Buying and Selling: April 2006 Archives

I realized that I hadn't covered timeshares, and decided it was time.



I suppose I should define what a timeshare is, just in case. A timeshare is a property where you buy the rights to use it for a certain amount of time every year. The most typical time share is a two week period.



Timeshares are attractive to developers because they can get more money for building the same property. You might have a high-rise full of condos where the market price might be $200,000 each. But they can sell each of twenty-six timeshares for maybe $20,000 each. Because it's not such a big bite, their potential market is far wider, and they can sell to way more people. People are willing to pay more for vacation lodging that regular housing.



Developers also make money off of the financing, and off of the monthly dues for management expenses, which are analogous to association dues in a condominium association, paid to keep the complex maintenance up (and usually maid service, etcetera). Furthermore, since very few lenders want to finance timeshares, the interest rate can be (and usually is) outrageous, not to mention that you should be prepared for severe interest rate sticker shock if you're financing one somewhere outside the United States. The developer can gouge because most lenders won't touch timeshares, and it's not like the buyers are going to do any better elsewhere. Title insurance companies don't like timeshares either.



Developers love to tell potential buyers that timeshares are an investment, because they are real estate. The fact is that timeshares are like cars - there's a large initial hit on value, the instant the transaction is final. Nor do they tend to recover. There are at least two websites that specialize in helping you sell your timeshare, because most people figure out within a year or two that they've been taken. I don't deal with them any more than I can avoid, but I have never even heard of someone recovering their investment in a timeshare (except the developer).



Sometimes the time you buy is always the same two weeks in the same unit, but this can very. Quite a few have a yearly drawing among owners of a given unit for the most desirable time frames, and a few even put all units and all owners into the pool. Read the individual sales contract carefully for how this is accomplished. If you have or draw a time that's unusable to you, most of the same places that will help you sell the timeshare in its entirety will also help you sell or trade your time slot for the year. Nor do folks generally get back their annual cost of the unit by selling their time slot, but it can be a good way to buy a vacation time slot cheap if you are prudent and plan ahead.



Furthermore, of course the timeshare is always in the same place. This is great if you want to return to Honolulu every single year, but not so great if you want to go a different place every year. Many developers tout swap programs, often to swap your slot in such desirable locales as Ultima Thule for one in Tahiti. Not likely to happen, or if it does, likely to require a good deal of cash outlay in the direction of the people who bought in Tahiti.



Additional issues are that maintenance can be problematical. Since no single owner is responsible for the complete upkeep of any given unit, let alone the entire complex, the management is often lax about repairs and preventative maintenance. After all, if they put that new roof off for a year they can just pocket the money. Where even condominium owners have to deal with any problems pretty much every day, timeshare owners are there for a couple of weeks per year.



All of this is not to say that there are no happy timeshare owners. If you are going to go to Las Vegas for two weeks every year and your schedule is flexible enough that you can go no matter what time slot you end up with, more power to you, and a timeshare might be the way to go. If you need to go during the summer months because that's when the kids are out of school, or if you don't necessarily want to go there every year, not so much. I've never owned one myself, but I understand some nasty fights break out among co-owners for time slots, as well. Most people think the idea of a timeshare in Phoenix is to go there in the winter and play golf while the rest of the country is freezing, not go from perfectly acceptable weather elsewhere on July 4th to a modern day version of the La Brea Tar Pits because the temperature is 125 degrees Farentheit where the asphalt melts and people sink in and get trapped.



Caveat Emptor.

UPDATED here

One of the most important things for the buyer in any transaction is confidence that the seller has disclosed all known problems. One of the things most people don't realize, or act like they don't realize, is that it's at least as important to the seller.



The California Association of Realtors (CAR) has a program called Winforms that lets me ask all of the little niggling questions about the home. Very convenient, very nice, and I've done my duty when I fill it out with a listing client.



This does not mean that I or the seller can ignore any metaphorical elephant in the room not covered by the form. If there's something that's obvious, I have a duty to ask about it and record the answer, even if it isn't on the form. The seller has a legal duty to disclose anything they are aware of that might cause a reasonable buyer to change their minds or their offering price. A cracked light switch protector plate is not a big problem and you're going to either fix it or agree with the seller that you won't. But past termite damage, whether someone has died in the home recently, soil subsidence (even on the far side of the property), and any number of other factors can be reasons why prudent buyers may no longer be interested, or may wish to re-evaluate their offer. The rule for smart people is "disclose everything and let the buyer decide if it's important." A certain percentage of sellers, however, just want to get through the transaction without the buyer changing their mind. For Sale By Owner (FSBO) sellers seem to be significantly worse about it, by the way, which is one of several major reasons I'm always leery of FSBO properties with my clients. These sellers either don't realize how strongly omissions can come back to bite them, or are hoping they will be gone by the time it comes to light.



First off, unless you're planning on dying, you can be found. I know a lawyer that makes a good living at it. Furthermore, failure to disclose frequently makes your liability worse, in that you had a duty to disclose and you did not. It is possible that failure to disclose means a judgment for punitive damages in addition to increased economic damages is in your future, whether you are seller or agent or even buyer's agent if it was bad enough. Furthermore, you can count on the damages being larger because the problem has had time to get worse, paying the costs incurred in order to find you, and so on, when if you had simply disclosed in the first place you would have been off the hook.



Now, your real estate agent is not (generally) a building inspector, tax records expert, or any of those kinds of specialist. I recommend an inspector for every purchase, because I'm certainly not qualified to do that job. But if I spot something that may not be right, I have a duty to disclose it to my principal, and find out if it really means anything from a real expert. Sometimes there's a tax assessment that has passed or pending that doesn't have numbers associated with it yet. If it's passed, the title report should have the information, but they've been known to miss one occasionally. If it's pending (e.g. bond measure on the next ballot), it's a good idea to tell the buyer, or at least tell the buyer about where to find out.



For an agent, failure to disclose may mean that your professional insurance won't cover it. The professional insurance is for errors (honest mistakes) and omissions (errors of ignorance), not intentionally hiding something. This liability can easily run to several times any commission you made, so it's a really bad idea to hide anything. Agent or seller, if they buyer can prove you knew, or that you should have known, you're basically up the creek.



Caveat Emptor (and Vendor).

UPDATED here

What's negotiable on a purchase?

The short answer is everything.

There may be standards and traditions in your area, the same as there are in mine. That doesn't mean they are not subject to amendment by specific negotiation. Once you get outside legal requirements, anything is subject to negotiation. As long as both (or all) parties concerned agree to it, that's the way it's going to be.

This is not to say that some things aren't better left alone. For example, if I was buying a property and the seller didn't want to pay for the policy of title insurance, as is traditional, I'd certainly think long and hard before continuing with the transaction. Furthermore, such behavior would certainly cause the price I'd be willing to pay to drop dramatically. If I'm helping clients, the same applies even more strongly. I'm going to tell them that this may mean the seller may not be able to deliver clear title.

This is also not to say that there may not be consequences as the result. For example, if I or my client is selling the property, and someone asks for a $10,000 credit towards closing costs, the lowest offer I'd accept would be at least $10,000 higher, probably $11,000, maybe more. Why? Because commissions and transaction costs are based upon the official sales price, not the sales price less that rebate to the buyer. The bottom line is that it costs at least $10,000 to rebate $10,000 thusly. A $400,000 offer that requires $10,000 in rebates isn't a $400,000 offer. It's a $390,000 offer at best.

In order for it to be a valid contract, the two parties have to agree in every particular. If there is not complete, total, 100 percent written agreement as to what is going to happen, there is no contract. Two parties haggling over whether one light bulb gets replaced do not have a valid contract any more than two parties haggling over whether the price will be $200,000 or $500,000.

Nonetheless, except for those very few things mandated in law, it's all negotiable. Specific negotiation can change anything that's not legally mandated, and most things with defaults specified in law. If you've got a gold bathroom faucet that you want to keep, a normal sales contract says that it stays by implication (it's a furnishing attached to the property and required for the property to function normally). But you can change this by specifying that you have the right to remove it in the contract. Now if they buyer is only buying the home because of that gold faucet, they can walk away or counter offer that it stays. Let's say you eventually agree that it will be replaced by another gold faucet. That's specific negotiation. The replacement will be required to be installed, equal in functionality and free of defects - unless you change this by more specific negotiation.

I've seen negotiation for personal property to remain, furnishings to leave, the disposition of existing tenants, allowing leasebacks to the prior owners, and just about everything else under the sun. If there's something about the standard contract you don't like, or something specific to this situation or this property, specific negotiation is how you deal with the issue. Furthermore, even if you don't want to change anything, the other side might. Indeed, probably more properties have further negotiations due to problems or issues raised by inspections than don't. Something is revealed to be not quite right, and the seller either has to make it right or negotiate with the buyer for acceptance in the current state.

This is not to say that as long as the transaction records the seller is golden, by the way. If the buyer can show reasonable evidence that the seller knew of the issue but failed to disclose it, that's a bone for the lawyers to fight over when it's discovered. Some sellers fight a losing battle over issues like this for years - and it ends up costing them far more money in the longer term. The buyer finds out something you should have told them after the transaction, that's a bad situation for a seller to be in. Better to disclose right away and be done with it. When the seller can prove the buyer knew the full extent of the issue and bought anyway, that's much better protection.

So make sure that if there's some issue you want resolved, the purchase contract resolves it completely and unambiguously. That contract is how the transaction is going to happen. If it's not there, you're at the mercy of the other party. They might see it your way. Then again, they might not.

Caveat Emptor

UPDATED here

I am hoping to buy in the (city) area and am reviewing the possibilities. While I fear that the local market may be peaking, I intend to live in the home for at least ten years, so I am not trying to time the market.

My questions have to do with the down payment. I expect to shop for a property in the $450,000 range, and currently have $60,000 available for a down payment. I make a decent salary and receive an annual bonus of $35,000 - $40,000 each February. The bonus, while not guaranteed, is very dependable. After taxes and deductions, I should realize about $20,000 - $25,000 from it.

Do you think I would be wise to wait until February, by which time I will be able to make a down payment of $90,000 and perhaps avoid PMI and pay less interest over the life of the loan, or seek to buy now and lessen the taxes on the bonus? (I itemize, am single and am in the 28% bracket). Will the greater down payment help me to capture a better interest rate on the loan? (My credit scores are right around 800). Also, if I buy now, is it possible that I will be able to negotiate a mortgage in such a way that I can pay my realized bonus in February as a lump sum towards the remaining principal without incurring penalties? Ideally, i would like to use my bonus each year to pay down principal, as I can afford to balance my budget, including regular mortgage payments, without touching the bonus.

While on the subject of credit scores, I am reminded of another question - does an 800 score do me any good as contrasted with, a 740 or 750? Thank you again for your consideration. Your writings have been invaluable to my education.

I needed some more information, so got a subsequent email

I would expect the property taxes to run about $5,000 annually and association dues to be another $350 monthly. As I don't have a car, parking fees will be inapplicable. My closing costs should be somewhat reduced as I work for a bank (parent company) and they offer employees favorable mortgage rates with no points and no origination fees. Of course if I go elsewhere for the loan that would not apply, but I would only expect to do so if I received even more favorable terms.

As for an equivalent property, the market would price the rent at about $2,200 a month, although I am only paying $1,520 now (for a less desirable place than what I am shopping for).

First things first. You are easily A paper. Some lenders might have a small incentive (no more than 1/4 of a discount point) for folks with credit scores over 760, but most don't, and even if you go looking for one that does, it's no guarantee that their overall rate will be better than what you could get elsewhere. Remember, it's not important that they give you a quarter point incentive if their trade-offs were more than that above the competition. Look for a loan based upon the bottom line to you, not a little tweak that says you get treated a little better than the next guy.

Second, split your loan into two pieces to avoid PMI. One first loan for 80% of the value, and a second for the remainder, whatever that is. The second will be at a higher rate, but better that than paying PMI on the whole balance. It's likely to save you a lot of money this way. If you intend to pay it down, be very certain that there will be no prepayment penalty.

Now, let's look at now versus basically a year from now (Since February is ten months away). One thing I'm going to look at is whether your location may be above sustainable levels. My rule of thumb is that if a 20% down payment won't break even on rental cashflow, your area is likely to be overpriced. With current rates (6.25% for a thirty year fixed rate loan at par for the first, something like 9% for a 10% second), payment on $360,000 runs about $2215, plus taxes of $420 per month plus association dues of $350 plus an allowance of $50 per month for insurance. Total $3035 per month. As opposed to $2200 rent. An investor would be down $835 per month even if the place was never vacant and never needed repairs. Prices would need to drop $100,000 at least to cover that. I'm also going to assume you need $10,000 for closing costs out of your own pocket, reducing your down payment to $50,000. Now, I'm going to look 10 years out based upon this situation.

Year 1 2 3 4 5 6 7 8 9 10 11

Value $450,000.00 $374,500.00 $400,715.00 $428,765.05 $458,778.60 $490,893.11 $525,255.62 $562,023.52 $601,365.16 $643,460.72 $688,502.98

Monthly Rent $2,200.00 $2,288.00 $2,379.52 $2,474.70 $2,573.69 $2,676.64 $2,783.70 $2,895.05 $3,010.85 $3,131.29 $3,256.54

Equity 50,000.00 21,008.26 9,995.46 43,151.06 78,608.20 116,526.98 157,078.65 200,446.41 246,826.23 296,427.77 349,475.31

Net Benefit 31,500.00 -108,625.29 -91,384.89 -72,677.63 -52,395.49 -30,423.16 -6,637.55 19,092.60 46,907.31 76,955.83 109,397.24

Now, let's look at suppose prices have come down that same $100,000 in a year, but rents have gone up by inflation - roughly 4%. However, rates are a bit higher - let's say 7 percent. Furthermore, you have $90,000 less $10,000 for closing costs leaves $80,000 down payment. I'm assuming property taxes are based upon purchase price, as they are here in California, but if they don't go down when prices go down, that's going to make a difference of about $100 per month to start and more later on. Let's look 9 years out for an equivalent time frame.

Year 1 2 3 4 5 6 7 8 9 10

Value $350,000.00 $374,500.00 $400,715.00 $428,765.05 $458,778.60 $490,893.11 $525,255.62 $562,023.52 $601,365.16 $643,460.72

Monthly Rent $2,288.00 $2,379.52 $2,474.70 $2,573.69 $2,676.64 $2,783.70 $2,895.05 $3,010.85 $3,131.29 $3,256.54

Equity 80,000.00 107,242.69 136,398.64 167,602.25 200,997.33 236,737.81 274,988.43 315,925.50 359,737.71 406,627.01

Net Benefit 24,500.00 4,200.10 18,090.11 42,543.32 69,346.64 98,702.88 130,831.85 165,971.77 204,380.83 246,338.88

The picture looks much better by waiting a year for the market to get rational - assuming it does. If it doesn't, all you've done is taken that last year of benefits off the first chart, or worse, as perhaps the prices continue to rise for another year. Nor have I assumed that you paid extra on the loan. Quite frankly, once you've killed off that second trust deed, leverage is your friend, and you are better off investing the difference.

The question is "When is Wile E. Coyote going to look down?" Okay, not all that funny, but it has applicability to the situation. As long as everyone is in denial, and there is a market of folks willing to pay those prices, the market is going to stay afloat. What's caused our local sputter is the fact that everyone has "looked down", and they don't like what they see. There is no convincing reason why highly paid jobs have to be even more highly paid so that they can afford local housing here, whereas a large proportion of the jobs in certain cities like Washington DC or New York don't really have the option of leaving, as they are where they have to be. The government isn't leaving Washington DC unless it gets nuked, and the big guns of the financial industry aren't leaving New York unless every other big gun does so. You know better than I to where your city lies on that spectrum. My impression is that where you are is closer to the inelastic employment point. Nonetheless, if the rest of the country "looks down," so will those places that are relatively insulated.

If a 20 percent down payment doesn't pencil out as an investment property, as it doesn't in your case, the question is not "if?" the market is going to adjust, but "when?" and "how?" Here locally, you can almost hear the "pop!" If things are relatively inelastic, employer- and jobs-wise, a long slow deflation may be what occurs. You may even keep current prices while inflation makes things catch up. It's hard to say when I'm not as familiar with your city's economic engine as I am with my own, but here's what happens if prices stay stable for ten years:

Year 1 2 3 4 5 6 7 8 9 10 11

Value $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00 $450,000.00

Monthly Rent $2,288.00 $2,379.52 $2,474.70 $2,573.69 $2,676.64 $2,783.70 $2,895.05 $3,010.85 $3,131.29 $3,256.54 $3,386.80

Equity 50,000.00 53,930.19 58,150.38 62,682.08 67,548.41 72,774.22 78,386.23 84,413.13 90,885.78 97,837.36 105,303.52

Net Benefit -31,500.00 -39,318.42 -47,361.14 -55,634.47 -64,145.15 -72,900.45 -81,908.24 -91,177.08 -100,716.30 -110,536.19 -120,648.06

As you can see, you build up a fair amount of equity, but would have been better off renting and investing the difference.

Which of these scenarios is most likely? Here it's the one attached to the first two tables, except that we're a good portion of the way towards table two right now. Where you are, I'd make an educated guess that you're still looking at table one right now. There's money to be made even there if you buy and hold long enough, but you could be upside down for quite a while.

Thank You for asking, and please let me know if this doesn't answer all of your questions.

Caveat Emptor.

UPDATED here

One of the most common questions in real estate is "What is this property really worth?"



The easy answer is the same as the deepest, most profound one I can come up with, "Whatever you can get someone to pay for it." It's the answers in between that you've got to watch out for. The appraised value is simply a guesstimate based upon the sales of similar properties. But there is no such thing as an identical property. A Price Opinion is just a guesstimate based upon what an expert thinks might be an appropriate asking price. Even an accepted offer means nothing if the offerer backs out, changes their mind, or can't qualify.



Now it's no secret that some people can get folks to pay more for real estate than others, and others can bargain the price down better. But the bottom line is that if it's not worth what you paid, why did you buy it? If it's worth more than you sold it for, why did you sell it? There isn't a good answer to either one of these questions. It's worth what it sold for. Period. The only exceptions are when there's a distress sale, and even then, the answer reads, "Under the circumstances, that's what the property was worth," which is remarkably similar (like identical) to what the answer is in all other situations.



This goes for the other side of the coin, failed transactions, as well. Why didn't you sell to a good offer? Why didn't you offer more? Because it wasn't a good offer, or because it wasn't worth more, to that person.



If you walked up to the average person on the street and offered to sell them a parcel of land on which there's a home, anywhere in the US, for $5 or $10 or $100 or even $1000, most people would take you up on it sight unseen so long as you could deliver clear title. I can safely say that the average residential property in this country is worth at least $1000 to every legal adult in the country. Why then all of these elaborate rituals of listing contracts and MLS and inspections and offers and escrow and title insurance for the transfer of property?



The answer lies in the fact that sellers want to get the highest price possible. Ideally, they want to find the one buyer who will bid more than anyone else on that particular property, because the property is worth more to them than anyone else.



To find that one perfect buyer is actually fairly rare, in my experience. But you can certainly find buyers willing to pay more than $1000, in most cases. How much more? Well, that depends upon the property and the buyer, how widely and effectively your net is cast and how long you are willing and able to wait. As with all investments, it's a trade off and sometimes the money you'll get from a better buyer isn't worth the money you spend finding them. Knowing stuff like that is part of what I get paid for.



It does you no good to accept the offer of someone who can't qualify for the loan they need in order to purchase the property. It does no good to make such an offer. How do you tell, as a seller? Make it a part of your counteroffer that the deposit revert to you the day after contingencies expire. That's not friendly, and it may lose you some potential buyers, particularly in a buyer's market, but it's the only way to be sure. Prequalification letters are basically used paper, for all they really mean.



There is nothing wrong with saying, "My property is worth $X" as long as you understand that it's shorthand for "Similar properties in my area are selling for about $X". Because your property is never worth $X. Nor are any of mine, Donald Trump's, or anyone else's. It's not worth that unless you sold it for that, and if you sold it, it's not yours anymore, is it?



People get caught up in the damnedest ego blocks on comparatively few dollars. You put the property up for sale because you wanted something other than that property, right? You're out there offering money for the property because you think you can make more money with the property than with the money, right? Trying to squeeze too many dollars out of the other side of the transaction can and often does leave you with no transaction. There is a thin line between hard bargaining that gets you a good bargain, and overplaying your hand that gets you left out in the cold.



Don't get left out in the cold.



Caveat Emptor.

UPDATED here

One of the concepts I keep seeing without a decent treatment is the concept of leveraging an investment. Real Estate has this like no other investment. You go talk to a bank about leveraging eighty to ninety or even one hundred percent of your investment in the stock market, or the same percentage of a speculative venture, and see what happens. Be prepared for laughter, and they're not laughing with you. But real estate they will do it. Why? Because it's land. It's not going anywhere, and they're not making any more.



The fact is that real estate has the potential for leverage like no other. This is due to the interplay of two factors. One is the fact that you can rent the property out to pay for the expenses of owning it, and even if you use it yourself, you're able to save the money you would be paying in rent. Everyone's got to live somewhere, and every business needs a place to put it. The other, more important factor is leverage, the fact that you're able to use the bank's money for such a large portion of your investment. The bank will loan you anywhere from fifty to one hundred per cent of the value of the property. Yes, you've got to pay interest on it, but you're paying that through the rent - either the rent you'd save or the rent you're getting - and there are tax deductions that make such costs less than they might appear.



Now here are some computations based upon the situation local to me. Suppose you have a choice as to whether to buy a three bedroom single family residence for $450,000 (to pick the figure for a starter home) or rent it for $1900. Let's even allow for the fact that the home may be overpriced by $100,000. You have $22500 - a five percent down payment. More than most folks, and you would invest that and the difference in monthly housing cost, and earn ten percent tax deferred if you didn't buy the house. Let's crank the numbers and see what they say.

Year 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 26 27 28 29 30

Value $450,000.00 $374,500.00 $400,715.00 $428,765.05 $458,778.60 $490,893.11 $525,255.62 $562,023.52 $601,365.16 $643,460.72 $688,502.98 $736,698.18 $788,267.06 $843,445.75 $902,486.95 $965,661.04 $1,033,257.31 $1,105,585.32 $1,182,976.30 $1,265,784.64 $1,354,389.56 $1,449,196.83 $1,550,640.61 $1,659,185.45 $1,775,328.43 $1,899,601.42 $2,032,573.52 $2,174,853.67 $2,327,093.43 $2,489,989.97

Monthly Rent $1,900.00 $1,976.00 $2,055.04 $2,137.24 $2,222.73 $2,311.64 $2,404.11 $2,500.27 $2,600.28 $2,704.29 $2,812.46 $2,924.96 $3,041.96 $3,163.64 $3,290.19 $3,421.79 $3,558.66 $3,701.01 $3,849.05 $4,003.01 $4,163.13 $4,329.66 $4,502.85 $4,682.96 $4,870.28 $5,065.09 $5,267.69 $5,478.40 $5,697.54 $5,925.44

Equity 22,500.00 -48,406.32 -17,287.01 15,999.55 51,604.93 89,691.37 130,432.52 174,014.27 220,635.59 270,509.51 323,864.05 380,943.34 442,008.77 507,340.18 577,237.20 652,020.69 732,034.20 817,645.65 909,249.05 1,007,266.37 1,112,149.54 1,224,382.64 1,344,484.16 1,473,009.54 1,610,553.79 1,757,754.34 1,915,294.15 2,083,904.97 2,264,370.91 2,457,532.19

Net Benefit -31,500.00 -110,236.00 -94,761.88 -77,990.23 -59,828.07 -40,176.54 -18,930.59 -4,021.36 28,797.71 55,524.07 84,333.56 115,367.22 148,774.35 184,712.85 223,349.64 264,861.00 309,432.96 357,261.61 408,553.54 463,526.08 522,407.72 585,438.30 652,869.38 724,964.38 802,381.90 885,736.68 975,442.55 1,071,939.93 1,175,697.38 1,287,213.19

The Net Benefit Column is net of taxes, net of the value of the investment account. The cost of selling the property is also built in. Now most people won't really do this, invest every penny they'd save. I have intentionally created a scenario that contrasts a real world real estate investment where you bought in at a temporary top, with a hopelessly idealized other investment.



There is a potential downside, and it could be big. This is a real risk, and anyone who tells you otherwise is not your friend. Look at the beginning of years numbered 2 through 5 in the equity column. You haven't gotten your initial investment back until sometime in the fourth year. Look at years 1 through 7 in the net benefits column. You're immediately down $31,500, due to me assuming it would cost you seven percent to turn around and sell the property. A year later, due to me assuming the bubble has popped, you're down by over one hundred ten thousand dollars, as opposed to where you'd be in you put it in the idealized ten percent per year investment. There is no such thing, but for the purposes of this essay I'm assuming there is. This is the illustration of why you need to look ahead when you're playing with real estate - a long way ahead. A loan payment that makes you feel comfortable for a couple of years isn't going to cut it. You need something viable for a longer term. If you'll look at projected equity at the beginning of years five and six, it goes between fifty odd thousand and eighty some thousand, assuming you've been making a principal and interest payment. You have plenty of equity to refinance there if you need to. If you need to do something in year three, however, you're hosed. If you've been negatively amortizing, you're hosed. You owe more than the property is worth. The payment adjusts, you can't afford it, you can't refinance, and you have to sell at a loss, as well as getting that 1099 love note from the lender that says "You Owe Taxes!"



But now look ten years out. At the beginning of year 11, you have $323,000 in equity, and if you sell at that point, you are $84,000 ahead of where you would have been if you invested that money in the idealized investment I've posited. That's four times your original investment, and I only assumed real estate went up seven percent per year, whereas the alternative investment went up by ten percent per year. How could that possibly be right?



The answer is leverage. That $450,000 was almost entirely the bank's money. The appreciation applied to this entire amount. But you only invested $22,500. The bank isn't on the hook for the value; their upside is only the repayment of the loan. If the property goes to a value of $481,500 and then $515,205 (normal seven percent appreciation in two years), then that extra money is yours. Think Daffy Duck shouting "Mine! Mine! All Mine!". Daffy's got to pay some money to get the property sold, as real estate is not liquid. The bank gets all of it's money. The bank always gets all of its money first. After that, however, then the extra belongs only to the owner, not the lender.



The lender gets none of the appreciation. This is all fine and well with them, by the way. They've been well paid whether the property increased in value or not. This money from increased value is all yours. This applies even, as in our example, if the property lost value for a while. Yes, if you had had to sell in year two, you'd have been up the creek. But you didn't; you kept your head and waited until the property increased again. Given that you didn't, the only numbers that are important are the numbers when you bought it, and when you sold it. The rest of the time is completely irrelevant to the equation, a fact that is true for any investment, by the way. Doesn't matter if the value is ten times what it was when you bought on paper, it only matters that when you actually sold, it was for a loss. Doesn't matter if the value goes to zero the day after you buy, and stays there for thirty years. If in the thirty-first year it rebounds to fifty or a hundred times the original purchase price and that's when you sell, then you really were a genius. Get it? Got it? Good.



So when the property appreciated back to $688,000 and change at the beginning of year eleven, and you only owe $364,000 and change, that's $323,000 in equity. You're almost fifty percent owner. Even after you pay seven percent to sell the property, you come away with $275,000, as opposed to a little over $191,000 that you'd have in the idealized but unleveraged investment.



Keep in mind this whole scenario is a hypothetical. Every Real Estate transaction is different. Every property is different, every market is different, and the timing makes a critical difference. That's why you can't just call your broker to sell it and get a check within seven days, like you can with stocks and bonds. That's why a decent agent is worth every penny, and a good one is worth more than you will ever pay us. But properly executed, a leveraged investment pays off like nothing else can, and real estate is the easiest way to make a highly leveraged investment that is stable until such time as it is favorable to sell.



Caveat Emptor.

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