IGNORANCE AND LEVERAGE.

"When you combine ignorance and leverage you get some pretty interesting results." Warren Buffet.

Happy Days Here Again? Certainly we all feel better now that the Dow Jones average is above 9,000. There is also some good news in the real estate market that shows the precipitous drop in the housing market is slowing. It can't be denied that this is good news; however, I don't share the optimism of those who are predicting 15,000 in the Dow. What I think might be happening is that the markets are starting to recover from the drastic combination of ignorance and leverage and the rush to de-leverage. Earlier this year, hedge funds had to sell into an extremely weak market in order to pay off huge amounts of leverage which had come due. This pushed the price of many solid companies below fair value as sellers far outnumbered buyers in the marketplace. While this may not be over, it has certainly slowed down. Residential real estate has performed similarly as over-leveraged families found themselves with mortgages they could no longer pay.

What Happened to Government Efforts To Help Families Avoid Foreclosure? These efforts simply haven't worked. Despite the emergence of "Loan Modification Companies" and attempts by major lenders to hire extra labor force to handle the huge demand for loan modifications by troubled borrowers, the foreclosure rate remains high. In almost 50% of the cases where loans have been modified to cure default, the borrowers re-default within a year of the modification. Why is this the case? One of the main reasons is that it may be in the borrowers best interest to default if the mortgage far exceeds the property value. Of course, the benefits are often short term, but it appears that we have become a society focused on short-term benefits. A home owner who owes $200,000 on a house worth $150,000 can skip three or four mortgage payments during the foreclosure process and have the money to move and an immediate $50,000 improvement in net worth after the process is complete. The damage to the borrowers credit report and the trauma of moving the family to a rental is often deemed worth it to the borrower with a large negative equity. Again, this illustrates what happens when leverage and ignorance is combined. Of course, the combination s a two way street as lenders exhibited the same ignorance as borrowers when they financed 100% of the value of a property with little consideration given to the borrower's ability to pay.

The Housing Market Will Cure Itself. Builders are producing very little new housing inventory since buyers can buy cheaper than builders can build. Building activity has slowed to a crawl and existing housing inventories are shrinking. This cycle will continue until supply and demand is brought into balance. This is a regional phenomenon and some areas, like Colorado and Texas will rebound quicker than others. Many local governments, eager for revenue, can slow this process by adding more development and water tap fees for builders, making it more expensive to build new houses. The difference between real estate costs in high affordability states (like Texas) and low affordability states (like California) is often largely a result of high governmental fees charged to builders and developers.

Back To Colorado. Next Monday, I will be flying to Denver with the main objective of solving some problems with real estate I own. I am always eager to make time to visit with clients and friends. Call Susan at 720-449-0200 to get on the list.

REAL ESTATE INVESTMENTS: YOU HAVE TO NEGOTIATE

The Financial Markets Are Called Negotiated Markets. That's pretty much a joke. You don't know what negotiation is until you're bought a real estate investment. The trouble is that even experienced investors don't really know how to negotiate. Most employ strictly positional bargaining. The seller prices a property at more than he expects to get and the buyer offers less than he expects to pay and they meet somewhere in the middle. A very experienced high end investor explained that process to me and then told me "it's not rocket science." Given that attitude it certainly isn't "rocket science."

Perhaps We Should Study The Process A Bit More. Here are some things to consider.

1. Know your BATNA and try to project what the other party's BATNA might be. I guess every one doesn't know what BATNA means. It's "Best Alternative To a Negotiated Agreement". You may think you know your BATNA right away but if you spend some time contemplating what it might be, you may come to a different conclusion. When I bought a lake front lot, I started out with some strictly positional bargaining but when I thought about it, I concluded that although lake front property may be somewhat plentiful in East Texas, I wanted to be within a reasonable distance from a town, I wanted a wooded lot, and I wanted an area that might be attractive to potential retirees from an industrial area 50 miles down the road. A little research told me that the sellers were heirs to a sizable estate and could afford to hold the property since there was no loan on it. They could wait for another buyer easier than I could find another lot. With that in mind, I was willing to pay nearer their asking price than I had originally anticipated.

2. Retain your objectivity as much as possible. One of the main points here is to avoid letting your emotions interfere with your logic. I have seen transactions that were in the best interest of both parties fall apart because they made their differences personal rather than financial. One of the best principles I know is to be more rigid on substantive issues than personal issues. Give the other party every possible to save face while you stick to your guns on what's really important to you.

3. Remember there are several aspects to a transaction. A seller might be favorably influenced by a large earnest money deposit which could cost the buyer very little since it is ultimately credited into the transaction. Sellers might also be favorably influenced by a speedy closing date. Buyers can be favorably influenced by attractive seller-carry terms which can also be in the best interests of sellers who might not need all the funds from sale right away.

4. It's not over until its over. Just because you have a signed contract don't think you no longer have to negotiate. There are inspection contingencies and title issues to deal with. In large commercial transactions, there is often a "due diligence period during which a buyer can cancel for any reason. Once a buyer or seller discovers what he considers a critical issue, the negotiation process begins all over.

5. Both parties expect to win in the negotiating process. Most of us have heard of the "win-win" negotiating strategies. While this may sound a bit hokey, it is true that both parties can win in a mutually beneficial transaction. In reality, you can expect that neither party is going to participate in a transaction that is not in their best interest. A broker in a transaction can earn more than his fee by discovering the interests of both parties and facilitating an agreement.

Have You Read The New Financial Publication? It's called Rolling Stone. For all these years, I have considered this mainly an entertainment magazine and not bothered to read it. Ms. Betty bought home the most recent edition which featured an article that concluded that the next big bubble would be the green energy phenomenon brought on by the proposed "Cap and Trade" legislation. The author, Matt Taibbi, provides rhetoric that wall street firm, Goldman Sachs, has been involved in manipulating market bubbles ranging from the great depression to the "tech wreck" of the late 90's to the sub-prime mortgage debacle of 2007. During this time they have made a fortune participating in these markets. The "cap and trade" bubble will allow Wall Street to broker "carbon credits." Again this will make them a fortune by doing what they have always done: taking a very small piece of a multitude of huge transactions. While I don't like this author for a number of reasons, I must admit that it provided me with much food for thought as I endeavour to make investments for myself and my clients.

WHO IS TO BLAME?

"Many an optimist has become rich by buying out a pessimist." Robert Allen

Are You An Optimist? Robert Allen, author of the above quote made a fortune by being an optimist. He wrote a book entitled, Nothing Down in which he outlined how to buy real estate with no out-of-pocket cash. You certainly have to be an optimist to run up large amount of debt with no idea of how you might pay it back. Looking at some statistics I am about to share with you the only conclusion is that we have been a nation of optimists. While I strive to be optimistic, I don't want to carry it to the extreme of being stupid.

Not All Debt Is Bad. I have always believed that debt has a place in many financial strategies. You might say that one of my specialties has been one of helping my clients develop sensible debt strategies. Unfortunately, you can't say that all debt is good since one inevitable consequence of debt is that it adds risk to your life. Although you can utilize debt to create wealth, it can also destroy your wealth. When carried to an extreme, it almost always creates risk that is virtually impossible to manage. As a simple example, consider the purchase of a million dollar property with an operating income of $100,000 a year. If you buy this property with a million dollars worth of debt at 5%, your interest cost is $50,000 a year. If everything works right, you have just created $50,000 in income from thin air (since you have none of your money in the deal). You have also obligated yourself to pay $50,000 a year whether or not your tenant pays the rent. This situation can be managed, provided you have a secondary source to make those payments or liquid assets available to pay the loan. The trouble is that most people don't have a clue as to how they might make those payments without income from the property. The other problem we have is that too many of us used borrowed money to purchase assets that produce no income and lose value rapidly. When this happens we look around to determine who we can blame for our predicament.

We Have Converted The Blame Game To An Art Form. In the current environment, we blame greedy corporations, lax government regulators, the war in Iraq, and huge federal deficits for our situation. I know I sound like a broken record when I call your attention to irresponsible borrowing by consumers so I have found some statistics to illustrate what I mean. Morgan Housel, who writes for The Motley Fool Stock Advisor derived some statistics that show how we have consistently increased our debt levels relative to our income. In 1974, the average household had total debt equal to 63.5% of annual income. This meant that a family making $40,000 a year had total debt of $25,400. By 1988, this had increased to 81.2%. Ten years later in 1998 debt levels were 92.6% of family income. By 2008, we were at 130%. This means a family making $100,000 a year had an average debt level of $130,000. These high debt levels relative to income means that our lives become more risky all the time. Since consumer spending is 70% of our economy, if consumers decide to cut back on spending to lower debt levels, the effect can be highly detrimental to such factors as unemployment, price stability and the government's ability to sustain spending levels.

One Last Point. Our congress is dangerously close to passing something called "Cap and Trade" with the objective of decreasing our reliance on foreign oil and encouraging clean, renewable, energy. Most of us will support those objectives but the real question is the methods they will use to accomplish those goals. There are a number of things I dislike about this legislation but one of the worst is a provision that requires the seller of any piece of real estate to undergo an "energy audit." Those properties that do not meet government standards will have to bring the property up to standard before it can be sold. Many sellers can not afford these costs, especially in an environment where home values are often less than mortgage balances. I wonder how many of us would really support this level of government interference into our lives.

JUST THE BUSINESS CYCLE OR THE END OF AN ERA?

The Noah Rule. It doesn't help to know it's going to rain unless you actually build the ark.

It's More Than The End of The Old Business Cycle. It Could Be The End of An Era. We may never go back to where we were and that may not be such a bad thing. We have concentrated so much of our lives on consumption that we don't slow down and consider what is important. Having been born at the tail end of a huge depression, I can remember what it was like before we became so affluent and it wasn't that bad. It's not that I would like to go back, maybe just slow down a bit and concentrate on what's important. Making and spending money can be fun but so can spending time with friends and family.

It's Time To Start Building Your Ark. I don't say you should stop spending money, just slow down a bit. I recently got an e-mail picture from a long-term client showing him sitting on a tractor-mower. He recently retired from almost 40 years in the airline industry. He now works at a golf course doing what we might call blue collar labor. Rather than feel sorry for him, I admire his willingness to do this type of work when he can certainly afford not to. As an added bonus, he also gets to play golf free. Since that is his real passion, the benefit is probably more important than the money he makes. My hat goes off to him.

Look At Your Investment Portfolio. I still think you have to emphasize cash flow. Dividend paying stocks and high quality corporate bond funds can keep your cash flow up and, while you can't afford to ignore share prices, you can take some comfort when you get those dividend checks. This is particularly important if you need to withdraw from your account to fund your living expenses. Trying to live off capital gains can be dicey since they are several orders of magnitude more difficult to predict than dividends. We also can't afford to ignore the potential for renewed inflation due to the anticipated huge deficits. One of the better hedges against this would be various kinds of real estate investments, especially REITs that are not over-leveraged and have low payout ratios.

Here's To My Favorite Holiday. I've always loved July 4th, especially in Colorado where the weather is usually pretty close to perfect. Before this holiday is over, we will have 15 or 20 family members up here. We will all over-eat, consume large quantities of various beverages, play music, and watch fireworks. I will be in Denver towards the end of this month and hope to see many of you then.