What makes a bad investment?

So when looking for investment properties you need to do the math (don't worry, it's easy) to figure out if you are on the right track. I'll walk you through the process I take when evaluating a house, but since there are 2,000 bad deals for every good one, I'll be lazy, take the easy way out, and walk through my thoughts on a horrible investment property.

Let's start with the property (through a listing on craigslist.org):

$325000 INVESTMENT PROPERTY FOR SALE steps from Metro

6 MONTHS OLD LUXURY ONE BEDROOM CONDO RENTED OUT FOR $1450 PERMONTH TILL OCT 2007. STEPS FROM DUNLORING METRO. STAINLESS STEEL APPLIANCES, GRANITE COUNTER TOPS, SEPARATE LAUNDERY ROOM inside the unit, RENTED OUT TO VERY NICE COUPLE.

ALL THE AMENETIES YOU CAN THINK OFF POOL, GYM, MEDIA ROOM BASKETBALL COURT ETC CLOSE TO 495, 66, 29

CAN EMAIL PICS ON REQUEST. FOR FURTHER INFORMATION PLEASE CALL KAY AT 202-689-4256 I am a realtor working for FAIRFAX REALTY looking for buyer for this condo.

Ignore the poor English and terrible grammar for a second...

A 6 month old condo that has tenants? Either this is a strange flip, or an investment gone bad. Right now I'm going to guess the latter, that the original investors eventually realized what a bad investment the unit made and is now trying to bail. But we'll go ahead and continue our evaluation.

One of the first things I like to do when evaluating a new place is look at it on Google Maps. If you have an understanding of the area, this can be extremely enlightening. For example our property claims to be at the intersection of Prosperity Ave and Gallows Rd. By pulling it up in Google we can see that the area in question looks like this (the green arrow indicates the intersection):

This tells us a couple of things, it tells us that when the realtor mentioned proximity to the metro (the DC subway), she wasn't lying. The metro station parking lot is directly to the northwest of the green arrow. It also tells us that the condo in question almost certainly isn't in a high-rise, but instead one of the smaller complexes. So far the condo looks pretty nice. The proximity to a metro stop is a definite plus as that will continue to add value as the area gets more and more over-crowded.

So the buyer seems to be asking for $325,000. Let's make a quick assumption that you, as an investor, are going to put 10% down. That leaves you with a mortgage of $292,500. At a decent investment mortgage rate of about 6.5% (investment mortgages are typically about 0.5% higher than mortgages for a personal residence), we have a monthly payment of.... Uh-oh. $1848.

That's more than $400 a month more than the rent the unit is currently generating.

Let's continue our investigation. I'm going to assume for a moment that we can get insurance to the tune of about $50 a month. It may be a little on the cheap side, but if you do your homework and wrap that insurance up with your personal home insurance and your auto insurance, I'm sure you can get a comparable rate. That brings our monthly costs up to $1898.

In Fairfax County property taxes are set at 0.0089%. Assuming the unit in question is appraised near the sell value, that puts our annual property taxes at $28292.50, adding another $241 to our monthly bill, bring our total up to about $2139 a month to own this thing.

Since this is a condo, the association will charge a monthly fee to maintain the complex. These fees can vary wildly from building to building and aren't publicly advertised. The best place to get them is to look up the condo on google and try to find some resident complaining about the fees via a forum. Since I don't know the name of the complex, I can simply google "Gallows Rd Prosperity Ave condo".... and it looks like I hit the motherlode. The second link leads to a blog that I'm somewhat familiar with, referring to a condo at Dunn Loring called the Halstead. The link shows a wonderful picture depicting the number of units for sale in that particular project:

Even if our condo isn't a part of the Halstead, it's right across the road from them (on the Google Map the Halstead is built in the woods directly south of the metro. Consistent with our "6-month old" description). So this photo gives us a lot more information about the market in this particular area. We've now found strong evidence that this is a strong buyers market which will give us a lot of strength in negotiating, if we decide to buy the place.

But we still don't know about the condo fees. Unfortunately further searching is fruitless. No specific information can be found. But after a little bit of googling I can estimate that the average condo fee for a 1-bedroom in Fairfax is between $200-$250 a month. Since this condo is extremely close to DC, I'm going to assume that the condo fee is on the high side of that, giving a new monthly total of $2389, but since most numbers in this article are approximations, we'll round it to $2400.

So if our numbers are somewhat in the ballpark, at the rate the current tenants are paying (until October 2007), we'd be losing $1000 a month to pay for this property.

Is the rent too low? Maybe the condo is in relatively poor shape and we can fix it up, or perhaps the condo is just being under rented. There are a variety of methods you can use to determine fair rent, such as craigslist, your local papers, etc. According to Rentometer.com, the median rent in our area for a 1 bedroom is only $1300. Proximity to the metro can easily explain why this property is earning more than the median, and when the tenant moved out, I wouldn't be surprised if we could easily get another $75-100 a month out of the place.

Adjusting rental prices to account for amenities is more of an art than a science. Amenities that could inflate rentals in one investment type, could do nothing to another. For example, when dealing with a one bedroom apartment, it's probably a waste of time to even look at school district information. Biff and I's townhomes, however, are located in the best school district of their county, which is a significant advantage for them. On the other hand, proximity to a college campus is more likely to raise the rents of apartment/condos than single family homes.

So what have we learned?

• At the current price, we'd have to expect about a $1,000 a month loss to maintain the property.
  
• The rent is already relatively fair and while we could probably milk a little more out of it, it's unlikely that we could get too much more.
  
• Given that the condo has a tenant and is only 6 months old, the seller is motivated. They either need the cash right now, or their "investment" is sucking the life out of them.
• Most likely, as learned through Google, condos in the area aren't selling very well and there is a very large number of them on the market.

So the deal, as stands, probably isn't a good one. If you estimate that the unit could take in about $1500 a month, once you subtract the condo fees and the insurance, you're only left with about $1200. If you take out property taxes of about $200 a month, you're left with only $1000 to pay the mortgage with. This condo will likely only be profitable if your loans are only equal to about $150,000. (By the way, note that the largest single expense on this property is the condo fee. It's only an estimate, but I would be surprised if the condo fees were lower than that, and not very surprised if they were higher. This is one of the reasons I'm not a big fan of condos, the fees are so high that they just eat up your income.)

So the final verdict? I actually like the area the condo is in. Being located across the street from the metro station is a tremendous asset that will help the unit's appreciation significantly over time. However right now the asking price is far too high. Given what we know about the condo, I think that there's no chance we could make a positive investment out of this unit.

Obviously I'm not surprised with the result. For one thing, there's no real way in which we can add value to the unit, short of dumping a tremendous amount of cash into the down payment. Not to mention that if you are looking for good investment properties, craigslist probably isn't where you want to start, especially with listings that scream GOOD INVESTMENT in their title. Those are usually anything but.

But just for recap, let's run over the important steps we took on this little path of discovery:

1. Look up location on the internet, figure out distances to major highways and landmarks. Maps are invaluable. Even if you go there in person, unless you look on a map you might not realize that I-95 is just a minute away.
2. Google the name of the complex. You never know what might turn up (like our photo above).
3. Estimate your mortgage costs.
4. Estimate your insurance costs.
5. Research the local property taxes.
6. Are there any condo or home owners association fees? Either research or estimate them.
7. What rent can you get? Figure out local averages and then adjust for specific amenities.
8. Compare the costs to the rental income

While the actual methods and formulas that investors use to make their investment decisions vary widely from one investor to another, almost every method requires that you determine the above information. Without this data you are just helplessly speculating.

Try a college town

A short while back I wrote an article about how money is made in real estate. No the answer wasn't to "buy and hold" or even to "buy and flip". The answer is to provide value to one of your three client types, either the seller, the tenant or the buyer. While maximizing value to the sellers and buyers are often discussed, maximizing the value of your property to a renter rarely is. I mentioned in my article that working with people who were not motivated to buy could raise your rental value. CNN.com just released an article that said roughly the same thing.

Why are college students such a good market? Simply the fact that they're not going to be around very long. As I mentioned before, transient populations, groups of people who move around a lot) make a wonderful rental opportunity. Your average renter, if faced with the option of renting for $1000 a month or buying for $1050 a month would always choose to buy. But your average college kid still wouldn't buy. Even if they had money it wouldn't make any sense because once you factor in closing costs and realtor's fees, they would rarely break even after 3-4 years.

The secret here is to find tenants who have money but don't want to buy. Biff and I have currently identified two demographics that fit that description. College students (who parents can pay nice rents) and military families. Military was the demographic we settled on due to Biff's proximity to a heavy military population. When we bought our first property we only put 10% down, yet were able to find someone who was willing to pay a high enough rent that we immeadiately had a $25 monthly positive cashflow. Even though our tenant wasn't military (he was ex-military), the large number of military familes looking to rent in our area has pushed up the average rental prices to a point where we were profitable on day one.

So what other demographics can you think of that fall into the "have money but are unlikely to buy" category?

Why fund a child's Roth IRA?

In my previous post I talked about how to save on your taxes by paying your children. I also encouraged parents to use at least some of those wages on funding a Roth IRA. A couple of people have since asked why a Roth IRA instead of a regular IRA or just normal brokerage accounts?

A Roth IRA offers significant advantages over either of the other two investment types and could be a great tool for teaching your children.

Compounding what?

As many individuals, wiser than I, have noted, a young person's best asset is time. By the miracle of compounding interest, the earlier a person saves the greater the benefit. Just about everyone has heard the tale of how Jon started saving $1,000 a year at age 20 while George started saving $2,000 a year at age 30. When they each turned 50, Jon had considerably more money than George.

Unless you are in the business of start-ups (where fortunes are created and lost in a matter of days), nothing helps money more than time. If I could magically speed up the clock and jump 30 years forward I would find that not only are my houses all paid off, but they are worth over 3 times as much as they were (assuming a conservative 4% appreciation each year).

So help give your children a head start on saving for their future life, and help them learn to start saving money now.

Why into retirement?

So if we're going to help our children save, why not put that money into a more typical brokerage account? Why put it into a retirement account?

I've never been impressed more than with Warren Buffett's decisions to leave the vast majority of his wealth to charity. Buffett refers to the children of wealthy people as "the lucky sperm club" and repeatedly insists that to pass along great wealth to your children can often hinder them, instead of help them. The author of The Millionaire Next Door agrees, and makes a strong case in his book that giving too much money to a child will make them more dependant on you, not less.

A popular trend that is emerging these days is to pass on your wealth to your children, but to limit their access of it until certain periods of their life. A certain amount might be accessible immediately, a little more might be given to them when they hit 30 or 40. Usually the entirety of the amount is passed along when the child reaches 50 years old.

The theory behind this method of disbursement is that by delaying the balance of money until the child reaches 50, they will have to work hard throughout their lives and earn their own money. They only receive the exceptional gift at a point in their lives when they are set in their ways and unlikely to make any significant changes to their lifestyles.

The same philosophies are true with any gift of money. Any unexpected money is likely to make your child more reliant on the source of that money than less. Let's look at an example where you put $3500 of your child's yearly wages into a stock index fund, between the ages of 10 and 18. The fund returns an annualized average of 10%. By the time your child heads off to college he'll have over $47,500 stashed away in those accounts.

Think back to your post-high school years. What would you have done with $47,000? Would you have made a down payment on a nice home? Or would you have bought a bitching BMW Z6 convertible? Maybe you would have let it sit. But more likely you would have spent every spring and summer in Cancun.

The advantage of an IRA is that the government tries hard to discourage people from taking money out until they are 60. It helps even more if your child doesn't have direct access to the broker in charge of the account. By putting the money in the hands of a retirement account, you've helped limit the allure that the cash holds over all of us who have windfalls.

Retirement account have other added benefits as well. When your child decides to purchase their first home, they can withdraw up to $10,000 out of their retirement plan without penalty. If something happens and some medical bills pile up, those can also be paid for out of their retirement plan without penalty. By building a retirement account for your children, you have given them a safe cushion to protect them from disasters, but kept them from wasting it away themselves.

Pay taxes and die

There's an old saying that says there are only two certainties in life, death and taxes. The first may be completely unavoidable, but the second can be dodged from time to time with careful maneuvering.

A traditional IRA is a retirement vehicle that allows you to reduce your taxable income today at the expense of future taxes. For example, if you earned $100,000 this year, but put $10,000 of it into a traditional IRA, then your taxable income would be $90,000, saving you roughly $3,000 in taxes. However, when you withdraw that $10,000 later in life you'll have to pay taxes on it. The IRS eventually does get their hands on that money, they just have to wait for it.

Out children, however, don't have to deal with paying much (if anything) in the way of income taxes. If their income was under the standard deduction, then they will pay nothing in income tax. So they should be looking at using a Roth IRA instead. A Roth IRA taxes you on your income now, but the benefit is that when you take the money out later you pay no taxes at all. That $47,000 we helped our children raise in the previous example will be 100% tax free when they retire. And since they didn't have to pay any taxes on it when they put the money in, the result is a retirement fund that the IRS will never touch.

For further reading on IRAs and Roth IRAs, take a look at the IRS's official pamphlet on the subject. It's a bit dry reading, but at least it's not written in legalese.

The littlest millionaire

There are plenty of advantages that real estate investing provides over other forms (including stocks). One of them is the sheer simplicity of making your children millionaires, and at a discount to you. The key to this simple trick is employment. Employ your children and pay them wages. Take those wages (which they probably won't have to pay taxes on) and put them in a Roth IRA for them.

First I need to make a quick legal disclosure. I'm not actually a lawyer, though I'm sometimes mistaken as one. The basis of the child labor discussion in this article is the federal Fair Labor Standards Act (FLSA), but every state has their own additional labor laws. While I feel confident that my recommended course of action shouldn't violate any laws, you should further research the child labor laws in your own state.

However, with that boilerplate out of the way I should tell you that child labor laws are generally designed to prevent people from exploiting children and protecting them from dangerous work environments. Since our purpose isn't to exploit our child's labor, but rather to expose them to the world of business and investing (as well as give them a financial head start), we're probably safe from that first condition. And the most dangerous thing our child may experience in our line of work is a rabid mortgage broker, so we're probably covered with the second as well.


What if your child's iPod was tax deductible?

There are obvious life lessons that can be taught through paying your children a wage. Younger children can learn the money results from doing work, not begging their parents. Other lessons, such as saving and budgeting, can be very easily incorporated. However I'm not a psychiatrist, nor am I Dr. Phil, so I'm going to refrain as much as possible from telling you how to parent. Instead I want to focus on how paying your children affects you.

When you pay your child (or any other employee of your business) those wages are deducted from your income in the same way as any other expense. If your company made $100,000 last year and you spent $10,000 on advertising and $10,000 in paying your children, the IRS will only tax $80,000. OF course the IRS doesn't just forget about the $10,000 you paid your children, that money is now their (taxable) income.

However, generally, children are taxed the same way as everyone else, and they are entitled to the same deductions as everyone else. This year the standard deduction for a single tax-payer is $5,000. So if your child earned $5,000 from you this year that money is entirely income tax-free. If you are in the 28% tax-bracket, you have just saved your family $1400 in taxes. No matter how that money is spent (on clothes, to fund a Roth IRA or on an iPod), you've avoided the taxes.

How do I deal with my child's income, and what about taxes?

The IRs tells us that a minor only has to file a return if they earn over $5,000. This actually get slightly more complicated to figure out if your children have unearned income as well (like stocks), but odds are that you won't even have to file paperwork with the IRS unless you need to get a tax refund.

But the refund is a moot point since, if your child is earning that little, you don't have to withhold any money for the government (though you will have to report the earning, which is discussed later).

So we don't have to give the government any money for the child's income taxes, but what about Social Security? If you run your business as a sole proprietorship, general partnership, or an LLC that is taxed like one of those two entities, niether you nor your child will be responsible for paying any social security taxes. If instead you chose to form a corporation, or an LLC that is taxed like a corporation, you unfortunately will be responsible for paying Social Security.

Yet another reason why I don't recommend incorporating yourself.

So how can I put my child to work and what should I pay them?

Generally children under the age of 14 are not allowed to work. However the federal law exempts the age restriction on parents who are employing their children (section 29 CFR 570.2 - Minimum age standards). So the federal law places no restriction on the age at which your child can begin to work.

It's worth noting, however that the age exemption only applies to parent's or "those playing the role of a parent". It appears that the court interprets "playing the role of a parent" as raising and providing for the child, so unless you are directly raising your nephew/grandchild/cousin, you are not allowed to hire them at younger than 14. In addition you cannot hire your grown child, who then hires their minor child. The parents must own the business in order to exercise this exemption. Of course, once the child reaches the age of 14, they can be hired by anyone regardless of relation.

Pay is something that is left to the employer, all that's mentioned in the laws is that they are to be paid a fair wage. Paying too high will probably be more of a problem for us than paying too low.

It's highly unlikely that the FBI will be knocking down our doors for violation of child labors laws, so it seems that our chief concern lies with the IRS. Part of your reasoning for hiring your child is the tax benefits, and the IRS's job is to get you to pay every last cent that they legally can. Hiring your children, though completely legal, is likely to run up a red flag at the IRS and they'll probably keep a somewhat closer eye on you. To protect yourself in the event of an audit, you'll need to follow a few steps.

1. Request an Employer Identification Number (EIN). This is required before you can hire anyone, and it's a free simple process created by the IRS.
2. Assign jobs that are acceptable for your child's age. An 6 year old could help you fold letters or lick stamps. A 10 year old could help you rake leaves on a rental property. A 14 year old could help you paint.
   
3. Only pay them for jobs that are directly related to your business. Mowing the lawn of a rental property applies. Mowing your lawn doesn't (you can still pay them for mowing your lawn, you just can't deduct it from your business).
   
4. Keep a detailed record of all of your children's hours and efforts. Use a notebook or a spreadsheet, but carefully record dates, hours worked and work accomplished. Don't record that your 6 year helped you fix the plumbing, instead record that he/she held the light for you to see what you were fixing.
   
5. Pay a fair wage. Don't pay your children $50 an hour to lick stamps.
   
6. Issue a W-2 at the end of the year for your children. Each child should get their own.
7. File a 944 form with the IRS every year. The 944 Form is your way, as an employer, of notifying the IRS of the wages you paid out. Without this form, they'll view your deductions as very suspect (and probably illegal). By the way, the 944 form is a new, annual version of the old 941 form that had to be submitted quarterly. You can only use 944 if your employees' tax liability (the amount they are expected to pay in taxes) is less than $2500.
   

So there we have it. In one not-so-simple step we've managed to teach our children about our business, instruct them in the value of the dollar, build a solid financial foundation for their future, and save ourselves taxes to boot. Running a real estate business can be a lot of work, but the pay offs can be grand.

And if you get your children to work for you from age 10 until age 18, putting $3,500 away each year into a Roth IRA, earning 10% a year, they could go to college with nearly $50,000 tucked away, TAX FREE. If they never save another dime (just the original $28,000 you put away for them) they'll be millionaires before they are 50.

Schadenfreude

Schadenfreude is a word that I've seen appear more and more frequently lately. Maybe it's because of the rockiness of the real estate industry. Maybe it's because it's becoming a new fad. Maybe it's just because when you are thinking about something, it tends to stick out at you (selective perception). We'll get to the meaning of the word in a second.

A common wisdom in investing is "a rising tide floats all boats". The general concept is that when things are going well all investors succeed, no matter how flawed their plan. Anyone could have made money by investing in dot-coms in the late 90's. A monkey could have picked dot-coms and tripled his money. The same thing happened with real estate in 2000-2003. Every investor, speculator and flipper made plenty of money.

Warren Buffet is credited with scribing the corollary to the above rule. He said "when the tide goes out, you can see who isn't wearing shorts". He was saying that when things get bad, you can rapidly tell the investor with solid plans from those who are just floundering along. The winners continue to survive, but the losers collapse. While the stock market crash in 200 hurt nearly everybody in the US, the most devastated were the individual investors who had no idea what they were doing. Their portfolios were demolished because they didn't actually know how to seperate true value from irrational exuberance.

The tide is going out on real estate. Now we finally can find out which investors have a solid plan in place, and which ones were just flipping with no understanding of the market. Now we find out which homeowners have avoided playing with their equity, and which ones took out loans like they were candy.

Schadenfreude is a German word that means "to take pleasure in someone else's misfortune". Other people's misfortune is never really a great thing, even if it's largely deserved. However since I am human and prone to human weaknesses, I have found myself taking some joy in the blogs that expose "investments" gone bad. We can all learn a lesson here.

First on our list is the father of all deals-gone-wrong. Meet Casey at www.iamfacingforeclosure.com. I've mentioned him before so I won't go into too much more detail.

Close to my beloved DC is the Bubble Meter. The photo near the top of the post is from their archive.

Then we have the blogs that, through sifting MLS databases, have found flips gone bad.

The best of them, in my opinion is probably OC FlipTrack. They do a spectacular job of showing homes, their purchase dates, price histories and even their HELOCs.

The next up Bubble Tracking also does a good job of showing what a bad deal these people got themselves into. He provides you with the percentage loss each property has generated (if it were sold at the current price).

Short but sweet is the mantra of Flippers in Trouble. This site doesn't waste time or space, they just give you the numbers. At the moment, their top find is a poor sap who'll be taking a $600,000 loss before any commissions.

Since Irvine seems to be a very popular place, we can also visit Irvine Housing Blog, who gives us a variety of real estate news in addition to the Failed Flops he's Found. He also uses the term Schadenfreude in his blog description.

And last, but not at all least we have San Diego Market Monitor, who doesn't give you a photo of the property in question, but makes up for it with links to the county assessor's office.

The sad part of this story is that while some of the speculators will be able to absorb their loss and move on, many can't. Taking advice from self-proclaimed "gurus", they've over-extended themselves and are headed down a road to financial devastation which will undoubtedly reach into all other aspects of their lives as well.

Are you interested in real estate investing? No problem, there's still money to be made. The good investors, with careful research and planning, are going to continue to turn a profit. That being said, it's also an extremely dangerous time to make a mistake in your investments. In a typical market, even a poorly planned real estate venture has a solid chance of nearly breaking even. In today's market, a poorly planned misstep can easily cost you hundreds of thousands of dollars.

Oh, and for the love of God, don't be another idiot flipper. If you intend to flip a house, at least try to add value to it before you jack up the price.

What is depreciation?

If you are interested in real estate investing you've probably heard about depreciation and how it can work wonders on your tax returns. Every Top 10 list of benefits for landlords includes depreciation. A lot of people will even tell you how to calculate it into your taxes. But what is it really? Let's start from the beginning.

When you run a business you only pay taxes on your profits. If you collected $100 by selling bananas, but buying the bananas cost you $25, you are only taxed on $75, not the full $100 (Profit = Revenue - Expenses). This is simple and it makes perfect sense (this is true whether you have formed a corporation or not). But it can get more complicated really quick.

Let's say your banana business is booming and you need to buy a bike (to deliver the bananas to seniors, an expanding market), and the bike costs you $100. So this year you are spending $125 and making $100, therefore you wouldn't pay taxes, right? Or maybe you financed the bike and only have to pay $20 this year. How would that affect your taxes?

The government steps in at this point and say "we need a simple way to figure out how long-term purchases affect taxes" (And believe me, this is a good thing. Otherwise accountants would be running around all willy-nilly and figuring out ways for businesses to never pay taxes, increasing the burden on you and I). So the government looks at your bike and says, "We think that bike will last 4 years before you need a new one. So each year you can count one fourth (25%) of the cost of your bike as an expense."

So now the government is basically saying "We want you to pay taxes every single year. But we have to admit that the bike is an expense and should reduce your taxes. So since we think you will have to buy a new bike every 4 years, we'll spread the expense of that bike over 4 years." So now, for the next 4 years, our expenses are $25 for the bananas and $25 for the bike giving us a deduction of $50 on our tax return. If we paid cash for the bike that means that in year two we're making $75 profit but only paying taxes on $50.

This rule goes for every thing a company uses, that lasts many years but eventually breaks down and has to be replaced. FedEx can depreciate their fleets of delivery trucks, Ford can depreciate the machines in their auto plants. And since the government can't look at every piece of equipment they've created nifty little tables that help companies figure out how much they can depreciate for their new truck or bike.

Now when you bought your investment house, the government says you actually bought two things. It says you bought a piece of land, and you also bought a building on top of it. This is important to them because while land doesn't wear out, a building does. The house you bought is wearing out and every last part of it will eventually need replacing (like your roof).

So the government says that because we are using the house to make money and because the house is wearing out, we should be able to depreciate it (use part of the cost of the house as an expense). The government tells us that they expect an average house to last 27.5 years and they've given us a little table to use in figuring out how much we can deduct each year.

So how does this impact our personal taxes? Pretend Tommy Hillbilly earned $10,000 last year in taxes. Over the year he paid $9,000 in mortgage interest, and also paid about $1,000 in regular expenses (advertising his house, buying paint, etc). On his income tax return he claims revenue of $10,000 and expenses of $10,000, giving him a taxable profit of $0. That's nice, since he won't owe an extra taxes.

But Tommy was smart and deprecated his house. According to the tables above he gets to deduct $5,000 in wear and tear on the house. So now he has revenue of $10,000 and expense of $15,000. So he'll probably be looking at a nice tax return this year. The amount he gets back depends on his tax bracket, but it's money in his pocket right now.

There's only one final catch to depreciation. When you depreciate an asset, the government is expecting the value of that asset to drop to $0 (like a broken down truck). So if when you sell your home (and it's worth something) the government wants to be paid back for the tax breaks it gave you. While the gains on a long term house sale are a measly 15%, the depreciation you claimed is taxed at a much larger 25%. This is called recapturing depreciation.

In other words, say you buy a house for $100,000 and the house is valued at $75,000 (the remaining $25,000 is the value of the land). You claim the full 3.6% depreciation each year and then sell 10 years later for $250,000. Over the 10 years you claimed $2,700 as a deduction each year (in depreciation) for a total of $27,000. So when you sell your taxes will be 25% of $27,000 (recapturing your depreciation) and 15% of $150,000 (capital gains tax for your profit). You'll pay $6750 in depreciation recapturing.

Or, in a simple form, when you sell you owe the government:
$27,000 (the amount you depreciated)
x 25% (the depreciation tax rate)
= $6750 is the amount you have to pay the government in recapturing depreciation

$250,000 (the amount you sold the house for)
- $100,000 (the amount you paid for the house)
= $150,000 (the capital gain you got for the house)
x 15% (the capital gain tax rate)
= $22,500 is the amount of tax you have to pay for your gains

Your total tax bill will be $6750 + $22,500 = $29,250. (It's important to note here that in this situation, the capital gains tax would remain the same whether or not you had depreciated the property)

So is there an advantage in depreciation? If you tax rate is 25% or higher that answer is obviously yes. But what if you happen to have a lower tax rate, say 20%? Well, each of the 10 years you save $540 in taxes from depreciation. If you put that money in a decent savings account and earn 5% on it, then after 10 years that account will be worth $6792. When you have to pay your depreciation recapture tax bill of $6750, you'll be left with $42. Obviously not much of a gain, but it's still a gain.

(For the record, if your tax rate is 33% your account will end up worth $11,206, therefore depreciation will save you almost $5,000). In addition to the extra cash, you will have access to that money throughout the 10 years in case of any emergencies (like the aforementioned roof), which could help you avoid having to take out a loan.

So, in short, depreciation is simply the government's way of letting you deduct the expense of buying a house, but over a long period of time. Any questions?

Why the bubble will take some time to sort itself out

Basic economics teaches us a lot about the decisions we make. Take the simple example of supply versus demand. Most people are aware that if supply is greater than demand, prices fall. Which turns out to be true in an abstracted economical construct.

The stock market is almost such a construct. It is as close to pure economics as you can possibly get. When no one wants to buy a certain stock, it's price will fall until someone does. There is no waiting time, time to pitch your stock to a potential buyer, it simply falls until it is attractive to someone. The same is true in reverse, if everyone wants the stock, the price will rise until enough owners are willing to sell. When the average investor buys or sells, they don't negotiate or consider multiple offers. The market economy is abstracted away to the point where the investor is told what the stock is worth and that's what they use.

So why do houses take so long to sell? If you can buy a stock any day and sell it any day, why does a home sit on the market for weeks or even months? Simply put, it's because economics fail to take into account the power of emotion and perception.

There is a game anti-economists play to prove that humans are not economical. It's called The Ultimate Game, and it's really quite simple. Take two strangers off the street, we'll call them Thing 1 and Thing 2. Put $1000 on the table and tell Thing 1 to divide it however he wants between them. Then Thing 2 gets to accept or reject the offer. If he accepts they each take their money and walk away, but if he rejects they both go home with nothing. It's an awfully simple game.

In the world of conventional economics, Thing 1 should maximize his own gain and offer Thing 2 $1, while keeping $999 for himself. Thing 2 might not like this offer, but classical economics say that he should realize that $1 is better than nothing and accept the offer. Too bad it never actually works out that way. In tests throughout many countries, Thing 2 always rejects the minimum offer. In fact, he rejects more than half of the offers consisting of lower than 30% of the total. Why? Doesn't he know that going home with $1 is better than going home empty handed?

To answer that question we need to put the game into a void. Go up to a stranger (or even someone you know) and offer him a dollar. Odds are high that he will accept it. So obviously the dollar itself isn't the problem. Let me pose two theories of why Thing 2 wants more than the minimum:

1. When the money is first mentioned, Thing 2 immediately perceives half of the money to be his. When the lowball offer comes in, Thing 2 perceives that offer as a loss.
   
2. When Thing 1 makes a lowball offer, Thing 2 compares his gain to Thing 1's gain and is insulted.
   

Both scenarios are interrelated and both result in the same way, Thing 2 turns down an offer that would have benefited him, simply to punish Thing 1 for being unfair. But for the moment, I want to focus on the first theory.

In this theory, Thing 2 hears the rules of the game and realizes that it's a cooperative game where each player only benefits when they work together. Thing 2 immediately perceives half of the money as his, after all Thing 1 gets nothing without his cooperation. When the lowball offer come in, instead of seeing the offer as a $1 profit, he views it as a $499 loss. Emotion and perception rule over hard logic.

I hope now you've seen the connection with real estate. The tremendous news rush about the housing boom lead many Americans to have an inflated perception of the value of their homes. In addition they've seen houses all around them sell for enormous profits, and naturally they then perceive those profits to be theirs as well (once they sell).

This is the reason why, instead of home prices falling as much as they should, homes have been sitting on the market for much longer periods of time. Everyone knows that the sellers have over-inflated opinions of their home's value, but they refuse to readjust their views because they don't want to take a "loss". So they leave their over-priced homes on the market, just waiting for either the general prices to rise back to their previous levels or for some greater fool to come along. Eventually most of these people will reach a point where they can no longer afford to wait and will end up in an even worse situation, selling for a "loss" as a "motivated" seller.

One lesson that investors can take from this is simply that some people are more logical than others. As an investor, if you received that offer for less than you wanted, you should be able to properly analyze the situation. I know you were hoping for a $500 profit, but is that realistic? Or is the current profit the best you can hope to get? The same goes for our investments. We always picture our future profits in our head, and are disappointed with under performing assets. We need to release our expectations when we are making business decisions, and just deal with the facts at hand in a logical, economic way.

Even the small profits are profits too.

Why it matters where mortgages go...

A short while ago I wrote about what happens to a mortgage after you close it. The short end of the story (you can click on the link to read the whole thing) is that banks will almost always package up your mortgage with others and then sell that package to an investor. Typically this doesn't matter much to you, the borrower.

However an article recently at CNN.com brought up one point that could matter. Just as the company who buys your mortgage can't change the terms, neither can you. If you think you were sold an obscene loan (usually some derivative of an ARM), one step you can do is talk to your mortgage company about "re-characterizing" your loan. Essentially you are asking them to refinance your loan (at no cost) to a reasonable fixed-rate loan.

The bank is not beholden to acquiesce to your request (bonus points if you recognized the reference), however if you can convince them that such a move would be mutually-beneficial (such as, you may have to foreclose under current terms), they may be open to such an agreement. This isn't the type of option you can use to strong-arm the bank into a discount rate, but rather to try to switch from a variable ARM to a fixed-rate loan.

The catch? If the bank has sold your mortgage then they no longer have the ability to alter your terms. At that point you have no other recourse than true refinancing (and paying the fees that go with it).

The Danger of Overextending Yourself

I know that I can be hard on Rich Dad, Poor Dad author Robert Kiyosaki. I’ve referred to him through several posts, none of which cast him in an angelic glow. To be fair, it was Rich Dad, Poor Dad that inspired me to get into real estate investing, leading even to the establishment of this very blog. However while the motivational value of what Kiyosaki says can't be under-estimated, I've found personally that his advice sometimes seems lacking in the details. And occasionally I worry about the young investors that may read his books become greatly motivated, and then go out and do something stupid. Investing takes a great deal of research and planning, both of which can kill the emotional high of reading highly motivational material. One of the common criticisms of Kiyosaki is that, according to the old adage, he teaches you just enough to be dangerous.

Of course, no serious investor would take something said at face value and then make bad decisions based on it, but many amateur investors do just that. I want to talk about one specific problem today, what I feel to be the second greatest problem facing all real estate investors. I refer, of course, to over-extending yourself or, in other words, going too far out on a limb. (I'll tell you what I think the greatest problem facing an investor, but you'll have to read to the bottom to find it)

I refer, this time, to an article that Mr. Kiyosaki wrote for the Yahoo! Finance page titled “Learn to Invest Like a Pro”. While there were a few claims that he made within the article which I have questioned, there was one in particular that left me aghast and stupified. In the article he describes a situation where he had discovered an investment property that would cost him $300 a month to cover the gap between rent and mortgage payments. His rich dad scoffed at the idea of investments running you a monthly cost.

When he asked me, "How many investments can you afford that cost you $300 a month?" he was also asking, "How many investments can you afford that earn you $300 a month?" The obvious answer is, "As many as I can find."

The obvious answer is not always the right one. Take, for example, the experience of Casey, a 24 year old investor in California. Casey went to several real estate seminars, attended a couple of “boot camps” and decided to get into flipping houses. His strategy was to purchase homes with upside-down mortgages (mortgages that are larger than the closing cost of the house, so the buyer walks away with cash in his pocket), use the cash from closing to fix the houses, and sell for a profit. How many of those deals could he afford? As many as he could find, right?

He bought 8 houses in a matter of months, invested the closing cash into repairs and everything seemed perfect for a couple of months. Then reality came crashing down. Contractor delays, cost overruns and difficulties in selling blew his budget out of control. Before long he was broke and was using credit cards to help cover his $15,000 a month mortgage costs. Now he’s facing foreclosure on his properties and even optimistic projections leave him hundreds of thousands of dollars in debt when the dust settles.

Was Casey's original plan a bad idea? Plenty of investors make a living by fixing up old houses and selling for a profit. In fact, that's also the plan of most builders. So why did Casey go wrong? The problem was that from reading pieces like the Kiyosaki article, he thought "I can afford as many of these deals as I can find" when the truth was actually much less appealing and much more complex.

But, you doth protest, Kiyosaki is talking about renting those investments out so there aren’t any carrying costs, right? If he was having trouble selling, he could just rent longer and make more money, right?

Alas, poor reader, trouble besets not just flippers, but holders as well. What happens if your investments go vacant for a couple of months? Could you afford them then? What if they needed new roofs? Or the air conditioning unit breaks?

The correct answer to the question "How many investments can you afford that pay you $300 a month?" is “As many as I can afford to carry.” Unless you are paying cash for all of your properties, you are playing with Other People Money (a favorite phrase of real estate gurus everywhere). The trouble with Other People’s Money is that Other People tend to be very serious about their Money and they don’t like excuses. Try telling the bank that you can’t pay your mortgage because no one is paying rent.

Biff and I have agreed to a rule: at all times we want to have enough cash on hand to cover at least 3 months rent for all of our properties. The likelihood of having all of our properties vacant at the same time is extremely low, but the cushion will save us if one place goes empty while another’s roof leaks. And in the case of any unexpected costs, we can pay out of the companies coffers, instead of our own wallets.

Maybe keeping that much cash on hand is overly conservative, but the only cost to us is that we take a bit longer between each purchase to rebuild our reserves. The slightly slower growth is preferable to the alternative, getting wiped out by one bad bet. You realize what causes the bankruptcies of most investors? They take a small risk and it pays off, and then they take a slightly larger risk and it pays off too. Eventually they are leveraging enormous amounts of money against the future prices of natural gas and when they lose, people go bankrupt.

Besides, that "emergency fund" is currently earning us over 5% risk-free, which isn't too shabby.

All investing incorporates some sort of risk-taking. But the nature of risk-taking is that eventually you are going to lose. The difference between a wise investor and a fool is simply that the wise investor choose his risks and is prepared for some of them to fall flat. Those failures can set him back a bit, but he'll still go strong. The foolish investor takes risks he doesn't understand, without knowing the consequences of failure. He may succeed for a while, but all it takes is one loss to demolish him.

Consider the parable of the fool at the roulette table who figures out a system to beat the game. This system will allow him to win 80% of the time. He brings his life savings of $50,000 to the table. Carefully, he places $25,000 of it on black and wins. Excited, he places his original bet and is winnings ($50,000) on red and wins again. Thrilled, he nows places all the money ($125,000) on black again and wins once more. He's now up to a quarter of a million dollars.

He runs to all of his friends, and begs them for money so he can make an even bigger bet. They lend him another $100,000 and he places all of it on red and wins once more. He now has $700,000 (minus the 100 grand he owes his friends). He does the math in his head and calculates that he could be a multi-millionaire by the end of the night and a billionaire by the end of the week.

He throws all $700,000 on black, but this this his system fails him (remember, we knew he was only going to win 4 out of 5 times anyways). He's left with nothing. His life savings are gone, and so are the savings of his friends. He's a pauper because he didn't have the common sense to prepare for the occasional loss.


So if over-extending yourself is the second greatest threat to a budding investor, what is the greatest? Simple, the greatest threat is the fear that prevents people from ever making an investment.

Where do mortgages go?

If you own your own home, or some investment homes, you have probably received notice (possibly multiple times) that your mortgage is being sold. Sold? Who would want my mortgage? What are they going to do with it? Am I going to get screwed in the deal?

I'll explain where your mortgage is going, but first I'll address a common concern that people have with mortgages and their sales.

When your mortgage is sold, the terms of the mortgage do not change

If my mortgage, created by USAA, is sold to, say Lehman Brothers (an investment bank), the terms that USAA creates transfer with your mortgage. Lehman Brothers won't change the interest rate (if you had an ARM, they'll only change it according to the original terms). They can't change the payment schedule. They cannot change a single thing about your mortgage.

"But", you cry, "when my mortgage was sold they sent me a notice telling me to pay more money!". When most people make a mortgage payment, they usually pay money to an escrow account instead of the bank. This escrow account then doles out the money to several creditors, including the government (for your property taxes), the insurance company (your home premiums), and the bank (interest and principal). When your mortgage is sold, these accounts are often reviewed, and sometimes you can come up a little bit short (if your taxes increase, for instance). This can also happen if you mortgage isn't sold, but the mortgage loan itself always remains the same.

So what happens to the mortgage when it's sold?

First let me explain what a bond is. A bond is essentially a loan. When a company (like General Motors) needs some money to build a new factory, they create a new bond and trying to sell it (it's a giant I-O-U). The buyers of the bond give GM a very large sum of money and in return GM pays that money back, with interest, on a regular schedule. Does this sound familiar to you? Sounds awfully similar to a mortgage to me...

Bonds are a big business on Wall Street. People are constantly buying and selling them, just like stocks. Their values go up and down according to the interest rate benchmarks. For a hypothetical example, that GM bond you bought last year that pays 5% is worth less today because the interest rates rose to 6%. Essentially, by buying a bond issued today (at 6%) you can get a better return then by buying a bond that only pays 5%, therefore the old bond isn't worth as much. On the other hand, if interest rates drop your bond becomes more valuable. So the values of bonds go up and down and people trade them just like stocks.

Let's look at a fictional bank, the Bank of Value, which has $1,000,000. The Bank of Value ends up giving out 10 mortgages, each for $100,000 at 6%. That's not a bad deal, and the Bank of Value will earn almost $60,000 in the first year. Not a bad investment, and it'll provide the Bank with some decent cash flow over the next 30 years. But the Bank of Value isn't in the business of waiting for cash flow, it's in the business of making loans. However, since they have loaned out all of their money, they can't make any more loans.

So what the Bank of Value does is take the ten loans and put them together into a sort-of-bond. No one wants to buy a $100,000 bond, that's too small an amount of money for a big investor to care about. They normal trade in the millions and billions of dollars. But when you put 10, 20, or even 100 mortgages together, you get a very big sort-of-bond.

Mortgage-backed securities (bonds) tend to be bought by larger investors like pension funds. The pensions have money today (from their employee contributions) and need more money tomorrow (to pay back the employees when they retire). The banks have money tomorrow (which will be paid back by the home owners over 30 years), but need money today (to make more loans). Mutual Funds are another major investor in mortgages.

So the Bank of Value now takes it's sort-of-bond and sells it to a pension fund for $1,100,000. The bank is happy, because now they have made a nice profit and can make more loans. The pension fund is happy, because they will be getting 6% over the next 30 years, not a terrible return. The Bank takes their $1,100,000 and now make 11 new mortgages, and the entire process starts all over again.

And that's why your mortgage is sold. It gets the loans to the people who want them (so they can get money over a long period of time) while freeing up more money to be lent for tomorrow's home buyers.

If this subject interests you, I highly recommend that you check out Liar's Poker, a very amusing tale about Wall Street during the 80's, with a large section talking about how mortgages became one of the hottest securities on the market.

Hire people smarter than you?

In Robert Kiyosaki's best-selling book Rich Dad, Poor Dad he mentions that one of the secret's of success is to "hire people who are smarter than you." Due to the best-selling nature of the book, that saying quickly became a common platitude, which eventually led to satire, culminating in one of my favorite Dilbert cartoons where a conversation goes as follows:

PHB: A good manager is one who hires people smarter than he is.

Wally: So... Your boss is dumber than you?

Alice: And your boss's boss is dumber yet?

Dilbert: According to your theory, our CEO is the dumbest person in the company.

Obviously this touch of wisdom is comparable to the warm leavings of a male bovine, but like many trite sayings, it contains a slight nugget of truth at its center. When you hire someone to do a job for you, you hire them for one of two reasons:

1. You don't have the time to do the job
2. You don't have the expertise to do the job

To further differentiate, in the first you retain decision making powers, and expect your employee to carry out your wishes. In the second option you are giving your decision making powers over to someone that you hope will make better choices than you (which, of course, is the type of hiring that Kiyosaki is talking about).

Janitors, and the kid next door who mows your lawn, are obvious examples of the first type of hiring. That kid next door isn't smarter than you (well... at least not yet) so you're not hiring him for his expertise. You are hiring him because it's worth the $20 a week to free up your time for other activities that you find important.

Bill Gate's accountant was hired because Bill Gates doesn't have the necessary education to understand the laws surrounding the management of his extraordinary wealth. Nor does he care to spend the time to get that education. Bill Gates is almost certainly more intelligent than his accountant, but he doesn't have the specific expertise.

Some jobs can swing back and forth between the two. I'm a computer programmer, and at my first job I was one of 8 programmers on the team. We were all managed by an environmental engineer who thought he had seen code once. We were hired because of our expertise, if the manager were left on his own he'd be incapable of doing the work. Today I work at a different company and I'm managed by a very intelligent programmer. He never asks me to do anything he couldn't do himself, but due to the sheer volume of work involved, he can't do it on his own.

So what does this have to do with real estate? When hiring people to help you run your company, you need to clearly identify which sort of hire you are making. In a previous post I wrote about an investor wanting to hire someone to manage her property. The investor was clearly capable of doing the job herself, she just lacked the time. The only things she needs to look for in her interviews are reliability and competence. She can show her managers what to do, they just need to be able to do it. The potential managers would have some limited decision-making related to their jobs, but she would probably be making all of the important decisions.

On the other hand look at Frugal over at My 1st Million. In one of his posts (which actually was the inspiration for this entire post) he had decided to try to find a money manager that could better his performance AND give him more free time. The problem, he found, was that he felt he knew more about money than any of the so-called advisers.

Many "information-specialty" occupations (real estate agents, financial advisers, debt counselors) are filled with young kids (or old kids) who don't necessarily know any more than you do. In fact, their knowledge (which can sound awfully impressive when you hear their sales shpeel) can be limited to what their employers are asking them to push. But since you are hiring them for knowledge that you don't have, how can you possibly tell the difference?

Frugal's solution was to create a simple, four question, binary test. Every question on that test is fair (I answered all of them in a matter of seconds), yet demonstrates at least a basic level of economic understanding. That way he could very quickly discover if the individual he was speaking with was worth interviewing further.

His solution is practical and elegant, and repeatable. If you are ever stuck hiring someone for their expertise, do a little research and make a quiz. The purpose would be to give the individual a chance to prove that their knowledge of the material is both wide and deep and that they are, at the very least, as knowledgeable as you are. This should go for everything from Real Estate Agents who want to sell your house, to accountants who want your tax business, to money managers.

Just remember, other people are rarely looking out for you.