Gonna make this short and simple so I don’t fall into the War & Peace trap.

First here’s the gist of of the plot from last time. Real leverage comes from the relationship between the cost of borrowed money and the return on the investment itself. Positive leverage results from the return exceeding the cost of the debt. Negative leverage is then, of course, the other side of the coin.

You borrow $100 from Uncle Dick, who charges you 6%, the normal nephew discount. Immediately you go out and ‘buy’ a $100 note from your buddy, Timm. The note calls for 8% interest.

Each year you receive $8 from Timm, whereupon you immediately send $6 of it to Uncle Dick. You pocket the remaining $2. What you have there, is classic positive leverage.

Note: Have you figured out what’s missing yet?

On the other hand — what if Uncle Dick lent you the $100, same rate, and you lent it to Timm at an interest rate pegged to a particular index, which would
set the rate the following day. It was a gamble, but one you thought prudent, as you were pretty sure the index was gonna rise. Of course, it didn’t. It fell like a rock — finally landing at 5%. You now have a problem, don’t ya?

Each year Timm pays ya $5, a dollar short of what you now owe Uncle Dick for the year’s interest on his loan. You find yourself diggin’ into your pocket for the extra buck needed to make the payment. You just felt the sting of negative leverage.

Notice in this example there wasn’t a ‘down payment’ of any size — you borrowed the $100 and ‘bought’ the note given to you by Timm with the same hundred dollar bill. You own the note free and clear — yet there’s still leverage involved.

And yeah, yer right, free and clear is a stretch here. I know it’s 100% financed by the money lent you by Uncle Dick, but you get the point.

I’ve enjoyed many a free drink proving the existence of leverage in a so-called ‘free ‘n clear’ transaction.

Now, apply this to your typical real estate investment. You might put 20% down plus some closing costs, totaling roughly $50,000. The new 80% loan carries with it a fixed rate of 5.5% interest. Using the same simple arithmetic used in the examples, we find our return is 12% — positive leverage. And, if the property’s return had been less than the cost of your money — 5.5% — your leverage would then have been negative.

The concept of leverage is one of the laws of the physics of economics.

Does all that make sense to ya? Call me at 619 889-7100. Have a good one.

The reason I bring this up is due to the flippancy with which the subject is tossed around in the media, at conferences I attend, and even by well intentioned real estate investors themselves. Viewing leverage as merely the ratio of down payment over debt is about as wrong as one might construe the concept. I’m reminded of a conversation on one of my all time favorite shows, M*A*S*H.

Seems Colonel Potter needed Hawkeye and BJ to be nicer to Frank. (Major Burns) Said Potter, “He’s not really a bad egg. There’s just some things he doesn’t know.” Whereupon Hawkeye responded sardonically, “But Colonel, it’s so hard to keep up with everything Frank doesn’t know.” One of the show’s best lines ever.

How then is leverage defined?

First we must understand there is positive and negative leverage, and it has zip, zilch, nada to do with the ratio of down payment/debt of an investment.

Positive leverage occurs when the return on the investment expressed as a percentage is greater than the cost (interest rate) of the borrowed money used to acquire it. Period.

Negative leverage then, is the opposite — the cost of debt (interest rate) is greater than the return (%) on the investment.

Here’s an example

You have a fourplex, and you buy it using 50% down, a very ‘low leverage’ position given the commonly accepted definition. The interest rate on your loan is 6%. You own the property for a couple years and do an historical analysis of your up to date return. It comes out as 14%. That’s classic positive leverage. Yet, the typical investor will conclude the leverage utilized was relatively weak based upon down payment size.

Same fourplex — this time with a 20% down payment — and the same 6% loan. The two year historical analysis clearly indicates a 5% return so far. Oops — classic negative leverage. That investment ain’t goin’ as planned. If something doesn’t change to move that return up to at least 6%, the ending won’t be what was most surely hoped for.

The most common false premise

Returns can fluctuate on one property showing positive leverage with a lower down payment, while a comparable property will show negative leverage with the same amount down. Assuming a low/high down payment ensures positive leverage can be deadly.

It’s all about Investment Physics. Leverage is unwavering in it’s consequences, as is gravity. We can use gravity resulting in both positive and negative outcomes.

Leverage is commonly defined as the ability to move something large and cumbersome like a large rock with a long stick. Look at negative leverage as you being on the wrong side of that rock when it begins to move. If you think you’re standing on the wrong side of your rock, um investment, there’s a chance you can ‘get on the right side’ to safety. If not, there are also ways we can often use to remedy the situation.

I’d love to talk with you about your portfolio. How’s it doing these days? You can reach me at 619 889-7100. Have a good one.

I remember with a wincing smile the day I arrived at a friendly broker’s office to drop of an offer. It was way back in another life. I hadn’t seen this husband/wife team in over a year, so was lookin’ forward to the visit. When I arrived the wife happily remarked, “We were wondering who the chubby blond guy was.”

Ouch! Not exactly how I perceived myself.

That was the inauspicious beginning of my marathon career, another post altogether. Suffice to say, the next year or so saw a loss of 40-something pounds and over 7 inches on the waistline. Ultimately it was the consequence of merging reality with perception. The whole ‘perception is reality’ concept is true enough, but the so-called reality is often nothin’ but a mirage, as was my laughable ‘lean and mean’ self image.

Warning: Hard, brakeless segue.

The average loss suffered my the vast majority of IRAs and 401Ks has been over 40%. Yet from what I’ve seen first hand, read, and heard second hand, most folks still perceive themselves as having a diversified portfolio, even though 100% of their Qualified Plans are still hogtied to Wall Street.

Furthermore, they perceive a rocky road to the full recovery of their losses, while often not knowing what options they have to get that accomplished. The frustration is almost palpable.

The most effective adversary to long term capital growth is a loss. Duh. Yer smilin’, but let me finish. The consequences of a loss aren’t limited to the present. The bottom line effect is how many years your Plan is essentially on ‘pause’ while it makes up the losses. Only when you’ve regained the losses do you resume your journey on the growth highway. Meanwhile you stubbornly keep havin’ birthdays.

And there’s the rub.

Fact: Your 401K/IRA has suffered a discouraging loss. It’s time to focus on a strategy to get back to where you were, and resume growing.

First — recognize that you’ve not been ‘diversified’ regardless of what you’ve been told. Wall Street’s idea of diversification is akin to puttin’ a governor on a Ferrari, ensuring it can’t exceed 60 mph. Why would you do that on purpose? Don’t get me wrong, I’m not anti-stock market. I offer Max Whitmore as prima facie evidence.

Fact: Once you’ve sustained a significant loss, time is no longer your friend. You keep havin’ birthdays while the losses remain an ongoing reality.

Tick tock.

One option is to take the bull by the horns as it relates to your IRA or 401K. How? First, you must find out if you’re eligible to roll your current plan into a Self Directed IRA — not everyone has that on their menu.

For now, if you have a 401K from a former employer, you can probably roll it to a Self Directed IRA. Many over 59½ can also. More on that later.

The bottom line is, with an IRA whose funds are directly controlled by you — the funds can be invested — leveraged or not — into real estate. It’s not for everyone, but over the long run, your plan’s cash flow and capital growth will improve if a generous portion of your plan’s capital is directed towards real estate. For every 1% of real estate appreciation (leveraged — 1/3 down) your capital grows roughly 3% — which means if your plan’s real estate has a year of 3.5% appreciation, the stocks in your plan will hafta exceed 10% just to stay even.

That doesn’t account for the real estate investment’s cash flow, which will almost universally far outpace any dividends thrown off by stocks. Frankly, it’s an unfair contest from the start. But if you’re gonna begin making measurable headway in the race to regain your lost capital, ’start’ is what you might wanna strongly consider.

I can show you how, and recommend highly experienced pros to guide you in every step of the process. Don’t risk your perception further clouding reality. The one thing none of us can do is put time on pause. Again — tick tock.

Call me, and we’ll figure out what’s possible for you and your circumstances. 619 889-7100 — Have a good one.

Regardless of the passage of time, one of the constants remaining firmly implanted in many investors’ mindset is the idea that an investment property without abundant cash flow is to be avoided at all costs. The problem inherent with that school of thought is rooted in a few related principles, plus the difference between today’s realities and Grandpa’s memory of the way ‘it used to be’ — which in reality means to Grandpa, ‘the way it should be’.

The Principle in play: To the extent you go for growth you retard cash flow — and vice versa.

A very simple way of saying pick one. You want more cash flow in a particular region, you must begin with a larger equity position. If you wish for the velocity of your capital growth to be greater, you must, to the extent prudent, increase leverage. Also, put enough oversized down payments into several properties, and before you know it, the guy who isn’t chasing chump change cash flow has bought a couple extra properties — using the same capital amount you did.

Notice how this isn’t rocket science. As a matter of fact, a principle of calls for the aggressive avoidance of growth inhibiting behaviors when capital growth is your investment goal.

Before we continue with our regularly scheduled post, a word from one of our loyal sponsors.

Prudent means you have a generous Sominex (Ambien for those under 40) Account. For those new readers, that’s BawldGuySpeak for CASH RESERVES.

Please don’t allow me to give the wrong impression here. The ‘there must be cash flow school‘ is just as valid as any new approach or thinking. After all, who would argue against having cash flow, if that’s all you were talking about, right? An investor won’t go wrong limiting themselves to buying only cash flow properties. However, is it cuz they need cash flow right now this minute? Or is it cuz that’s what they’ve always heard?

The must have wheelbarrows of cash flow approach will limit the size of their menu, as properties offering both leverage and cash flow, (regions for that matter) are few and far between. Consequently, those who insist on having their cake and eating too, will find themselves spending the majority of their time looking, instead of doing. That’s fine and dandy if you don’t have much capital. If you’re trying to spend a couple hundred grand using low downs while demanding cash flow — hunker down good buddy, cuz yer in fer a buncha lookin’.

Your also in for a less rewarding retirement.

This wasn’t as nearly universally true a short while back.

For example: Clients in San Diego were consistently using great leverage while enjoying a modest cash flow up until as late as 2002-03. Up to 2000 it was possible in most of the area. Now? In San Diego using leverage to a break-even is anything bought with less than a 35-50% down payment. This is why I’m telling SD income property owners to move their equities to lower priced growth regions. They’ll acquire more property with far superior leverage, while gaining more actual capital growth dollars — but with the exact same net equity. There’s simply no argument, objectively speaking, for staying in San Diego with our real estate investment capital. Most solid growth regions offer the same or more cash flow with less down payment than does San Diego properties.

Here’s the point.

There are enough growth regions around the country that allow for decent leverage. (20% down payments) There are precious few that allow that leverage and reward you with cash flow. Frankly, my experience is those that don’t pass the BawldGuy ‘Mom Rule’, which states — If you wouldn’t put my mom into the property to live alone, don’t bother calling me about it. Anywho, until retirement is actually imminent, cash flow should not be your primary agenda.

Why?

Let’s say you’re a married couple in your late 30’s to late 40’s, and earning a total of $75,000 yearly. Unless you’re living up to your eyeballs, (which means you haven’t managed to save any real money anyway) what do you care about cash flow? You need to grow your net worth as big and as quickly and as prudently (capital P) as you can. Don’t lose sight of your main goal and keep your eyes on the prize: Retirement income.

What is cash flow?

All cash flow, in the final analysis, is simply a yield on capital invested. If two investors put a million and two million bucks respectively into an investment upon retirement, yielding 8% — they both make 8%. The difference, of course, is the guy with twice as much capital is now sitting in retirement with twice as much monthly income. Duh. So by stressing over cash flow when your main goal is, or at least should be, growth, you’ve sacrificed future retirement income. You want to be the guy with the two mil, right? Right.

Ah, now I have your attention.

The lesson is to grow your net worth like crazy — then just before and in anticipation of retirement — convert your energy to obtaining cash flow — yeah, like crazy.

Let’s get this boiled down to where we all live — dollars in our Levis.

Over the long haul — I’ve seen investors literally cost themselves from $1-3,000,000 in net worth by making just this kind of mistake. It’s not that hard — when your mistake is compounded and repeated over a couple decades. Let’s take the midpoint — $1,500,000. At just a 6% yield — chasing cash flow to the extent you’ve consistently retarded your capital growth — your retirement income has been reduced — forever — by $90,000 a year. What?!! Yep — $90,000 every year. And you lost it because you were chasing chump change during the biggest earning years of your life.

Imagine the guy next door getting to live on almost a million bucks more over his first decade of retirement — just because he didn’t chase chump change cash flow while he was earning well over what he needed to live very comfortably.

The only benefit I’ve ever scene from a growth client chasing cash flow, is their ability to brag about it at their neighbor’s backyard BBQ.

They won’t be bragging when it comes to adding up their retirement cash flow — and isn’t retirement when they really wanted needed it?

Yeah, I thought so too.

Call me at 619 889-7100 so we can talk about your retirement income. Have a good one.

Words mean things. To the real estate investor the word leverage connotes a specific concept. Most would say it means — to control real estate with a relatively small amount of capital.

First of all, what’s small? Then, what’s relatively small? Then there’s the question being begged — is your meaning for leverage the same as the other guy’s?

With apologies, most investors would be incorrect. Sure, using a small down payment to control real estate is one form of leverage, or rather, one meaning. But that definition is simplistic at best, and potentially ruinous at worst.

Ideas, principles, and concepts are defined by words. If the wrong words are used for this purpose, the entity defined is rendered worthless. Following worthless, incorrect ideas, principles, and/or concepts is never part of anyone’s plan, right?

For example, what if you looked at a map thinking west was north? You’d always end up at the wrong point B. You’d never have a chance for success. West means something totally different than north. Surely, that’s an extreme example, but it clearly illustrates my point here.

Words mean things. Those understanding the value of correctly used words, don’t often fall victim to misunderstood ideas. Here’s an example of one of the most understood concepts in all of investment real estate.

It’s leverage. Worst thing? Folks use the ’small down payment’ definition, succeed wildly, then conclude they understand the word, and therefore the concept itself. That’s akin to runnin’ a 10K in a really good time, then concluding that success means you’re ready to run a marathon. The problem there, among others, is the misunderstanding of adequate training. Training is a word. Adequate training can be an idea, principle, or concept. Learned that one the hard way. Inadequate training for long distance running is a cruel mentor.

So, what is leverage?

Primarily, leverage is the ability to borrow money at a cost (interest rate) lower than the return on the property in which you’ve invested. If for example, your return is 8%, and the borrowed money costs 7%, you have what’s known as ‘positive leverage’. Whether you put 1% down, or 99% down is irrelevant to that definition.

The other side of the leverage coin is ugly. That example has you earning 5% return on your property while paying 7% interest on your borrowed money. That’s ‘negative leverage’ and the investor is doomed.

BawldGuy Axiom: Exactly as the laws of physics, for example, gravity, works every time, the Physics of Economics will not be mocked.

Uh, wait just a doggone minute some are sayin’ about now. If I put a larger down payment I could conceivably increase the return of a property via the resulting increase in, or creation of cash flow. If that return then became larger than your cost of borrowed money? Bingo! Instant positive leverage.

But wait another dang minute! Did he just say increasing a down payment can increase positive leverage? Huh? What?

Yes, he did.

So if an investor doesn’t understand what the primary meaning and real life relevance of leverage is? He’ll realize what the banker realized when he borrowed money at 5% and lent it out at 4% — which is the answer to a question I’ve always loved.

How do ya make a small fortune? It’s simple — Start out with a huge fortune and religiously employ negative leverage.

See what I mean? Words mean things. Ideas, principles, and concepts matter.

Down payments can make huge differences in the growth rate of your invested capital. They don’t, however, supersede the primary principle of leverage as applied to investing. When real estate investors, however well meaning, violate this concept, the penalty is guaranteed. Just as gravity is brutally objective in its predicability, so too is the principle of leverage.

Wanna get together and figure out a Purposeful Plan for your circumstances? It’s as simple as sendin’ me a quick note, or callin’ me at 619 889-7100. Before ya know it we’ll be talking about the retirement for which you’ve been workin’ so hard. Have a good one.

Keep the faith — slowly but surely, this will dovetail into real estate investing for retirement.

The gladius was different. It’s design aided the Roman legionary’s battlefield tactics. First, it was much shorter than what we’ve come to know as a sword. The blade was usually only 19-20″ long. Second, it was double edged, able to cut savagely both ways — a huge improvement. Third, its design went away from the oft used leaf shape, to a simple, straight blade.

These changes were a result of Rome’s enemies modifying their defenses. I won’t bore you with the details here, but here’s a description of what a legionary was now able to do in battle.

While holding his shield with one hand, he held the gladius in the other, like most soldiers of the time. However, his new and improved sword sported a much shorter blade, which helped him get inside his opponent. Also, if his first downward slanting-cutting motion missed his target, it wasn’t necessary to raise his sword arm to try again. He simply reversed the motion, essentially a backhand, and saved precious time, (if not his life) by wounding or killing his opponent that much more quickly. Also, because he was working with the relatively shorter new blade, and was therefore more easily able to get inside his enemy’s kill zone, it was far easier for him to thrust into the abdomen, an almost guaranteed kill shot.

It was a truly effective (read: nasty) weapon, made possible by it’s planning, vision, knowledge of the enemy, and ultimately, design.

Where’s the Roman legionary’s flexibility? His javelin, known as a pilum. It was roughly seven feet long. He used it for both throwing, and thrusting. He had a weapon for close, savage, infighting in the gladius. His javelin gave him the option of dealing with his enemy from a longer distance when logistics allowed. The goal was, however, the same for both weapons — victory on the battlefield.

And yet…

Most military historians agree — the gladius wasn’t really the primary reason for Rome’s military dominance. It was their vision, forward planning, objectivity, but most of all — their massively superior training — which produced brutally reliable discipline. Their vision, planning (Purposeful?), and objectively focused discipline, not only carried out that superior training — but created the ability to be flexible when confronted with (sometimes rapidly) changing circumstances.

Here’s how we can look at this from a real estate investment viewpoint.

Prudent leverage, the right financing, solid location, quality construction, tax shelter, tax deferred (1031) exchanges, are all examples of the investor’s gladius and pilum.

But they’re not what makes an investor victorious.

What provides ultimate victory, defined as a magnificently abundant retirement, is vision, Purposeful Planning, objectively executed, while seasoned with flexibility.

BawldGuy Takeaway: Don’t mistake the weapons in your arsenal as the way to victory. What will, in the end, provide you with your dream retirement: vision — plus Purposeful Planning — combined with objective execution and flexibility.

Create your own empire. First though, you have to ask yourself what you want it to look like.

What does your retirement look like? Or rather — what does it look like if you keep doing what you’re doing? That last question either put a smile or a distinct frown on you, didn’t it?

I’d love to talk with you — and will when you call 619 889-7100 OR just email me. Ask anyone — I’m pretty good at gettin’ back to folks. Have a good one.

Here’s Randy’s question:

Now when deciding to invest now or at some point in the future the cost of that leverage has to be taken into the total purchase price.

I noticed that you had been advocating making purchases given the current benign interest rate environment. Is there some rule of thumb that will dictate current purchase (or total ownership prices) in a higher interest rate environment … so in higher interest rate environments, won’t prices come down to account for higher financing costs? Is it not this simple (it never is)?

Randy — Great question — and no, it’s never that simple.

Here’s a factoid for ya. When I entered the business as a know-it-all 18 year old in October of ‘69, the median price for a home, if memory serves, was under $20,000. Attach that fact to this one: I didn’t see an interest rate below 7% until the 21st century. Yet we had double digit appreciation for multiple years in the 70’s, 80’s, and early 2000’s BEFORE rates ever hit the 6% level. That’s well over 30 years.

Yet from ‘69-2002 prices went up by a rough factor of 10 — or more. From that empirical experience, I learned. Interest rates are important, but there’s a ‘range of tolerance’ with which the market will barrel along, more or less unaffected. In ‘79 when rates jumped to 10%+, that tolerance disappeared like steam in the air. But when it was 8.5%, property not only sold, but rose in value at impressive velocity. Yet today, home buyers and investors alike would scream like stuck pigs if rates went over 7%.

You make a keen observation about leverage. The public’s working definition of that concept is potentially dangerous. Simply acquiring property using low down payments is not what leverage is all about. The problem with that, is the results aren’t predictable. They’ll be positive most of the time — until they’re not. The million dollar question though, is why?

Here’s why. Leverage isn’t primarily a low down payment. It’s the acquisition of an investment using borrowed money wherein the cost of the borrowed money is less than the return on the investment. If you borrow at 6% and the property returns 9%, you’ve experienced ‘positive’ leverage. If however, the same property returns 5% you now have ‘negative’ leverage.

Notice I didn’t mention the down payment. Whether the investor put 0% down or 50% down, the property must return at a higher % than the cost of the borrowed money.

Over the years I’ve seen folks using huge down payments, but who ultimately lose due to negative leverage. On the other side of that coin I’ve seen folks use 10% down and enjoy hugely positive leverage. Using down payments as the ultimate test for leverage is the fastest way to learn this lesson the hard way.

That said, there’s still no accounting for one of life’s greatest investment truths: Your crystal ball and mine are just as cracked as the next guy’s. There’s no predicting the future. This is, in essence, why it’s called ‘risk capital’.

Here’s another practical factor as it relates to leverage and the real estate investor. If solid analysis clearly indicates a property requires 40% down to achieve positive leverage, the investor would do well to search for potentially superior alternatives. If they found well located equivalent properties in another region for which the same analysis demonstrated 20% down would result in positive leverage, they would now be able to acquire twice the property. That’s a good thing. Any time you can achieve the same or superior results using the same or less capital to control more property — to the extent it remains prudent — choose more property. What do I mean by prudent? Even when appreciation rates exceeded 20-30% I refused as a matter of policy to be any part of no-down loans. It’s silly, and in my opinion shouldn’t be used in the same sentence with the concept of prudence.

Look, if Property A needs 40% down to produce your required return, and you can get that return in an equally desirable setting on Property B for 20% down — why wouldn’t you opt for twice the property for the same capital? It’s at the point you’ve been able to acquire two Property B’s that the issue of down payment amount becomes a critical factor.

Investors often speak of the assumptions used in the analysis of income property as fundamentally crucial — a fair statement. However, it’s my contention their understanding of the underlying concepts implied by that same analysis is far more important in the long run. Well done research and analysis done with an erroneous understanding of any one investment concept renders the analytical results virtually without value — or worse — tragically misleading.

Am I making sense?

Let’s make sense together. We can begin by you calling me at 619 889-7100 or send me a note by way of the Contact BawldGuy button up top. Have a good one.

Is land a vehicle equipped to provide a smooth ride for real estate investors on their way to Retirement Land? Not in my humble opinion, and for several concrete reasons.

1. When capital growth is needed most, the first dollars of any real appreciation are soaked up by the cost of simply holding the land — and that’s free and clear land.

2. To the extent you took on debt in the acquisition of the land, your negative cash flow is now approaching scary territory. And don’t say, “I put 50% down’ ‘cuz that means you’re now servicing debt at a rate of at least 5-8% a year. To have your capital grow one itty bitty drop, the appreciation must exceed all your holding costs by the same little drop. Not freakin’ likely, mate.

3. In times like these your options menu doesn’t include ‘Hold until this blows over’. Why? Oh, I dunno. Maybe ‘cuz now, instead of the dirt not increasing in value, it’s losing value, while you continue to add to your losses by making your loan payments and staying current with the taxes.

4. Oh, did I mention taxes? If ya bought this pile of dirt during more or less good times, tax assessors love to reflect that by raising taxes. Duh. Ever notice they don’t use the same logic as it’s losing value?

Let’s create an example.

You bought a couple acres of land for $100,000 back in 2003, using 50% down. Your annual debt service, based on 6.5% interest only, is costing you $6,500 — year in and year out. It appreciated at a relatively fast pace the first couple years or so, around 15% a year.

2½ years at that rate puts its value at around $142,000 or so. Problem is, it’s over three years into this correction, and you’re lucky if it’s worth what you paid for it. Really lucky. Let’s see where you are now.

5 years of debt service — $32,500 out the door.

5 years of real estate taxes — $7,500 you’ll never get back.

We won’t even talk about the little surprise local cities/counties spring on vacant land owners. Ever got that warning in the mail? You know the one — you clean up the brush or we will, then charge ya for it? I have — think 30 acres of cleanup. It’s what Grandma called a learning experience. Why are they almost always painful?

So to review, you now own land worth about what you paid for it. It’s cost you $40,000 for the privilege. It’s saved you $2-3,000 a year in income taxes. How exciting for you.

Shall we stop the math here so as not to heap insult on top of injury?

If you were to list it with a land specialist and sell it today for 150% of what you paid for it, a fantasy if there ever was one, your net proceeds would be, um, enlightening.

After costs of sale, say 8% including everything, you’d net around $85,000 or so after paying off the loan. Sounds pretty good doesn’t it? You put $50,000 plus some closing costs into it at purchase, and got $85,000 back. Oh, wait a sec. You also poured around $40,000 or so into that money sucking black hole during the holding period, which again, you’ll never get back. That means you had over $90,000 into it — cash taken directly from your Levi’s and turned into steam which immediately did, well, what steam usually does. Disappear.

Here’s the cherry on this dirt cake — your CPA will be tellin’ you to write a check to the IRS. Seems you made a capital gain when it sold.

Isn’t land grand?

To be honest, yes, sometimes it’s pretty cool. Mostly though? Not much. It’s a whole lotta buy low and sell high, with time being of the essence, usually in a big way. That’s real estate talk for it better happen soon, ‘cuz with land time ain’t yer friend more times than not.

Leverage actually works against you, ‘cuz debt with no income ain’t recommended.

Even buying without debt guarantees negative cash flow.

No leverage means you might as well buy stock — at least there’s no negative cash flow.

It’s possible to owe capital gains taxes even though you lost money. Go figure.

What we haven’t discussed here is your opportunity cost. Oh yeah, that.

If you’d bought income property instead, it would be worth more or less what you paid for it about now. You would’ve put 10-25% down when you bought it, pretty nice leverage, relatively speaking. Let’s say you used 20% down. It’s been 5 years now, and the property has paid for its own operation. It’s given you the same tax shelter as the land would have, but with one little exception. It didn’t cost you a dime. It was based on a ‘paper loss, for which you lost not dime #1 from your Levi’s. Those tax savings are what we in the business call positive cash flow. Also, while your debt service was static, your net income probably (not for sure) rose due to rent increases. It could’ve dropped, but probably not if you bought in a solid growth region.

Since it held its own the last 5 years, you kept roughly $40,000 or so in your own Levi’s — a good thing. Furthermore, you can relax and wait for this correction to run its course. Every 1% of appreciation means your original capital investment of down and closing costs, (maybe $55,000) grows by over 4.5% as a result of your new best friend — income supported leverage.

Including my own sad story of woe, many clients have told me how they’ve been holding a piece of dirt for sometimes longer than 20 years — not only resulting in no real gains to speak of, but in San Diego, the literal loss of hundreds of thousands of dollars in gains not realized. A sobering thought for anyone.

BawldGuy Axiom: Most of the losses incurred from land investments aren’t from the land, which often rises in value. It comes from holding costs, lack of leverage, and gains not realized from better, more prudent investment vehicles.

If in 2000, in San Diego, you had taken $100,000 and bought a piece of free and clear land, by 2004 you might’ve made $75,000 before costs of sale. If instead you’d acquired small income properties for $500,000? That same $100,000 woulda turned into a whole buncha $500,000. Which scenario would you prefer? Go ahead, take yer time, no rush. Even if I tripled the gain on the land? It still wouldn’t amount to half of the gain on the income property. Oh, now yer payin’ attention.

OK, enough about land. Bottom line is, you can make a boatload of money investing in land. Problem is, your timing must be impeccable, and your pockets should be pretty deep. When investing for retirement, sorry, but land probably isn’t the way to go.

Here’s something you can do. Call me at 619 889-7100. Why? I need a fix, plain and simple. ‘Course I always need a fix — I always need to be creating new plans, solving new problems. It’s what I do. If you’d rather email me, just click Contact BawldGuy and you’ll be on your way. Have a good one.

So why do I tell folks to quell their irrational infatuation with the appreciation of their properties? Let me to go all Socratic on ya here.

Did you write a check for the amount of the purchase price? If not, how does the percentage of appreciation translate to a figure accurately representing the percentage by which your capital grew? Is it possible for one investor to enjoy a higher appreciation rate than his buddy, but have a lower capital growth rate? Does any kind of growth not ultimately ending up in your bank account matter a whit to you? Yeah, me neither.

Here’s the fifth grade math.

You buy a $250,000 income property with 20% down and 2.5% total net closing costs after all prorations. This results in a total capital investment of $56,250. Your buddy at work buys a similar property in another region for the same price and costs but with 30% down. Your property appreciates 4% the first year, while your friend’s rises by 5% — a rate of increase 25% higher than yours.

So to what property’s capital growth rate would the typical new investor be drawn? They’d prefer the highest appreciation rate — they almost always do.

Your buddy, ‘Joe’ ends up with a handsome growth rate of almost 15.4%, while you end up with growth of just over 17.75%. To review, even though Joe was the happy recipient of a 25% higher relative appreciation rate, 5 vs 4, your capital outgrew his by over 13%. ‘Wait just a doggone minute here’, says Joe. ‘I made $12,500 while he only made $10,000 in real dollars.’ Excellent observation — irrelevant, but good catch. Why is it irrelevant?

Let’s expand the comparison here.

Let’s say they both had $170,000 to invest. Joe acquired two. You bought three, ‘cuz Joe was putting an additional $25,000 in down payment per property with the same amount of initial capital. Since we’re now workin’ with more or less equal amounts invested ($169,000 for you, and $163,000 for Joe.), let’s revisit the comparative growth rates, using the same rates of appreciation.

Your relative capital growth rates haven’t changed from the original property to property comparison. However, you’ve now earned more growth in terms of percentage and dead presidents. And as we all know, it’s ultimately the quantity of dead presidents that separate those who retire OK, vs those who retire Woo Hoo!! Let’s do one more thing with these numbers. How would they look after five years?

Five years later Joe’s capital has grown from $163,000 to $301,000. Meanwhile, your capital will have grown to $331,500 from our originally invested amount of $169,000. The gap widens into a seemingly bottomless chasm in 15-20 years. Also, there will be a time when you get 9% appreciation on top of better leverage, while Joe gets 2% appreciation on his inferior leverage. When that happens, you won’t be able to see Joe in your rear view mirror any more.

BawldGuy Takeaway: Appreciation in the value of your real estate investments is solid ground for braggin’ rights, but you bank capital growth. Both leverage, and the value of the property acquired impact capital growth big time. Duh — Bottom line?

Appreciation is the shiny chrome, while capital growth is the engine driving you to retirement. Don’t make the mistake of being distracted by the cool lookin’ chrome.

Give me a holler and we’ll figure out what direction is right for your circumstances. Understanding the fundamental principles of real estate investing is more than a big deal when it comes to creating your retirement. It’s everything. Have a good one.

The winner.

Remember when we were kids, and came home from playin’ a game? They didn’t ask us all the ‘who did what’ questions until they got the answer to the only question that mattered — Who won? That’s no different than when folks learn the guy at the BBQ is a real estate investor. What do ya think is the first question most people ask him? Exactly — How’re ya doin’ so far?

Only then do the wanna know the details. Oh sure, they may ask where, who’s his lender first, but they’re really fishin’ around to learn if his team won or lost. You know I’m right.

Same goes for the attitude real estate investors should aggressively maintain, especially when in the midst of buying, or these days especially, selling income property. It’s even more important when selling property in San Diego’s current buyer’s market. Here’s a recent real life example. (Some details have been changed to maintain privacy.)

Carrie is a local client who recently had us move a few local rentals for her. Fortunately, at least we told her it was fortunate, she had one rental whose net proceeds were gonna net her just under $200,000 at sale. Two other investments had been acquired with timing that um, could’ve been better. (Her crystal ball was a big fat FAIL.) They’ll both yield long term capital losses when sold. So after analyzing her situation in depth, I advised her to sell all three. But why?! you ask. Easy, ‘cuz it’s the right thing to do at the right time, in the perfect set of circumstances.

Here’s the deal.

Her two losers have not only lost value, they’re costing her about $10,000 a year in negative cash flow to boot. Ouch. You bet, ouch. But here’s the silver lining. She can sell her ‘winner’ which will generate a long term capital gain of nearly $220,000 for this year’s tax return. Her two negative cash flowing soul suckers will generate a long term capital loss of that much — maybe more. Hey I have an idea. Why don’t we sell all three and use the losses to offset the gains, thus eliminating capital gains taxes. Yeah, that’s the ticket.

A no-brainer, right? Yeah, but it’s funny how we humans tend to look at things when we’re in the middle of ‘em in real time. Carrie saw the first offer on her ‘good’ property and wanted to counter for more, plus she didn’t wanna go along with the buyer’s request to credit him with way over $10,000 in closing costs. It’s at that point I really begin to earn my keep as her advisor.

Back to baseball analogies.

It’s 2-2 in the bottom of the 9th, one out, a pretty fast runner on 1st, your #2 hitter in the lineup at bat, with your best hitter on deck. What to do? I wouldn’t even hafta think about it.

The batter’s gonna lay down a sacrifice bunt, which will move my RoadRunner to 2nd base, or as we baseball geeks like to call it, scoring position. There are now two outs with my best hitter at the plate and the winning run ready to motor in with the walk-off winner. The odds are in my favor. If my best hitter makes an out, we don’t lose. If he knocks his teammate in, we win. Works for me.

Back to Carrie, who’s not happy the offer is a bit lower than she’d of liked.

I pointed out we’re in a brutal buyer’s market. As nice as we made her place look, it’s still just another property for sale in San Diego — a dime a dozen almost. Here’s the fly in the ointment.

Even if there was a 90% chance the buyer would’ve come up in price, or gave up on her paying all his closing costs, or both, the downside for Carrie was too horrendous to even contemplate. Really, that bad? Let’s list the consequences of blowing a done deal in a bloodthirsty buyer’s market — especially when you’re an investor with a pretty cool upside.

1. She already knows where her proceeds will be going. Instead of trapped in a sluggish (to be kind) market, she’ll be in well located, growth region income properties. One of which, will not only allow her decent leverage (as they all will) but will also throw off over 10% cash on cash. No sale? That option goes away.

2. This sale allows her to immediately put her two losers on the market. She gains another $10,000 a year in cash flow the minute they close escrow. In plain English if the winner closes escrow she’ll acquire more property, better quality property, while simultaneously increasing her annual tax shelter significantly. Oh, and her net annual cash flow will almost immediately increase by over $20,000. (The elimination of $10,000 in negative cash flow in San Diego, and the acquisition of about that much in her new properties.)

3. When all three are closed and gone, she’ll not only have paid no cap gains taxes whatsoever, but she’ll be done with hands on, phone calls at all hours, ‘my sink is leaking’ management — probably forever. The thought of that alone keeps her focused like a laser beam at times.

Now tell me. Why would I advise her to risk ridding herself of all that negative crappola, while simultaneously gaining all that increased tax shelter, capital growth, and cash flow? All for a lousy $5-20,000? See what I mean? Taking her first offer was a no-brainer any way ya looked at it. She sacrificed her runner into scoring position, knowing she’d knock in the winning run on the next pitch.

BawldGuy Takeaway: Keepin’ your eye on the ball as a real estate investor means thinking with the long view in mind. Shortsightedness will come back to haunt you every time.

In the real world, Carrie will spend more on pizza, beer, and entertainment in the next 5-10 years than the money she was talkin’ about in price and/or costs. The downside was a penalty far too severe to contemplate for that piddling amount. It’s not always about the ‘now money’. It’s almost always about the end game — which is all about winning. Winning is always fun. Losing a baseball game hurts to be sure, but losing in your investment life isn’t a game — especially when you lose.

Let’s ensure a win for you and your retirement. Get a hold of me today so we can figure out the lineup your team’s gonna need. Stretchin’ the baseball analogy a bit? Send me a note and let’s get started. Tick tock. Have a good one.