and harder to meet in the coming years. It's my belief that this model will struggle greatly for the next 3-5 years, and may never quite recover due to the recent revolutions in the finance industry (and personal financial habits).

First I feel it is my duty to mention that one of the conditions of making this model work is having enough cash to pay for the home outright. Because the deals you are offering have to close very quickly, there often isn't time to bring in a mortgage, and the appraiser, and the paperwork... etc. This is not a model to follow if you have "No Money Down!"

But the number of people with enough money to make this model work is only growing, as is the number of individuals who are unable to make their mortgage payments and are facing foreclosure. So why is this model in trouble? Because it relies on one last, crucial, condition. The distressed home owner must own a reasonable level of equity in their home to make this work.

The home owner's equity is everything. The value you get is the equity that the home owner is willing to forfeit to make the deal go quickly. The value the homeowner gets is the remainder of their equity in cash form. If the home owner has little, or no, equity the deal simply can't be done. What homeowner is going to accept $200,000 for a home when they owe $225,000? At that point you are facing trying to accomplish a short sale, which is a completely different set of circumstances.

So the problem with the We Buy Homes business model is that the number of potential sellers is declining rapidly. It used to be that everyone bought a home with 20% down, guaranteeing a certain level of equity. Today 100% mortgages are one of the fastest growing loan types. Owning a home for 5 years used to mean at least a small level of equity with a fixed rate mortgage. Today, with interest-only loans and negative amortization loans, there's no guarantee. Even someone who has owned their home for 15 years isn't guaranteed to have any equity built up thanks to the proliferation of refinancing and home equity loans...

Since the vast majority of foreclosures we'll see over the next 5 years will tied to people with crazy ARM loans, who bought houses at inflated prices, it's unlikely that a discount investor will find many deals out there pre-foreclosure, if any.

Could this business model make a comeback? Possibly, but that would rely upon two things happening:

1. American home prices stabilizing. A wild market (which is what we've had for the past 6 years) is not good for this type of investing. To ensure a profit, we need to understand the home pricing within the area, which means somewhat stable growth.
2. Americans getting wise about their finance. We've become too much of a consumer society, where we're completely unafraid to sell our future for a toy today. As long as that mindset persists, the odds of actually finding a distressed seller with actual equity is very slim.

The first is extremely likely. Housing markets, like every other market, follow a cyclical pattern. After the current housing slump, it's likely that we'll get many years of solid, stable growth, and then have another boom, followed by another slump. The pattern is definite, the timing is not.

The second is very hard to predict. I would hope that American society at large would eventually settle down from it's consumer binge and enter an era of fiscal responsibility. But trying to predict whether or not that will happen is an exercise in futility. If the above model interests you, then the best you can do is try to build up your cash reserves and prepare yourself for a time when you can find distressed buyers with equity.

NAR thinks Real Estate is a great investment

So throughout this week I've been dissecting NAR's latest national ad campaign that tries to explain to us why today is a great day to Buy or Sell a House! I've been breaking it down partly because it's an easy target (as I wrote on Wednesday, the ad does more to comfort Realtors than convince a skeptical public). But I'm also breaking it down because it's a wonderful, if clumsy, example of advertising techniques.

A real estate investor needs more than just appraisal skills, they need marketing skills, leadership skills, accounting skills and possibly even handyman skills. In other words, real estate is an entire business. So by dissecting the ad for the tricks they use to persuade, we can learn how to use these tricks ourselves and become better marketers.

Now I admit that using words like "tricks" and "propaganda" sounds awfully evil. But I assure you, all advertising is propaganda, it's all designed to influence your beliefs. "Trust the Midas touch" encourages you to trust total strangers with your brakes. "The quilted, quicker picker-upper" implies that Bounty paper towels are better designed than others, without providing any evidence to support such claims. Even a Happy Meal is named that way for a reason.

These tricks, while they truly are propaganda, are simply used to best promote their product. And there is nothing evil in using them. I admit that it's one thing to outright deceive a person into believing something that's not true (which I would agree is a bad thing to do), but it's another to help a potential buyer to help envision themselves living a wonderful life in the house you just happen to currently have for sale... What do you think staging a home is, but propaganda?

Back to the conclusion of our dissection of NAR's national ad campaign:

REAL ESTATE IS A GREAT INVESTMENT
Homeownership is a safe, secure way to build long-term wealth. The national median price of homes bought ten years ago has increased 88 percent. The number of US households is expected to increase 15 percent during the next decade, creating a continued high demand for housing.

Now I obviously can't argue with the title here, can I? I mean I'm invested in real estate! Obviously I think there are good investments to be found within real estate. However, there are some clever techniques used here to promote their cause.

The first is oversimplification. They begin with the claim that owning real estate is a safe and secure way to build long-term wealth. First of all, they are being redundant, simply because they want to use as many emotionally-charged words as possible. Safe and secure, within this context, mean exactly the same thing, "risk-free". If I were nit-picking I'd go into a bit of a rant about how borrowing money for an "investment" is never safe. When you play with other people's money, you always run the risk of over-extending yourself and being unable to pay that money back.

In addition "safe" is only useful as a means of comparison, by itself it's an empty word. The "safest" investment is generally considered to be a Treasury Bill, which is guaranteed by the US Government. But what if the government fell next year? I'll agree that my scenario is tremendously unlikely, but it's possible. Nothing is "safe". They also use the phrase "long-term wealth". What does that mean exactly? Do they mean wealth that takes a long time to build? Wealth that lasts a long time? I'd spend some time thinking about it if it actually mattered.

So why do they use these words that have no real meaning behind them? Simply because these words are emotionally charged, that is, they invoke emotions within the reader. They specifically chose these words, "Safe" and "long-term", because they are trying to appeal to the American public which has just suffered through two bubbles in a row. If NAR had advertised real estate as "safe" in the late 90's everyone would have laughed. The public wanted "explosive" like eBay or Yahoo, not "safe". But now that we've suffered through two tremendous setbacks, the public is yearning for words like "secure".

Real estate is a very emotional product, evoking intense reactions from both buyers and sellers. So it's not a surprise that Realtors are pros at using emotional words. Look at your local listings and you'll undoubtedly find them peppered with such meaningless descriptions as "warm", "fantastic", and "luxury". These types of words are especially useful when accurate descriptions might not suffice.

However, they can backfire on you too. As propaganda has evolved, people have become more sensitive to it (consciously or subconsciously). Sometimes people will see emotionally charged words for what they are, words without substance, and count it negatively against you. In his famous book Freakonomics, economist Stephen Levitt noted the use of emotionally charged words in real estate:

In fact, the terms that correlate with a higher sales price are physical descriptions of the home itself: granite, Corian, and maple. As information goes, such terms are specific and straightforward - and therefore pretty useful. If you like granite, you might like the house; but even if you don't, "granite" certainly doesn't connote a fixer-upper. Nor does "gourmet" or "state-of-the-art," both of which seem to tell a buyer that a house is, on some level, fantastic.

"Fantastic," meanwhile, is a dangerously ambiguous adjective, as is "charming." These words, it turns out, are real estate agent code for a house that doesn't have many specific attributes worth describing. "Spacious" homes, meanwhile, are often decrepit or impractical. "Great neighborhood" signals to a buyer that, well, this house isn't very nice but others nearby may be. And an exclamation point in a real estate ad is bad news for sure, a bid to paper over real shortcomings with false enthusiasm.

If you study an ad for a real estate agent's own home, meanwhile, you see that she emphasizes descriptive terms (especially "new," "granite," "maple," and "move-in condition") and avoids empty adjectives (including "wonderful," "immaculate," and the telltale "!"). She patiently waits for the best buyer to come along. She might tell this buyer about a house nearby that just sold for $25,000 above the asking price, or another house that is the subject of a bidding war. She is careful to exercise every advantage of the information asymmetry she enjoys.

He's really just confirming what most of us already knew. That real estate agents have honed their craft to a fine edge, and have used words like "charming" so often that we have become numb to their effects.

Of course that doesn't mean that there isn't a place in real estate for the emotional appeal. It just means that the place to tug their heart strings just isn't in a printed advertisement. When walking a prospective buyer through a house it's easy to toss in a liberal number of adjectives designed to open your customers hearts, and their wallets:

"And if you'll come in the kitchen you'll see a beautiful breakfast nook that is a perfect place for the family to gather and share informal meals together. And you can see a large window, which not only lets the sunlight in, but also allows you to keep a close eye on your kids as they play in the spacious backyard from the comfort of your kitchen."

The next trick they employ is selective sampling. This is a trick used almost every time you see a statistic. They claim that housing has increased by 88% nationally over the last 10 years. They exercise selective sampling in two different places in this claim.

Have you ever watched a sports game where the commentators came out with the craziest comments? Like "this team has scored more than 20 points in their last 17 games against left handed quarterbacks when playing south of the Mason-Dixson Line"? The unstated assumption is that they will then score more than 20 points in this game as well (assuming that they are facing a left handed QB, and playing in the deep south). But even your math-impaired viewer realizes on some level that that statistic seems to be somewhat doctored. And it is, the announcers (and their stat doctors) are simply choosing data points that best fit their claims. Playing in the south may or may not have had anything to do with the team's ability to score points, but it fits their model.

The claim by NAR is the exact same situation. They are choosing the data that best fits their model (in this case, that houses are growing rapidly in value). First we need to translate that very large number (88%) into a more useful form. Using some simple calculations we can turn 88% over a decade into 6.5% a year. That's not a terrible return.... for that period of time. But since NAR selected the 10 year period, we can assumed that that's about as good as it gets.

Indeed, MSN Money columnist Liz Weston wrote:

In the past 40 years, the average appreciation for homes has exceeded the inflation rate by only a percentage point or so. Compare that to stocks, which have bested inflation by 7 percentage points in the same period.

I don't know for certain, but I'm relatively sure that her value for inflation is annualized to about 3% or so, giving us a typical real estate growth of 4%.

Of course a selective sampling then implies an unstated assumption. In this case the assumption is that real estate goes up a lot and will continue to go up. Consider that during the 10 years between 1989 and 1999, the S&P 500 (an index of stocks) grew by 429%! That's an annualized return of over 16%! Does that mean that 1999 was a great year to buy stocks? Obviously not, since over the next 5 years the S&P returned an annualized -2.7%.

If anything, the increased appreciation over the last 10 years should make you more cautious, not less, when looking into buying a home. If the housing market has under-performed it's average for the last 10 years (say only returning 2%), then that should make you more bold in entering the market.

Of course all of this is relatively moot because of their second selective sampling choice. They chose to use a national average for a market that is extremely local. If you are looking into buying a fund that owns houses all across the nation, the national prices changes may interest you a great deal. But for your typical home buyer the national average means little to nothing.

Consider this chart from CNN. They claim that home prices in the Virginia Beach/Norfolk/Newport News area (where I own) rose almost 24% from a year ago. And at the same time Minneapolis fell almost 2%. Aside from the fact that I haven't witnessed any of this magical appreciation in the Virginia Beach area, how's a homeowner in Minneapolis supposed to think when a Realtor tells him that the average American home appreciated almost 4% from the year before? How does that impact him?

So we've discussed, today, two of the most powerful tools of propaganda, selective sampling and emotionally-charged words. Selective sampling can be used in our favor, especially when we tell a potential buyer about the house down the street that just closed for $15,000 more than we're asking (assuming, of course, that it's true). We don't have to tell them that the house four doors over just sold for $5,000 less than our asking price.

Emotionally charged words can also be a very useful tool, but also a dangerous one. Trying to convey emtion through a printed word is a very bad idea, unless you happen to be John Steinbeck. Printing emotionally-charged words is a bad idea for two reasons. First, people like to connect emotions to people. When someone tells them "commune with friendly neighbors in your landscaped front yard" or that they can "OWN YOUR OWN BACKYAD OASIS !!!!!" they want to connect with a person, not an anonymous sales rep typing generic things down.

Secondly, the written word is apt to be read over and over again. Words that try to provoke images in your buyer's mind may work beautifully the first time through. But as humans, we go back to things we like over and over again. If it's written, we'll read it again. And the second or third time through, they become more likely to see empty words for what they are. When those same words are used verbally, all the buyer has to go back to is his own memory. And they're more apt to remember the image they created in their mind around your words than your words themselves.