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.


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