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Archive for June, 2005

Is There Really a Real Estate Bubble?

Yes! Many of the articles on this website clearly indicate a real estate bubble. Today I came accross an interesting article by the Angry Bear which helps to confirm that there is a real estate bubble. This article is more about the impact of a housing bust on the economy in large, however it does provide some great information, including two very important graphs.

Annual Increase Household Mortgage Debt

The first graph, seen above, shows a large increase in annual household mortgage debt. This is not a small increase, it’s a very significant increase! The amount was fairly constant for at least a decade until around the mid-90’s, at which time it just exploded, almost at a 45 degree angle. This means that a lot of individuals are getting much more leveraged than before, well beyond the historical averages.

The second graph shows that for the first time in at least 40 years, the annual increase in mortgage debt has been larger than GDP growth in the US. All these, plus the interest rate indicators, definetely lead me to believe a bust is going to happen very soon!

Mortgage Increase as a percentage of GDP Increase

The article also mentions that mortgage equity withdrawal has significantly increased, that is the amount of money borrowed against your home. This is what has in part, along other factors, fueled the refinancing boom. More and more people are taking out the equity from their houses to use elsewhere, often to pay or acquire consumer debt rather than re-investments.

To quote the article on the significance of this graph:

“Hatzius has calculated that homeowners have pulled $640 Billion from their homes in 2004, as compared to just $74 Billion ten years ago.”

That’s about nine times the mortgage equity withdrawal from a decade ago! Combined with the above two graphs, as well as the interest rate article I recently wrote, and the quote from business week, this really tells me that we’re in for a serious real estate bust.!

A Very Significant Increase in New Single Family Interest Only Mortgages!

Here is a quote from a Business Week magazine article (May 30, 2005 edition) that I just came accross today:

“31 – Percentage of new single-family mortgages that were interest-only during 2004. That is up from 1.5% in 2001”.

Take a second glance at this statistic, it is not just saying up 1.5%, rather up from 1.5%. This means 29.5%, not 1.5%, more single-familly mortgages were interest-only in 2004. This is a very significant increase in highly leveraged mortgages and a serious indicator that a housing bubble is in full swing. Its just a matter of time before it bursts. This is great news for the serious investor. This means that in the near future there will be a lot of properties available on the market from people who over-leveraged themselves during the boom, just like with stocks in the dot com boom.

How interest rates can drastically affect real estate prices

Mortgage principal amount difference as related to interest rate graph

Do you know the power interest rates have over real estate prices? Well, they can drastically affect real estate prices and the profits you make on your properties, probably more than you realize. If you look at the graph just above, you will see that the total amount of mortgage that you can afford changes significantly (assuming you want to keep the same monthly payment) as interest rates fluctuate.

As an example, let’s take a mortgage payment of $1000 at an interest rate of 5% amortized over 30 years. With these numbers, you can pay a mortgage principal of $186,281.62. Now let’s increase the interest rate by 1% to 6%. If you want to maintain the same monthly payment of $1000, then you cannot sustain a mortgage of more than $166,791.61, making the mortgage principal amount 10.97% less than before. Let’s take a higher, more realistic interest rate, of around 8%, what difference does this make? Well you can now only afford $136,283.49 of mortgage principal, a significant drop of 26.8%.

Many people believe that what has driven the real estate market to today’s high prices is the investment value of properties, plain and simple, just like stocks in the dot com boom. However, if you ask someone walking down the street what started the boom, as in what exactly is the “investment value”, most won’t be able to answer you. Put fairly simple, housing got affordable really quick because interest rates dropped like a rock, to their lowest in decades! The reality is that for each 1% interest rates dropped, a person could afford a lot more mortgage with the same monthly payments, especially when the interest rates are on the lower side. That is what initially fueled the real estate market, however as the flames burned high, the market has taken a fire all of its own because people forget why the market started to get hot.

Mortgage percentage difference as related to interest rate graph

From the first graph we can extrapolate the data to create the graph just above.The good news is that we can see the mortgage principal drop to be more significant at first, so if you can ride it out for the first little while, you’ll probably be able to make some real money, pennies on the dollars. All those unfortunate souls that have been buying up real estate without really doing the research or working the numbers, or that are on the edge, will most likely get squeezed out and cause some over zealous fire sales, much like the dot com bubble and bust of 2000. For the smart investor, the next few years may become really fertile lands for making profits.

For your interest, I’ve added below the table used to compute these graphs (for a monthly payment of $1000):

Interest Rate (%) Mortgage Principal Amount Percentage Difference
4 $209,461.24 12.44
5 $186,281.62 11.69
6 $166,791.61 10.97
7 $150,307.57 10.29
8 $136,283.49 9.66
9 $124,281.87 9.07
10 $113,950.82 8.52
11 $105,006.35 8.01
12 $97,218.33 7.54
13 $90,399.61 7.11
14 $84,397.32 6.72
15 $79,086.14 6.35
16 $74,362.88 6.02
17 $70,142.20 5.71
18 $66,353.24 5.43
19 $62,936.92 5.17
20 $59,843.74 4.93

For the smart investor, the coming real estate bubble bust can be a great time to increase their wealth! And now that you know and understand how much interest rates can truly effect housing affordability, you are in a much better position to make some real money from this real estate bubble bust.

The 3 Essential Rules that Guarantee a Successful Business

Three business rules to succeedI’ve found that the absolute best and easiest way to keep our customers happy is to provide them with a product that follow three very simple rules: solve one of their real problems, make it as easy as possible to learn and use, and make sure it works as expected. That’s it! Three very simple rules by which to run almost any business. What’s amazing is how often these three simple rules but incredibly powerful rules are so often overlooked.

To be a success, you don’t need to have the end all be all widget, no one expects a coffee maker to also be a stove, microwave, etc. Most people will be extremely happy with a coffee maker that is easy to operate and makes great coffee consistently. Of course I suspect some of you are already saying a coffee maker that makes coffee for you in the morning while you sleep is better than one that doesn’t. Yes, of course, assuming it FIRST follows the three main rules, it’s easy to setup and use and it makes great coffee every morning, without failure. If you fail in any of the three rules, then I would strongly suggest that you first fix them before you proceed to add new features such as automatically making coffee in the morning.

Why? Well let me ask you this, how long will a coffee maker that is combersome and/or complicated that makes ok coffee most mornings last on the market? I don’t think it will be long before this coffee machine is a thing of the past.

These rules are not rocket science. They are common sense rules that really work, as you can see with our success with LandlordMax Property Management Software. We are continually adding new features and functionality, but only after we have confirmed that they obey to the three golden rules: it solves our customers needs, it’s easy to use, and it works every time. For the last step, we do substantial internal testing, then we pass the product on to our beta versions where it is sent to our beta group of customers. It’s only after it has passed all these steps that we finally proceed to release a new version. We do our absolute best to make sure that everything works the first time it goes out the door.

Going back to the rules, the first and easiest rule, find a problem that needs solving. How many businesses have created a product that doesn’t really help the customer? Or what about products that solve one problem but cause another? Or my favorite, what about products that solve a problem, but only work some of the time (those are the most frustrating for me personally because its like being dangled a carrot in front of your nose). So the first thing you need to do to start a successful business is to find something that needs solving, something that will make someone’s life easier and save them time. Don’t create something that will require more effort than the current system, or that’s more complicated. Find a solution that is easy and works all the time. You don’t necessarily need an original idea, what you need is to find a problem that is not correctly addressed today.

For example, how many of you have a change jar? Wouldn’t it be nice if there was a machine that rolled your coins for you? I hate Coin Stackhaving to sort them all out and take the time to roll them all up, so I wait until I absolutely have to, making it even that much more arduous. Now what if there was a machine to do this for you? Well there is, more than one machine. Since I’m not a bank, I can’t afford a premium machine that costs a lot of money and can roll enormous amounts of coins in no time. I just need a simple cost effective solution that’s easy to use (dump the coins in the machine and gets the rolled coins out), and that works every time (doesn’t get jammed every 5 minutes with coins, or that the coins are not correctly sorted and my penny rolls have dimes in them, etc.). I haven’t been able to find such a machine, they all have their problems, or they cost an arm and a leg. I’m sure if someone came up with a cost effective solution to do this chore, it would sell well, and this is definitely not a new and innovative idea!

Let’s take another example, property management software. My company, LandlordMax Property Management Software helps landlord’s and property manager’s (and property management companies) run their real estate portfolios, which if you have more than one rental property, you will quickly understand the need for some kind of property management system. Is there really a benefit for the user to use software versus paper and pencil? There most definitely is, otherwise my company wouldn’t be around today. What we offer to our customers is a way to enter in information about your properties, tenants, etc. Although that’s nice, that’s not the real benefit. The real benefit is that we can quickly sort through all that data for them in very meaningful ways in seconds. Whereas on paper they would have to sort through reams of papers, we can generate reports for them in seconds. We can give them information on their cash flow, how much profit they’re making, when their leases are up, which tenant lives where, who owes what, etc. Our benefit to our customers is that all their information is available to them in seconds, sorted based on their specific needs at the time.

Of course we don’t only offer this, we offer many other features as well, such as amortization table calculations, etc. to help with their other tasks, however, if we didn’t have the reporting capabilities I just mentioned, and our customers needed to sift through all of their data on the different screens, then our solution would only solve a small part of their problem, and it wouldn’t be a good solution. Would it be enough to purchase the software? Maybe, maybe not, but with reporting on almost everything at the tip of a finger, that’s definitely something our customers really value.

Now that’s only part of the value. What if entering the data was difficult or hard to understand? What if navigating through the software was painful? What if generating a report was painful? What if entering a tenant or accounting entry was difficult? Then the value of the reporting quickly drops. Not only do you need to solve a problem, you need to make it easy to solve. I myself wouldn’t be interesting in a property management software that was difficult to use. It would quickly lose its appeal in no time at all. You not only need to solve the problem, but you also need to solve it in a way that is easy for your customers to use.

So let’s assume that you’ve figured out a problem that needs solving, how should you go about attacking the problem? Well first you should design an interface to your solution, be it a coffee maker, a software program, a car, etc. Your interface should be as easy to use as possible. Generally, if you require a user manual to use it, then it’s too complicated. If you have to explain it to someone else who is not familiar with the product, then it’s also too complicated. The last thing I want to do when I buy a new television is be forced to read through a full user manual with detailed step by step instructions just to turn it on. When I get home from the store, I want to watch my television right away, I don’t want to have to spend an hour configuring the channels, the time, the menus, etc. I just want to hook up the cable in the back and turn on the power, that’s it. Well at least that’s it at first, being a geek and all, I’ll eventually want to dig into the cool features and play with them, but for the first little bit I just want to test drive it. Think of it as a car, I don’t want to assemble the engine when I buy it, I just want to turn the key and drive off the lot with my brand new car. I don’t have the time, and especially not the inclination, to learn and read on the intricacies of every item I purchase, I don’t know anyone who does. I just want to be able to use it as quickly and as painless as possible.

This is my simple wish, it’s not very complicated, but it’s amazing how many products don’t, or won’t, do this. Remote Control with easier button layoutHow difficult would it be to highlight with another color in some way the main buttons I’ll need to play a DVD movie? There’s only a few buttons, power, eject, play, stop. Everything else is an extra feature (which is great, I like extra features, but not everyone needs or even uses them), so let’s make sure these buttons stand out some way for the non-expert users, so that I can quickly and easily find them. I would love to be able to put in my dvd movie and press play. I don’t necessarily want to muck around with the audio settings, etc., I just want to play a movie.

There will of course be some more advanced users (who will probably range greatly in skill) who will want to fine tune everything, and this functionality should be available if possible for them (again, assuming the three rules are upheld), but it shouldn’t hamper the 90% of the population that is not interested. Why would I want to annoy 90% of my customers to make 10% happy, when that 10% is very comfortable looking for advance features anyways, and wouldn’t be annoyed if the options are a little more difficult to find (for example a button that is not highlighted).

Let’s look at it another way, how many of you know the intricacies of a car? I mean do you really know how to fine tune your car? Everyone knows how to turn on a car. The next level could be a user whole likes a manual transmission over an automatic transmission, so that they have better control of how the car changes gear. It’s a great feature to provide, but we don’t want to force everyone to drive a manual car. What about a reverse direction? Yes, we should provide that for everyone in an ease to use manner. We don’t want to make it a tricky button that you have to find and press that is located in the glove box, and that will work some of the time. You want it to be at an intuitive location (the gear box), that requires only one step (shifting the gear handle to reverse). You can continue this analogy to the stereo in the car. Most people will want one, even though it’s not required to drive. If you have a radio, you need to have at least the basic features highlighted, such as changing the channel or the sound volume. I think everyone can perform these two tasks on a radio, but what about changing the time, or changing the bass volume, etc. That’s probably a little harder, requiring more expertise. Wouldn’t it be nice if it was just as easy to do as change the volume?

In our product, LandlordMax Property Management Software, for every feature we add, we spend the time to analyze how we can make it easier for our customers. Cup of coffeeMany companies just add news features, whatever that feature is, to their products only giving its customers a quick glance at how to make them easier. Considering that most products, well at least most software products, are built by engineers that are comfortable in complexity, this can mean that many features become daunting for the average person. This is not saying that engineers are smarter, rather I’m simply saying that they are used to dealing with cumbersome interfaces and they have therefore learnt how to deal with them. This is not something I wish to make my customers do. I wouldn’t want to do that myself. If I make a cup of coffee, I don’t want to spend an hour or two just trying to figure out how to make a cup of coffee, I have other things to do with my time.

If I can give my customer the first option of driving an automatic car, with a manual transmission as a secondary option, then I will do it. Why should everyone HAVE to learn manual? There’s just simply no need. So I will provide the option, but set the default to automatic, even if it costs our company a little more initially. I’ll do this because I believe that in the long term the benefits will far outweigh the costs. Although some cars are sold with manual transmissions only (mostly sports cars), the vast majority are sold with automatic transmissions as a default option. Actually, other than sports cars, I don’t think there is any car manufacturer out there that has it’s manual transmission version selling more than its automatic version.

I can tell you that at LandlordMax, we often get emails from customers, or even prospective customers, saying how easy the software is. We are excited every time we hear this! It means that for every person that tells us this, at least 100+ think it and don’t say it. This means that we are achieving our goal. By doing this, we’ve just drastically lowered our customer’s barrier to entry. That is they are much more likely to buy our product because they can use it right away! And more importantly, we’re very much more likely to help them solve their problems.

Once you’ve figured out how to make your product as easy as possible for your customers, you must absolutely focus on making it unbreakable. There’s nothing that frustrates me more than when a product you just bought with your hard earned money breaks! I don’t know of anyone that likes this, do you? Although it’s impossible to make everything unbreakable, you should try your absolute best to release your product in the market without any known issues. Of course no product can ever be 100% perfect, but you should have ironed out all the issues you knew about. I understand that it’s not always economical to do this, but push this limit as much as you possibly can, because the cost of frustrated customers is very very expensive. It can take an enormous amount of energy to create a happy customer that will spread the news about your product to others, but it can only takes a second of carelessness to have a customer spread negative feedback about your company. Keep your customers happy by giving them a great product.

Let’s take a look at another example. Let’s say you build a race car, the easiest race car in the world. Can of Diet PepsiIt’s fast, it’s responsive, it looks great, it’s pretty much everything you wanted. You get out there, and suddenly after a day of driving, you start to encounter problems with the engine. What impression does that leave you of the car? Are you likely to recommend the car to someone? Are you likely to buy another? What about a smaller and more affordable everyday product? Let’s say suddenly Coca-Cola or Pepsi-Cola start to make their beverages inconsistently, that each new can of soda tastes slightly different, something good, and sometimes not so good. What if one in every one hundred cans tasted bad? Do you think they would be in business long? The key to success is to consistently provide your customers with an exceptional product as much as you possibly can.

If you want even more reinforcement on this, look at movies. If a movie is a bad, people will talk about it and it will be out of the theatres in no time at all. This happens all the time, it’s very common in Hollywood. Now, if the movie is great, it will last and make a lot of money. Just look at Star Wars the largest grossing movie franchise ever. Let’s take a step back though, how many of you have heard of a sleeper hit? This is a movie that starts with little or no fanfare, but that has an audience that grows or doesn’t stop growing over time. You see, for most movies, opening weekend is the make it or break it time, they will make more money in the first week than any other week. For a sleeper hit, the money will continue to roll in week after week and it will often increase each week! This is very unusual, but it really goes to show the power of having a great product that doesn’t break. If your customers are happy, they will spread the word about your great product. And I’m sure many of you know that a testimonial from a friend, family member, co-worker, and so on, basically someone unrelated to the company is worth its weight in gold. There’s simply no better marketing tool than word of mouth, and this can only be achieved by giving your customers a quality product that will consistently work great, after all, no one will ever refer a lemon to anyone.

It’s amazing how simple these rules are. Solve a problem, create an easy to use solution, and make sure it works. If you want to see examples of this working in the real world, the next time you go shopping, look around, look at how you choose items on the shelf. Most likely you’re in the store for a reason, to try and solve one of your own problems (maybe to mow the lawn, drink a class of soda, find shampoo to wash your hair). You’ll probably look at many items to see what your options are. You’ll probably be looking for a solution that will easily solve your problem. I’m pretty sure you won’t be looking for a lawn mower that comes in a million pieces, or requires special hard to get fuel to start, or that requires several steps to start. You’ll probably be looking for a lawnmower that can be started by the press of a button, and if you’re budget doesn’t allow it, by a pull start. You’ll also be looking for a product that doesn’t have any defects, or maybe remember a testimonial from one of your friends (this is the best shampoo, you’ve just got to try it!). Assuming all the products look like they are well made, then you’ll likely select a product because of its company’s reputation for quality. I’m sure you’d rather buy something that will work than something that won’t. Assuming your company has a product that does all of the above three consistently, then you will likely succeed, no doubt about it!

How Taxes can Dramatically Affect Your Real Estate Gains

Many people believe that flipping real estate is a good investment strategy, that it can give you a give boost to your pocket book, that holding a property for too long is not a good thing since you should cash your gains out often enough and re-invest it again and again in other properties to flip. This strategy does work for some individuals who are good at find hidden gems and can renovate them at a profit. However, for many this is a very sub-optimal strategy, unless you are doing a 1031 exchange.

What most people don’t realize is that flipping can be very costly. Every time you buy or sell a property, you need to pay the income tax on the capital gains (assuming the highest tax bracket and no 1031 exchange since you need to use the cash to live off of) of 50% on your capital gains, not to mention all the associated professional fees. This means that the next time you buy another property to flip, you lose 50% of your compounding gains. Over time this can drastically reduce your returns to only a very small fraction of what you truly could have gotten with nothing other than just holding your properties over a longer time.

Investing is about making money, not losing money, and one of the best and easiest ways to make money is compounding your gains over and over and over and over… Making $1 into $2, then making that $2 into $4, and so on. I find that a decent amount of investors flip real estate properties as soon as they have a reasonable gain and use that as their earned income. This is all fine and great, but imagine what you could do with those gains if you re-invested them? Since these investors don’t re-invest they lose 50% (assuming the highest tax bracket) of the gains to taxes. Assuming we use our example of $1 to $2, you would then have only made $0.50 to re-invest, not $1. You have just handicapped yourself a 50% compounded gain.

This might not seem like much, but let’s follow this simple example to the next stage, let’s now take that gain and double it again, so our $2 goes to $4. In our example, we take our $1.50 and double it to $3. Now we need to take 50% off of our $1.50 gain to taxes, which gives us a total balance of $2.25. We’re already 10% behind (our $4 is actually $2.50 after taxes as we need to pay 50% taxes on the $3 gain from our initial $1) as shown in the table below.

Year Income After taxes paid each year Income After taxes paid only on the closing date Difference (%)
1 $1.50 $1.50 0
2 $2.25 $2.50 10.0
3 $3.38 $4.50 24.9
4 $5.07 $8.50 40.4
5 $7.61 $16.50 53.9
6 $11.41 $32.50 64.9
7 $17.11 $64.50 73.5
8 $25.67 $128.50 80.0
9 $38.50 $256.50 85.0
10 $57.75 $512.50 88.7
11 $86.63 $1,024.50 91.5
12 $129.94 $2,048.50 93.7
13 $194.91 $4,096.50 95.2
14 $292.36 $8,192.50 96.4
15 $438.54 $16,384.50 97.3
16 $657.81 $32,768.50 98.0
17 $986.72 $65,536.50 98.5
18 $1480.08 $131,072.50 98.9
19 $2220.12 $262,144.50 99.2
20 $3330.18 $524,288.50 99.4

Let’s take a closer look. Our $4 becomes $8 (remember we only pay taxes at the end in this scenario). In our example, our $2.25 becomes $4.50. After we take out the taxes, we get a total of $3.38. We’re now about 25% behind the person who hasn’t sold their properties until the very end of our sample 20 year time period. By now you can already see how quickly the spread is increasing (as show in the graph below).

Percentage difference in gains based on tax strategy

If you continue this over 20 years (yes I understand that it becomes increasingly difficult for an individual to double each year for 20 years, however let’s assume for simplicities sake that it does really happen) you will get two very different final numbers! The first person who doubled each year and pays a large tax at the end of the 20 years will have after tax a whopping $524,288.50.

Compounding the interest and paying the capital appreciation at the end scenario

Compared that to our scenario where the only difference is that we flipped our properties each year and paid the capital appreciation tax after each year, we get a total of $3330.18 after taxes.

That’s an amazing difference of $524,288.50 or 99.4%! WOW! This really helps to explain why most investors take advantage of the 1031exchange in the US, or that they refinance their properties to buy new properties (no capital appreciation in this case since you haven’t sold the property, all you’ve actually done is shuffle your debt on the property).

In this perspective, commissions on real estate sales for example don’t seem as significant. Are we indeed spending too much time saving pennies? Compare that potential saving and benefit of holding a property for a long period of time. There is no better way to increase your real rate of return than to purchase properties with consistent growth over long periods of time!



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