Indicators of Success #6

Some people get it. It seems like every project they touch turns to gold and they can simply do no wrong. Other people don't and sometimes it seems like the world is set dead against them. They couldn't get a lucky break with a four-leaf clover and an army of rabbits donating their little furry paws to the cause. Why is this? Why do some people turn their real estate side ventures into multi-million dollar hobbies, while others put every last ounce of effort into their investments only to result in a sub-500 FICO?

The success of your venture in real estate is determined long before you sign your first tenant, long before you buy your first house, even long before you first read Rich Dad, Poor Dad. The difference between successful investors and amateurs is evident in every aspect of their lives. I'm going to write a series of articles about the various "indicators of success", but I don't plan on writing them sequentially. I'll just throw one together every once in a while (and not even in numbered order! Take that!)

The sixth indicator of success isn't the most obvious. While you may think towards school grades, financial savvy or boldness, the first indicator of success is far more subtle. The first thing to consider when either when looking at investing in real estate is "Do I finish the things that I start?"

Let's take two case studies, my wife and my sister. I love them both dearly, but they are very different people in just about every way.

My wife is 25 years old. After graduating, with honors, from her undergrad university she moved to Northern Virginia to pursue her career in non-profits. She applied to grad school, George Mason, and was turned down. Unfazed, she applied again and was admitted into their master's program for non-profit management. She spent the next three years working full-time for a national trade association while taking classes at night. When we decided to get married and move to London, she increased her class load while working 50 hours a week and planning our wedding. Now that we're in London she's finished her degree and gotten a new job fund raising for Down's Syndrome Research. So far, she has met every major goal that she has set for herself.

My sister is a very different story. Over the last ten years, she has pursued careers as a veterinarian, a personal trainer, a firefighter, an elephant trainer, a brail transcriber, and as a 911 operator. She hasn't, yet, actually held jobs in any of those fields. She ran, for a while, her own pet sitting business. Now in her mid 30's, she's looking into getting a Masters from an on-line university to pursue her latest interest, becoming an instructor for the blind. And no, not one of the jobs listed above is a joke or an exaggeration. Not even the elephant trainer.

I love both of these women, and think they both have fantastic lives. But if I had to place money on one of them to become a successful investor, guess who I would go with? There's more than just a determination to meet your goals, there's also an intelligence in picking goals that you can meet. My wife, as wonderful as she is, would probably not been as successful if she had a goal to become the next Brittney Spears. Her talents, though many, simply do not lie in her ability to carry a tune.

Let's take a look at two more real world examples. Casey Serin, the famed 24-year-old investor who's still struggling to figure out how to make a buck has, over the last 9 months, pursued web site hosting, real estate, penny stocks, commodities, and book deals.

Compare that to Warren Buffett. He is famous for following his strategy come hell or high water. He values companies that he understands, and stays away from the ones that he doesn't. He finishes what he starts:

"You ought to be able to explain why you’re taking the job you’re taking, why you’re making the investment you’re making, or whatever it may be. And if it can’t stand applying pencil to paper, you’d better think it through some more. And if you can’t write an intelligent answer to those questions, don’t do it."
Obviously a tendency to finish what you begin isn't a tell-all indicator for success. But if you take a look around you and you see a stack of mail you never answered, that hole in the wall you always meant to patch but never did, the shirt you always intended to return... you probably have some personal growth to work on before you begin your real estate empire.

What is a Hedge Fund?

Sometimes Blogger confuses me. I wrote a nice new post that I had been working on for a couple of weeks, but when I published it, Blogger decided that it belongs several days earlier. It doesn't make sense. Should posts be sorted by posting date instead of first-saved date?

Alas, if you want to read about hedge funds, where they came from and why you aren't allowed to invest in one, please kindly follow this link...

The Rich Dad Method of Losing Money

I know, I keeping talking about so-called "gurus" and their terrible advice. Today I was fully prepared to discuss other topics of interest, including some general success methods and a little chat about the history of hedge funds. All of that was put aside when I read the latest Robert Kiyosaki article on Yahoo! Finance.

I was raised Republican. I voted Republican. I believed that I truly was Republican. I honestly thought that free markets work and that everyone should be left to their own decisions. But as I age I find myself swinging more and more to the Democrats. I'm realizing that many people are truly idiots. They should not be making their own decisions, because they'll just end up hanging themselves. We live in a nation where a company that was founded to sell computers to the poor at insane rates, has now expanded it's line-up to include plasma TVs!

Today I beginning to believe that many (if not most) people are idiots. So when I see something that's utter ridiculous in an article written by a self-proclaimed "investor, entrepreneur and educator", it dawns on me that there are people out there who won't realize the foolishness. Who will make life-changing decisions based on his fallacies. And I worry.

Interestingly enough, Robert's article begins with a retraction. Of sorts. You see, the last article he wrote, about how horrible mutual funds are (see my post, 4 Lies That Gurus Tell You) wasn't really written by him. And you see, he wasn't really telling the truth either. Oh, he wasn't lying, he was simply joking. Of course smart readers would have recognized the joke. You're not a dumb reader, are you?

Maybe he was joking, and I have no conclusive evidence that leads me to my own personal conclusions that his article was so incorrect, and received so much heat, that he had to distance himself from those opinions. So not only is it a joke, but it's a joke that someone else wrote...

Then he begins a new article, and ends up committing a serious logical inconsistency that completely reverses his arguments. In other words, he actually proves himself wrong. Let's see if you can catch it:

There are other lessons to be learned from the investing food chain. One is the power of debt in contrast to equity. Debt holds a higher position than equity, and bankers and bondholders are in debt positions. Preferred stocks, stocks, and mutual funds are in equity positions.

The takeaway here is that most amateur investors try to get out of debt positions and into equity positions, where they invest with their own money or assets. Professional investors would rather be in a debt position -- investing with a banker's money, for instance -- simply because debt is less risky than equity.
Let's break this down to spot where he loses his train of thought. He begins by explaining that debt holds a higher priority than equity, thus making it a safer investment. He's correct in this. When something goes wrong, the first people to cash out are the debt holders. There's an anecdote from Liar's Poker about an investor and a bond trader. The investor makes some comment about owning a company, and the bond holder corrects him by saying that, actually, he owns the company. The investor is puzzled and says that he controls the majority of the stock, so the company is his, right? And the bond trader says "Yes, but let's see how much is left after I call on the company's debts."

Yes, I butchered the story (my copy of that book is an ocean away right now). But the point is clear, people who own debts are first in line to get paid. If a company like Enron goes down, the debtors are paid first and the stock holders get whatever, if anything, is left. So I have to agree with him in that first statement.

But then Robert tries to use that statement to leapfrog into a claim that amateur investors invest their own money and that the pros borrow money to invest. Do you see the problem here?

At first Robert is using the term "debt position" to refer to the person who owns debt. In the very next paragraph he neatly swaps the term "debt position" to mean someone who borrows a lot of money. He's talking out of both sides of his mouth at the same time.

If you extrapolate from his first definition of "debt position" you would reach the logical conclusion that to minimize risk you should buy debt vehicles such as bonds, treasury bills and municipals. That is actually sound investment advice, and people who can't weather the volatility of stocks often are advised to buy bond funds.

But he goes the opposite direction in the second paragraph and tells you to borrow money to invest, or in other words, invest on margin. How is that safe? If I invest the bank's money and I lose it all, how have I protected anything? You think the bank is going to say "Well, it was our money you invested... I guess I'll just let this go"?

My goldfish can give you better business advice than this.


Leverage is to finance as a baby is to a marriage. A baby won't make your marriage any better or any worse, it'll just multiply the conditions that already exist. A child born into a good marriage will strengthen the bond, but a child born into a rocky marriage will simply deepen the divide. Money is the same way. Investing borrowed money into a good decision will multiply your returns, but investing borrowed cash into a money-pit is the quickest route to financial ruin.

In addition he goes on about "recourse debt" and "non-recourse debt". He does a good job of explaining the difference between the two (mortgages, in case you were curious, are non-recourse). But then he lets on smugly that he only takes on non-recourse debt, as if it were some big secret that he's letting you in on. What he doesn't tell you is (if he's telling the truth, and not joking again) that he pays for that privilege. Banks are relatively smart, and they know the difference between the two types of debt as well. So if you want a non-recourse loan, which increases the risk that they might lose money, your interest rate goes up accordingly.

What kills me are the legions of adoring fans out there taking his advice at face value. The man literally wrote an argument that contradicted itself in front of a national audience and his comments are filled with phrases like:
- This advice is PRICELESS!

- That's my idol, a controversial expert! I really learn a lot from you Kiyosaki, you are a real genius. God I hope I will have a mentor like you.

- I love Robert Kiyosaki! He changed my life...I read One book of his, and now I own 3 houses a year later...this year I will buy 3 more.....oh and I quit my stupid leave him alone!!!!!!!!!!

- Robert, some people may never get it, but a few of us would, thank you!
With get-rich-quick minds like these, it's not hard to figure out why the rich keep getting richer. It's people like this who are driving me to become a Democrat. I honestly doubt their ability to take care of themselves. It because of these people that laws, such as those surrounding "accredited investors", exist. If you are unfamiliar with that term, I'll go into it in more depth on Tuesday (yes, I'm baiting you. But if you are really curious just Google the term).

In the mean time, let me leave you with my favorite comment:

What is a Hedge Fund?

I'm currently on vacation at my new in-laws, so my posting will be little off this week. New posts will be up before the Tuesday/Thursday promise, but (as in this case) sometimes that might mean a day early.

I fondly remember the Super Mario Bro's Show while growing up. It was a hilarious show that began and ended with two guys dressed up as the world's most recognized italian plumbers. In between they would show an animated sketch that usually starred Mario, Luigi and the other denizens of the Mushroom Kingdom. However once in a while they would replace the Mario cartoon with a cartoon based on The Legend of Zelda, a complete change of direction and arguably more exciting.

In honor of that most notable show, I too like to stick mainly with my bread and butter, namely real estate, landlording and dishonest "gurus". But every once in a while I like to go off in a somewhat random direction and talk about other things. Today is one of those days and I want to discuss a little bit about hedge funds.

Most people even remotely interested in money have heard of hedge funds. They are the investment vehicle of the rich, glamorous and exciting, they routinely bring about returns higher than 25%... right? Let's start with a little history lesson.

Every investor knows about risk, but in the late 1940's an investor named Alfred Winslow Jones came up with the idea of hedging certain risks in the stock market. When you "hedge" an investment, you essentially bet on both sides of an issue so that you don't lose or win regardless of the outcome.

Let's say that I buy two investments. The first investment is tied to interest rates so if they climb, the investment loses value. The second investment is tied to interest rates so that if the rates climb, it gains value. Now, no matter what the interest rates do, I don't lose any money. I've hedged myself against the interest rates.

But why would you do that? After all, if interest rates move you don't gain any money either! That's 100% true, but the interest rate isn't the only variable that affects my return, it's only one. The goal of hedging your investments is simply to limit the number of variables that can impact your portfolio.

Let's say that you believe that Volkwagon is going to post huge gains this year. You want to buy their stocks but you are worried. What is the euro falls against the dollar? If Volkswagon gains 20%, but the euro falls 20%, you've just seen all your gains wiped out by a currency change. So you buy the Volkwagon stock, but then also short the euro (shorting is an investment where you essentially gain if the investment falls in value). If the euro stays strong and Volkswagon succeeds, you will make money from the stock and the euro breaks even. If the euro falls and Volkswagon succeeds, you'll make money from the short on euro, and the stock breaks even. Essentially the euro no longer matters in the equation, you'll only lose if the Volkswagon stock falls.

That is hedging. Unfortunately for most mutal funds, hedging often involves shorting stocks and leveraging positions (taking loans to buy investments), something that mutual fund managers are not allowed to do by SEC regulations (or at least not do freely). So around the 1980's some enterprising finance whizzes came up with a way around it. They would invest outside of SEC regulations, but still within the law. And hedge funds were born.

Hedge funds can only allow accredited investors to buy in. An accredited investor is someone who has a net worth of at least $1 million, or has earned at least $200,000 a year for the past two years. Why does the government do this? Why does it prevent poorer people from buying into the investments of the rich?

Simply put, accredited investors are people who are allowed to invest money in schemes that are not regulated by the SEC. Because these schemes are unregulated, they can often be extremely risky, and contain all manners of undisclosed issues. The government coined the term accredited investor to represent someone who had enough money to be aware of the risks inherent in unregulated investing. In other words, the government is limiting the risks that poor people can make with their money (yet government still encourage lotteries... more than slightly hypocritical).

Early on, hedge funds enjoyed tremendous gains (as is typical whenever a new successful niche is discovered). For many years hedge funds were able to generate huge returns by eliminating un-wanted risks and focusing their growth on variables that they could predict. However, as with all new successful markets, competition sprung up all around them. Profits became harder to find, but the investors still expected mammoth returns.

Due to the lack of regulation by the SEC, the hedge funds began to leverage themselves more and more, and instead of eliminating risks they began to gamble. They would leverage huge amounts of money on "almost sure things". Of course, as I've written before, when playing with leverage, you only have to lose once to destroy yourself.

This happened to a company named Long Term Capital Management in 1998. For the first four years of it's existence, LTCM returned nearly 40% a year. At first everything was great because they had found a very profitabler niche in the market. But as their niche lost it's profitability, the firm found itself under pressure to continue with it's extrodinary gains. They took risker strategies and undertook an enormous amount of leverage. When the market turned sour in 1998, they lost $4.6 billion in less than 4 months and had to be bailed out by the US government (actually the bail-out was private, but organized by the government).

So there you have it. A hedge fund is simply a vehicle (like a mutual fund) that is allowed to undergo risky strategies because it's somewhat on the outside of SEC regulations. Some hedge funds put togeher extrodinary returns, but just as many fail miserably. While hedge funds retain their name from the time when they actually hedged against risk, today they are simply specialized investment vehicles open only accredited investors.

The strategies that are available to hedge funds allow them to earn slightly higher returns than mutual funds, but that gain is apparently over-stated and comes with extremely high risk. Barclay's Bank (a major British Bank) did some research into the "average" results that were compiled by hedge funds indicies and found:

Barclays outlined a series of methodological failings by index compilers,
including survivorship bias — the tendency to ignore funds as soon as they close
or fail. This alone added between 2 and 4 per cent a year to index performance
figures, according to academic studies, Barclays said.

And there's good news for average joe's who wish they had the the complexity of hedge funds available. Due to leveraging and shorting becoming more and more common-place in the market today, the SEC is considering allowing regular mutual funds the freedom to place limited leveraged positions and shorts. So soon these techniques will be available, in fund form, to everyone.

Statistics and Damn Lies

I'm sure that everyone has heard of the quote oft attributed to Samuel Clemens, "There are three type of lies. Lies, damn lies, and statistics." This quote was always on my lips as I suffered through my required statistics course in college. It was only when I had to help my fiance (now wife) with her graduate course in statistics that I found a new respect for the field. Nowadays I see the value that statistics can give us, but only when we make the judgments ourselves. Never trust a stat that someone else has quoted to you. Only the raw data itself is truly useful to you.

So what does this have to do with real estate. Well, first of all stop listening to NAR's statistics. They mean nothing. But more importantly, I recently read an old post at I Will Teach You To Be Rich that was highly educational.

Here's the synopsis. Ramit shows you two credit card offers from the same company. The economics of the offers are essentially the same, but the graphical designs are different. Different colors, different pictures, different layouts. One emphasizes "fixed [rate] until 201o", the other emphasizes "0% interest rate". From his post:

This is how real marketing is done–not by handwavy marketers saying “I think red is better!” but by actual, rigorous data analysis.
And he's right. Real marketing is done in this way. When marketers tell you that red ink draws more attention, they aren't relying on some biological study from a university discussing how the physics of light focuses the eye on red (at least not usually). They are basing that belief on statistical analysis. They sent out 1,000 credit card offers in red ink and 1,000 credit card offers in green ink and the red ink led to a 23% higher application rate (all statistics are, of course, made up).

How can we use this information? As real estate investors, we too, have to be marketers. We have to find people to occupy our properties. This could be done in many ways, we can advertise on one of thousands of websites, we can places signs in the community, we can go to a real estate company. But many of those options cost money, and which gives you the best return?

Biff and I have decided to find out. From now on, whenever we advertise an opening in one of our units, we're going to pay attention. Using just a simple spreadsheet, we'll keep track of each person who responds to our ads, storing the date, the advertising that worked, and whether or not they finally applied for tenancy. That last part is important, as Biff currently estimates that we get about 85% of all of our calls due to the neighborhood signs, but most of our actual applicants come from people who find our web ads.

We don't have that many properties and, if we're lucky, we won't have to find new tenants every year. But it's worth while to keep track of the statistics that we can. More information never hurt anyone. And if you've been paying for that ad every year, but never gotten a bite from it? Maybe it's time to stop throwing your money in that direction and try something new!

New Credit Report Laws

Quick update on the tenant situation. We have found someone who appears to be a good applicant and are now in the process of processing their application. This person is actually a referral from our current tenants (who are breaking the lease), which is a testament to the value of not burning your bridges.

Probably the most important step in the process is running a credit check. I've written about the value that you can get out of a credit check before, and most every landlord advice column talks about the credit check. So imagine my surprise when I go on-line to run a credit check and I discover that the laws have changed. Shockingly, not one other blog had brought this up yet, so it caught me a little bit by surprise.

The change is in the Fair Credit Reporting Act(15 U.S.C. §§ 1681-1681(u)). Essentially the three big reporting agencies (Equifax, Experian and Trans Union) need more information before they dispense credit data. The change is supposed to deter identity theft, so it requires that businesses register themselves and submit to an on-site inspection. From my understanding this accomplishes two things:

1) They can identify that the users in question are legitimate businesses with a legitimate need to access credit reports
2) They can certify that the credit reports, once obtained, will be safe from theft

So, if you have an immediate need to run a credit check (like we do), what options do you have? Simply put, while you aren't allowed to access a full credit report, you can get a little bit of information on an individual through the typical credit report agencies. Specifically you can know discover what "grade" a user's credit is. 800-850 is an 'A+', for example. You won't get their actual scores, nor will you get any of the credit history.

Longer term, what do you have to do in order to get true credit reports? You will have to submit your place of work to an official third-party inspection. This inspection costs somewhere between $75 and $100 and must be renewed annually. When the inspectors arrive they will want to see:
- Proof of ownership of your rental properties (title)
- Proof of rental (rental agreements/applications)
- Proof of identity (license or passport)
- Proof of security. This means that they are looking that your credit reports are secure from your living area. I assume that if you had a properly locked office it would suffice. If you only handle electronic copies of reports, I would hope that proper password security would be satisfactory, but I don't know for sure.

If you are a smaller landlord and only need to run 1 or 2 credit applications a year, then this essentially increases your costs to $115 per credit report ($100 for the inspection and $15 for the actual report). A simple decision has just become much more complicated. Biff and I are currently in the act of reviewing our needs and whether or not we'd like to pay for an annual inspection.

I'm sure that Congress's heart was in the right place when they made this law and for all I know it'll cut identity theft down by 90%. But it's definitely causing headaches all over the country for small landlords that needed to run only a few credit checks a year, for legitimate business purposes.

Mortgages in Britain

First a quick update on our tenant search. As of yesterday, we'd had around 10 inquiries into the house. The unit in question is a 3-bedroom townhouse, with the master bedroom on the ground floor. Two of our queries came from our website ad and 8 came from the sign posted in the front yard. No serious bites yet, but it's a promising early start.

I ran a quick rental comparison the other day, using Rent-o-meter, and while it's hardly a flawless tool, it did suggest that our rent was about average for the area. About 12 months ago, with a slightly lower rent, we were asking in the high side of rental rates, so rents in the area have climbed quite a bit in the last year.

I thought I'd take some time today to share a little bit about the state of housing in Britain. For starters, a 30-year fixed mortgage is rare over here. Almost everyone uses 25-year ARMs, and getting a fixed rate usually means extra fees up-front. Of course the rates are more competitive than most American ARMs, but a rate hike in the UK affects everyone.

This ad, which I saw on the Tube, is pretty standard when it comes to British mortgages. Notice that the maximum Loan-to-Value is 75%. That means if the house is appraised at $500,000 then you have to be able to put down $125,000 as a down payment. Compare that to most American mortgages where putting down 20% used to be the norm.

As a general rule, most British lenders are willing to lend you 3 times your salary or 2.5 times your combined salaries (if you are buying with someone else, like a spouse). Recently prices have been climbing so high that lenders face a choice of either not making loans or loosening their standards. Some banks have increased their lending limits up to 5 times your salary or more. Compare that to the US where lenders will lend you 5, 10 times your salary, even up to 40 times your annual income...

Mortgage brokers are facing the same situations over here that they were in the US 2 years ago. Note a job offer for a mortgage broker that offers a base salary of $36,000 to $44,000, but with expected total compensation of over $100,000. That's a lot of commissions (or just a few on very big loans).

Lenders are loosening over here, people keep taking larger and larger loans. Banks are specifically advertising "buy-to-let" loans for would-be landlords... It's looks like a perfect storm is brewing which can only lead to the same result as the US. A partial collapse of over-priced markets (as in the US, there are areas of Britain that haven't tripled in price over the last 5 years. And, as in the US, those places tend to be less urban).

Still, even "loose" lenders over here are just now hitting the same levels that most Americans are used to. The US actually has one of the best mortgage markets in the world when considering the consumer. So if you have a nice fixed loan, consider yourself lucky when the Feds next hike the rate. Not every country enjoys those.