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.

Financial Koans, Anglo Style

So I haven't posted anything in 5 months. I've been busy. What? It's not like you've been checking back daily.

Anyway, The V-Train and I are contemplating a couple-year stint in London, home of the $20 Burrito (I'm sure it's delicious). So here are a couple of financial questions I've been noodling over. I'll give my thoughts on them later - but first I thought I'd throw them out there for my vast reader base to do their own unbiased noodling.

Question the first - Would it make more sense for us each to take a job that gets paid in pounds, or one of us to get paid in pounds and one in dollars (assuming the total comp will be the same either way at today's exchange rate, and that each of us gets paid roughly the same amount)? What should be the considerations?

Question the second - With the housing market down significantly since last year, would it make more sense to sell our condo in a down market, or rent it out and wait for prices to come back up? Does it matter how much equity we have? What if we were upside down? We live the greater metro Los Angeles area. Assume there's no expat package that helps us with either option.

I await what's certain to be a flood of responses.

[Go to part II of this post.]

A Contrarian on Interest Only ARMs

So let's assume you've got full use of your cognitive facilities, and actually get the best loan for which you qualify. But should it be a conventional, ARM, or what? Obviously not an interest-only ARM... as we've already assumed you're not stupid.

But wait... here's a contrarian view. Everyday Finance rightly points out that you don't pay down much principle in the first several years of a loan. And if you're not planning on living in your home more than the time period of the interest-only rate, then you haven't lost much. At 6% interest, in the first 10 years of a 30 year loan, you'd pay down less than 17% of your principle, or about $49,000 on $300,000. So from a risk perspective, it's not as bad as people make it out to be. And if you don't blow that extra money on hookers and coke, you can actually get better returns.

If you've got a low low interest rate (assuming taking interest only doesn't increase your rate), you're probably better off investing your extra cash elsewhere like, say, the stock market. Then instead of $49,000 in equity you could have $55,000 in stock. Hell, I do this with my 1.9% APR car loan right now. Lexus Financial Services is investing in Powershares Water Resources (PHO) on my behalf, and I'd never pay off that loan if I didn't have to.

Don't quite agree with everything in Everyday Finance's analysis (for example, paying down principle is not the same as giving the bank free money) but the key point remains - don't be a sheeple and blindly accept advice from Money Magazine without thinking it through on your own.

SubPrime by Choice

One of the key assumptions of neoclassical economics, one that colors theories and analysis put forth by its practitioners, is that people act in their own rational self interest. How, then, can they explain this report from Fannie Mae that half of the sub-prime loans they purchased in 2005 were held by borrowers that could have qualified for prime loans?

Let's pause for a second to digest that.

The difference between prime and sub-prime loans could be up to 3 percentage points. Even if it's just two points, you're looking at hundreds of dollars a month on your standard Los Angeles mortgage.

So who doesn't shop around when they are taking out a $300,000 loan? Rational people for whom the the several hundred dollars a month is worth less than the time it would take to find a better loan? I'm pretty sure that The V-Train's meddlesome cousin (a former sub-prime loan underwriter) has something to do with this.

Or perhaps people act in their own self interest only if they can recognize what their interests are. Rational, but retarded.

Test drive of Yodlee

So I've been hearing a little about Yodlee, which offers an account aggregation service. That is to say, they will track all of your accounts - bank, mortgage, credit cards, stock, 401k, student loans, etc on one page, as well as offering billpay services and other benefits, all for the low low price of free.

My first thought is that it solves a real life pain point - and the plusses would be a godsend. That thought was immediately followed by another - if someone got ahold of your Yodlee account, and that account has full access to every other account you hold, you could be up a very deep creek without a paddle.

Still, after a little research, I found that Yodlee has a partnership with HSBC, with which I already have some accounts. HSBC in general has some good security methods, so I went ahead and took the plunge and signed up for their EasyView service.

I did take some efforts to protect myself for now. I chose a unique password that's more complex than the one I normally use. I also left my largest accounts - those holding my stocks and 401k - off for now. I did include all of my mortgage info because, while those accounts are large too, there isn't as much someone could do to screw me up by accessing my mortgages online.

So what did I think? I loved it as much as I thought I would. Accounts like my student loans, that I access rarely and have to look up my account information anytime I want to see them, come up as part of the dashboard, just as easily as my bank accounts and credit card info. Bonus - it computes your net worth for you based on the assets and liabilities in it.

There were a few accounts I couldn't get it to synch with - my car loan, for example - but it gives you a method for manually entering the information. I'll just have to update it periodically as I make payments. I've also heard they have partnered with Zillow, so soon it may go out and automatically get the value of my real estate assets and include that as part of my net worth. I've done it manually for now, because having the liabilities listed without the assets was making me cranky.

Overall, I'm very happy and plan to keep using it. I'll wait a while to decide whether to add any login information for my most sensitive accounts. Your risk tolerance may vary.

Real Estate Prices Explained

This article from today's New York Times Magazine is one of the most straightforward explanations I've seen for the factors impacting real estate prices.

The long and the short of it - it's not entirely appropriate to think of real estate as a completely different type of asset class, immune to the vagaries of bubbles and speculation.

Shiller’s gloominess has been widely noted. He thinks we are under the spell of that familiar goblin, mass psychology. Lemming-like, people are buying homes merely because they expect that prices will rise. This certainly holds for speculators, like the manager of a rental-car agency at the Tampa airport who confessed to a customer (an economist) that he owned no fewer than 20 condominiums. And it explains some of the impulse to buy second homes, which are closer to being tradable assets than a primary residence is.

But neither is it appropriate to think of it as being the same. Real estate is much stickier. Quoth The Times:

This is the problem I have with the real-estate-equals-dot-com argument. Most homeowners buy to have a place to live. If prices fall, they react precisely unlike stock traders; rather than bail out, they stay put longer. Every share of Cisco may be for sale every day, but every house is not. Case, Shiller’s partner, tracked 628 home listings in the Boston area during 2006, as prices began to fall. After four months, the majority remained unsold, but the sellers lowered their asking prices by only 3 to 4 percent.

But what I liked most about this article was it's treatment about the value of leverage in real estate investing.

Suppose the stock market did rise 10 percent; after a year you would be up $5,000. Whereas the gain on your home would be 5 percent over the entire purchase price — or $11,000. Over 10 years the gap becomes huge — not to mention over 20 or 30 years. This is the little guy’s (and also Donald Trump’s) trick for accumulating equity: leverage.

It then goes on to talk about how leverage is theoretically practicable for investments in other asset classes, but the truth is that the lending rules for real estate are much more forgiving. If stock prices go down and you are leveraged, you're forced to cover immediately. If that held true with real estate, as the author points out, very few of us would be homeowners. Overall, one of the better articles I've read on this subject.

Manhattan Real Estate Still Bubbling

Real estate prices aren't going down everywhere. According to the Associated Press, median prices for Manhattan apartments have risen 9% in 2006, and the mean price is up 5% over the fourth quarter of '05. The median Manhattan apartment went for an astounding $760,000 in Q4 of '06, 4.27 times the median home price in Boise, and making me wish my real estate holdings were on the other coast.

On the Upper West Side, large apartments are up 48% over a year ago. Condos stayed flat, and Co-Ops went up 3%: impressive when most of the country is experiencing, if not a burst, at least a deflation.

There are no signs of slowing in '07.

Points Don't Pay

A new study coauthored by Penn State and Freddie Mac shows that an overwhelming majority of the time, homebuyers buy more points than they should. A point, or 1% of the cost of the mortgage, lowers your interest rate a specified amount. The cost-benefit analysis simply entails figuring out how many months you'd have to have a the lower interest rate (and lower payment) to make up for the money you spent on the point. Once you buy the points, if you hold the mortgage for less than that breakeven period, you lost money by buying the points. If you hold it longer, your points were positive ROI.

The study showed that only 1.4% of borrowers who bought points ended up holding the mortgage long enough to make the points ROI positive. Of the people who didn't buy points, only 1.5% of people would have been better off purchasing them.

This study shows a couple of things, I think (even assuming the results are skewed by decreasing interest rates that caused a lot of unexpected refinancing). One: people may overestimate how long they're going to keep their mortgages. But a second likely explanation is that people probably don't bother to do the math. For whatever reason, they may just think that lowering your interest rate is worth more than it really is. Important stuff to keep in mind for the next time you look at a home purchase.

PMI Now Tax Deductible!

Wish this had been in place 10 years ago. For mortgages originating in 2007 or later, Private Mortgage Insurance is now tax deductible! Oh, happy day. This effectively cuts the cost of PMI by a third to a half, dramatically changing the balance between accepting PMI, or taking out a 10% piggyback loan at a high interest rate.

I took the piggyback on my last mortgage, and am paying 8.5% interest (effectively 5% or so after tax deduction) on that piece, and that could go even higher since it's a variable rate. If this had been in effect, I'd probably have gone with the PMI.

Of course, you could avoid all of this with a 20% downpayment, but then you'd lose some of the wonderful power of leverage.

More on Commercial Real Estate

I posted recently about the potential for commercial real estate in Bentonville, Arkansas. Today, a free article from the Wall Street Journal on real estate investors switching into commercial or multi-unit residential investing. The reason is that cash flow is now trumping anticipated appreciation as the key component of the investment. Commercial and multi-unit residentials offer much better cash flow, because they don't have the same speculative inflation priced in. This makes sense, since land appreciates much faster than the buildings themselves (since land is scarce, but buildings can be, well, built).

One notable nugget in the article:

The situation is bleaker for those buying homes and condos as an investment, says Mr. Liang. "They should have very limited expectations on appreciation going forward -- probably 0% to 3% annually for the next five years," he says.

That speaks to why I love real estate as a long term investment. Say properties appreciate 2% per year. If you bought the property on a 90% mortgage (you put 10% down), you're getting a 20% return on your invested money (before expenses, which can be significant). Has there ever been a significant period of time where real estate didn't appreciate a few percent a year? If you ride it out, it provides what I think are higher and safer returns than other types of investments. And in the long term, you can get some great periods of appreciation, like we've had recently. Get someone else to pay your mortgage, and the appreciation will come eventually, turning your $20,000 investment into $200,000 of equity.

The Joy of Refi

The heyday of mortgage refinance may be waning, but it isn't gone. About a year and a half ago, with mortgage rates at historic lows, I refinanced a rental property I own. This is significant: since it used to be owner occupied, I had a pretty good rate relative to the none-owner occupied mortgages that were available to me after I moved out. When I refinanced, rates had finally dropped enough to where the non-owner occupied refi rates would beat my original owner-occupied rate. In order to ensure that I was getting a good deal (it's difficult to make an apples to apples comparison when you're restarting your 30 year clock after a number of years) I took a "no closing costs mortgage", so then I only needed to ensure that the rate offered was lower than my previous 7% rate. As an added bonus, I got the Private Mortgage Insurance (PMI) eliminated at the same time.

The result was that I have several hundred dollars a month back in my pocket, which makes life a lot easier and made it easier for me to finance the monthly payments on my new residential property.

While rates are going up, mortgage refinancing still presents opportunities to save money. For example, a lot of people took adjustable rate mortgages a few years ago that could be getting ready to sting them. If they've gained some appreciation on their property, they could lose the PMI and lock in a rate that, while not the best ever, could beat the heck out of adjustable rates kicking in. If you took an ARM with the expectation that you'd be selling, and have changed your mind, refi could be a real life-saver.

Skate to Where the Puck is Going

One of the greatest real estate booms in the last twenty years has to have been in Orange County, a big part of which is occupied by the Vietnamese community. Immigrants want to live near each other, and as they've gained prosperity (through their entrepreneurial culture, mostly) they've driven prices in Little Saigon and the surrounding areas ever higher. I've got my eyes open for the next great immigrant influx.

In the meantime, The V Train was in Bentonville, AR last week and noted that the not-exactly-new trend of companies stationing employees, either temporarily or permanently, near WalMart headquarters was yielding some interesting and predictable effects. Yes, a whole slew of new hotel developments and corporate housing have started to go up in this once small town. But there are still no big-city type amenities (restaurants open late, e.g.) catering to the army of business travelers that shows up there every Monday.

You could capitalize on this by moving there and opening a business yourself, or you could invest in some commercial real-estate and take advantage of the "pull-marketing" effect to attract lessees.

Since I don't know jack about Bentonville or commercial real-estate, you can have that little golden nugget for free.

Home Prices Decline 3.5% - It's a big deal

The median price of a home in the US fell by 3.5% over last year's number, to $221,000: the biggest decline on record. If 3.5% doesn't sound like a lot to you, remember that most people buy homes on leverage, i.e. mortgages.

Suppose a year ago you bought a median priced home for $229,000. You put 10% down, so you invested $22,900 of your own cash money. Now suppose the price declined by about 3.5% to $221,000. You've just lost $8,000 of your $22,900, or 35% of your investment! If you turn around and sell it tomorrow because you're afraid the market will continue to decline you'll probably incur transaction fees ranging around 6% (real estate agents, escrow fees, etc), which would wipe out your investment completely. But if you don't turn around and sell it tomorrow, and we have another bad year or two, you could soon owe the bank more money than your house is worth, even though you put down 10% of the money yourself.

And with prime at over 8%, let's hope you didn't buy on a variable rate mortgage, because your payments could soon jack up without giving you the benefit of any additional equity.

Rising interest rates mean some people won't be able to make their payments. Declining prices will mean some people won't be able to solve their payment problem by selling. Hang tight, there's going to be a shakeout.

California foreclosures up 67% in Q2

The latest quarterly results are in, and California foreclosures are up 67% from the last quarter. That actually deserves some (!!!). Phoenix and Las Vegas were hard hit too, mostly due to speculators learning what "speculation" means. As in they got the cold end of the speculum.

Oh, that's so wrong. Sorry.

Rents Going Up, Finally

According to the New York Times, after a long lull rents have increased 3.5% to 5% in the last year. This is very significant, because the home price to rents ratio has been out of whack for a while. Rent and mortage are two different ways of paying for something very similiar: a place to live. Rents and home prices, in the long run, maintain something that approximates a consistent ratio. This is affected by things like mortgage rates, but at the end of the day the two must come into alignment.

In recent years, it has been much cheaper to rent than to own, indicating that people are speculating on future rising home prices. That the two must come back into alignment means that there either needs to be a housing price crash, a huge increase in rents or, more likely, some combination of the two.

A major increase in rents without a decline in housing prices would mean that real factors have conspired to make living space actually worth more. While that's certainly possible, any time that there's speculation (as there clearly has been) it's a pretty clear indicator that something is being overvalued.

The rise in rents is actually good news if you're a homeowner, because any rise in rents will reduce the amount of a potential housing crash. And it may make you feel better, because you're not overpaying quite as much for your living space.

Foreclosures May Be Less of an Opportunity Than You Think

I'm very interested in foreclosures, because there aren't any other good real estate deals out there right now what with the imminent collapse of the housing market. But this article points out that even with foreclosures up, the deals may not be out there. Banks are wising up to the fact that they're losing potential profits the way they've been handling foreclosures, and they're quickly shutting the arbitrage opportunities.

"Foreclosures sound good in theory, but now the banks have really gotten smart and they have realized they can get market value for their homes"

On top of that, the professional vultures are snapping up any good deals that are available. So I plan to keep watching this market, but I'm not as optimistic as I was a few months ago.