Loose Ends, Year Ends

Many weeks ago, I posed a couple of questions related to our potential move to London. One question was "in what currency we should want our compensation to be" and the other was "what should we do with our condo"?

Seeing as how we have decided, for the moment, not to cross the Atlantic (nor to take the longer route across the Pacific and through Eurasia), and because I enjoyed toying with you as I allowed the suspense to build, there was no urgency in answering them. But since I don't want to have to write a post that begins "Back in 2007...", I'll attempt to close them out now.

To answer the first question -- Would it make more sense to take jobs that paid in dollars or pounds? -- there were a couple things I took into consideration.

Can I predict which way the dollar is going to move against the pound in the next two years?

Of course if I could predict which way the currency markets would move in the next two years then it's a no brainer. In fact, it would be time for a complete reallocation of my investments. Of course, I can't, and anyone who says they can is probably one of the three quarters or so of Americans who considers themselves "above average". Predicting currency markets is notoriously difficult, and anyone who could do it with a lot of accuracy should be quite a bit wealthier than I am.

How much of our total salaries would we spend while we were over there? Would we be able to save a significant chunk of our income?

This is important, because what we earn will go to two purposes -- our living expenses, and our savings. By matching the portion of income that will go to living expenses while in London to the Pound, we'd reduce variability in our effective expenses. That's desirable...

Where do we plan to retire, and what type of currency would we need to finance it?

However, our retirement is much more likely to occur in the US than in London, so getting the portion of our income that will go to savings in dollars, we reduce variability in our retirement savings. That's desirable as well. Retiring in a third location (such as Mexico) would further complicate things, since having a diversified portfolio of currencies might actually reduce total variance the most. But we don't want to get too cute, and it makes sense to think that we'd want to keep our retirement savings consolidated in dollars.

If we assume that one of our salaries would cover our expenses there and the other would go into savings (a big assumption, but a worthy goal), then the optimal solution would be to receive the "spending" salary in Pounds and the "savings" salary in Dollars.

The second question -- what should we do with our condo -- is a little tougher to answer, because it requires math and stuff, but not that tough to set up. The mistake I've heard a lot of people make lately is this one: "It's a really bad time to sell... my property value is down 15% from a year ago, so I'm going to wait for it to come back up." Sound familiar? The problem with that is that it completely ignores the opportunity cost (and probably many other costs) of owning a house or condo.

The "opportunity" part of the opportunity cost is what you'd do with the money you could get if you sold the property. To make the math easy, let's assume my condo was worth $500,000 a year ago, and is worth $400,000 today (if you just spit on your screen, we'd like to welcome you to Southern California). And to further make the math easy, let's assume I have a $300,000 mortgage, so I have $100,000 in equity which I can turn into $76,000 in cash after real estate agent commissions (6% on $400k). These numbers are not real but should suffice for this illustration. Investing that $76k in an index fund or something, I should expect to make about $11k over the next two years (before tax) if I get a 7% return.

Alternatively, I can keep the condo and rent it out for the next two years. Let's set aside property value appreciation for a moment and treat it as a straight exercise of earnings net expenses. For a $400k condo in my area, I should be able to get about $2,000 per month in rent. As a landlord, you should expect a vacancy rate of between 5% and 10%, so let's say I get that rent for 11 of 12 months, for a topline revenue of $22k per year. From that, we must subtract the following expenses:
- association fees of $3,600
- only the interest portion of my mortgage (not principle since that's roughly the same as putting money in a savings account), which would be about $17,000 per year on a $300k mortgage at 6%.
- property taxes of about $5,000 (1.25%)
- other expenses of about $2,000 (plumbers, repairs, carpeting, paint,etc... a half of a percent of property value is very low but the association fees cover a lot of this)
- insurance... zero in my case, as the association fees cover this already
- property management: one month's rent plus 10% of rents. $4,300. Ouch. We would need this since we'd be abroad. You could avoid this fee, but then you'd have a brand new second job as a landlord, so it wouldn't really be fair to compare it to the passive investment of the equity you could get.

So that's a total of about 32,000 in expenses on revenues of $23,000 per year. I'd be underwater about $11,000 per year, or $22,000 for the two years I'd be gone. The alternative, you'll recall, is gaining about $11,000 over the same period.

So now the next question is... will the increase in property value (by itself, since we didn't count principle payments as a cost either) generate $33,000 (real cost plus opportunity cost) or more over the next two years? That's about 4% appreciation (on the initial $400k) per year. Normally, you could answer yes, but I wouldn't bet on it for the next two or even five years.

So for me, the answer is a big resounding "No, thanks. I'll just take whatever someone is willing to pay me for it now." Even if the value has dropped staggeringly in the last year, that has no bearing unless I think that that makes appreciation in the next couple years more or less likely.

"But what about the tax benefits?", you ask, as people so often do when talking about real estate. Simple - there are none. Once you go from living in your home to being a landlord, you lose this benefit. If you were net positive on the income net expense equation, then the tax benefit is that you'd get only get taxed on the net income instead of the total rents.

"But what if you consider a time horizon of more than two years?" You're welcome to do that. But be sure to factor in that once you've been out of your house for three years [corrected--thanks, commenter], you'll lose the best tax break in America - the ability to sell your home without paying capital gains taxes. If you're already underwater, or nearly so, this may not be a concern.

So there you have it - if we were moving to London we'd sell our condo and try to diversify our income into two different currencies. But we're not. So we won't. This entire post was for your benefit.

I hope you'll agree that I have successfully concluded my 2007 deliverables, and we can move on to new business in 2008.

Happy New Years.