By Mike Gold, A retired entrepreneur living the dream in the Pacific Northwest.
I’m certain that every one of you who reads this column has gone through the following exercise in the past year or so: “How much is our home worth?”
See, the astronomical increase in home prices especially in our greater Seattle area most likely had you calculating the immense profit you’d make by selling your home.
Just today in the Seattle Times, there was an article about how prices in our area have increased in the past year by more than any other metro area in the U.S. Over a 13% increase. If you have a $700,000 home, a 13% increase is approximately $91,000. Many of you can probably recall when you could purchase an entire very nice home for well under $91k.
It does not take a rocket scientist to understand why these increases are happening. It’s the combination of a number of factors:
1. The increase in people moving to our area – especially to take a well paying high-tech job. Over 250 people/day moving here. (For those mathematically reclined, that’s approx. 91,000 people/year.)
2. The lack of housing inventory (turns out many older home owners have elected not to sell their homes thus further reducing the amount of purchasable inventory. I’ve been told by my realtor friends that in Mill Creek, a home for sale will often be under contract even before the realtor’s open house. Bidding wars are routine. Very often, a seller (and their realtor) will announce that “Bids will be entertained this coming Wednesday” after an open house weekend – assuming that it is not cancelled due to an impending sale.
In normal times, that type of statement would be considered arrogant. The fact older folk are not selling is simply because unless they want to move to Billings Montana, they can’t afford to replace their own “sold” home with anything much cheaper.
3. The concept of “leverage.” Simply put, if you purchased your home for 20% down, and say the $700,000 home was worth $450,000 ten years ago, that means you put down $90,000. The $90k would have returned a profit of $250,000 in ten years. That’s a return of almost 11% in the ten years. (Note this calculation ignores any interest, taxes, other home improvement expenses and inflation.)
If you had only invested a 5% down payment, ($22,500), your return (again with the caveats above), would be a 27% return over the same period.
So the concept of “leverage” works to your advantage (buy low, sell high) when the value of an asset rises.
Likewise, if you leverage yourself to the max (a 5% down payment) and the asset decreases in value, say your home decreased by $200,000 (what happened in the real estate downturn in 2008/9), you would have lost $200,000 on a $22,500 investment. So you see, there is great risk in “leveraging” yourself too much.
I can vividly recall living in Florida in 2005/6. They were building new homes and condos as fast as they could put them up. Often, when the builder opened up their “sales office,” buyers would pay “pre-construction” prices, wait until the home was built, then “flip” the home often making a huge profit.
In fact, the builders started to write contracts that said, “Once the home was finished, the ‘buyer’ had to own the home for 18 months or more before they were allowed to sell it.” At one point, condos in Miami-Dade County were being purchased by speculators (over 90% at one point).
Well, we all know what happened. The real estate market crashed and burned in about 2008 to 2009. I had several friends who went bankrupt because they were so highly leveraged sometimes owning as many as five properties under contract at one time. They found themselves owing perhaps $1 million on an investment of $200,000. Unable to pay, they had to declare Chapter 11 losing everything except their own home; and sometimes, if they had a large mortgage on that home, they would also lose that.
Now Florida is the home of what my father called “the land of easy money.” Many people (not just in Florida) live within one paycheck of financial disaster. In Florida, it seems to be far worse.
People in the community we lived in “rented” everything. Their car, their large TV, sometimes even their dishes and clothes. So fair warning, the more you “leverage” yourself, the greater the risk.
I have a longtime friend who was an investor with Bernie Madoff. He took out a jumbo mortgage on his own home in order to give additional monies to Madoff to invest. (His spread was a 5% mortgage to earn a 12% annual return with Madoff). He was fortunate to get to keep his own home when Madoff’s Ponzi scheme collapsed.
As an interesting aside, as the stock market collapsed in 2008, while Madoff continued to report over 10% returns to his investors, many called in their investments. They were frightened over what was happening in the world markets. So even though, on paper, their investments with Madoff was “safe,” they elected to convert to cash to ride out the storm. It was all those redemptions that brought Madoff down. The irony is that by being so successful, investors felt “we should cash out – while taking our profits – as all our other investments would sustain a horrible loss if we cashed them out.” So Madoff’s “reported” successes, caused the run on his funds.
So if something appears too good to be true, it probably is. Caveat emptor.