Peter Pays Paul

Using a Little Stick to Move a Big Rock.

This is the description of leverage most common in Physics classes. Then you have the diagram: a person using a stick with a little rock underneath it to move a big rock on the other end.

The physical principle of leverage is very simple. A smaller weight over a long distance, when applied to the long end of a lever, can move a larger weight a small distance. Hence, a small man can move a rock larger than himself through the use of a lever.

The Principle of Financial Leverage

Financial leverage is similar to the physical concept. But instead of using a smaller weight to move a larger weight, a smaller equity investment is used, in combination with debt, to purchase a much larger investment.

Leverage has the effect of multiplying the return on investment, whether positive or negative. With a smaller initial equity (cash) investment control is gained over a larger investment and the returns on that larger investment are reaped.

Let’s look at an example. The first model is the purchase of a $100,000 investment with $20,000 of equity and by borrowing $80,000. The second model is the purchase of a $100,000 with $10,000 of equity and by borrowing $90,000. You will see two scenarios, one with 10% gain, the second with a 20% gain on the investment.

As you can see from the table, a return of 10% generates a 50% return on equity with a 20% investment. A return of 10% generates a 100% return on equity with a 10% investment. Debt always comes at the cost of interest. When the interest cost is less than the total return, a greater return on equity should be realized through the use of leverage over not having used leverage.

Leverage has a similar multiplication effect when an investment has a negative return. This means that you can lose more than your initial investment if the negative return is significant. Hence, leverage should be used cautiously and prudently.

This can mean reap huge rewards for a real estate investor. Imagine an investor with $100,000 of capital for investment in addition to their Sominex Account. With this capital as a 20% down payment they can purchase roughly $500,000 of investment property. Assume the property appreciates at a (moderate) rate of 8% per year for three years. At the end of the three years the equity in the property has increased over $120,000, a return on equity of 120%. When was the last time your IRA performed so well?

Now with close to $220,000 (initial $100,000 + $120,000) in equity the investor can gain control of $1,000,000 in investment property. If the $1,000,000 in investment property appreciates at the same 8% rate, the equity will grow by $80,000 per year.

Hopefully, you can see that real estate leverage can significantly increase return on equity. It needs to be used wisely and in accordance with a well developed plan. Using debt foolishly is called speculation and is the fast-track to foreclosure and ruin.

The second CERT training class was on Wednesday. This time my lovely wife attended with me. The classes are held at the Contra Costa County Fire Protection District Training Center on Treat Boulevard in Concord, CA.

This week we studied the fire safety. We had the opportunity to extinguish a small fire in a fire pan with the oversight of trained professionals. For some students it was the first time they had discharged a fire extinguisher. For all of us students it was good practice.

Some interesting fire extinguisher facts:

• A 5 pound fire extinguisher will only last about 20 seconds.
• Only try to extinguish a fire that is smaller than you are.
• Extinguishers do lose their effectiveness over time. The powder within the chamber settles and does not disperse when needed. This can be avoided by gently inverting the extinguisher every 6 months.
• It is wise to have two (2) extinguishers in your home in case of emergency.

We watched two demonstration videos displaying the speed that a fire can start and consume a room. The first video showed the speed that a dry Christmas tree could ignite an entire room. In less than 5 seconds the entire tree is engulfed in flames. In just 40 seconds the entire room is filled with smoke and flames. The bottom line is to keep live trees watered on a regular basis.

The second video shows the speed that a sofa in a living room can ignite the whole living room. After only 4 minutes the entire living room is filled with smoke and flames. It is amazing how fast a fire can spread.

These videos should instill in all of us the need for smoke detectors. The Santa Clara County Fire Department recommends, at minimum, placing one smoke detector in each bedroom, outside each sleeping area, and on every level of your home. For best protection a smoke detector should be placed in each living area, save the kitchen or bathroom.

You should also change the batteries in your smoke detector every six months. An easy system to remember to change the batteries is to change them at the same time the clock for Daylight Saving Time is changed.

Proper safety equipment can be an added selling point for your home. A $10 investment can help sell your home and can save your life or the life of someone you love.

The carnival of real estate investing is up over at Financial Freedom Through Real Estate. These carnivals are a great place to learn more from other authors on the web.

Jeff Brown has written a great article about the growth potential of $20,000. It makes you think about how you spend your money.

For most people a $20,000 decision is a huge. If you break it down, $20,000 is deciding 200 times how to spend $100. Or deciding 10 times how to spend $2,000. It may be 1000, $20 decisions. How are you going to get your $20,000? What decisions are you going to make?

A goal without a plan is just a wish.
- Antoine de Saint-Exupery

The Coming Train

Many of us have the goal of retirement. For some it is a small cloud of smoke on the horizon and for others the roar of the approaching train is growing and the locomotive ominous. Will the train of retirement be cramped and unbearable or will you be able to ride it comfortably into your sunset years?

Wishful Thinking

All of us hope for the latter option. We desire to enjoy retirement and do many of the things we could not do before. Maybe it is a trip to Europe, a vacation home, more time to fish or golf, more time with family, and the list is endless.

For a lot of people retirement is just a wish. They never plan for retirement. Few people even know what retirement looks like. They never stop and think what do I want to do in retirement? What kind of lifestyle do I hope to live? How much retirement income will I need to accomplish those goals?

How much income is available for the duration of retirement? Many planners recommend a withdrawal rate of between 3% and 5% of principal per year of retirement. This means that if you have $100,000, financial advisers recommend that you could withdraw $3000-$5000 in your first year of retirement. Does $3,000 plus Social Security meet the needs of your retirement dreams?

Setting a Destination

If we use a 4% withdrawal rate, our calculations are easier. We can multiply your present salary by 25 to achieve the necessary amount of accumulated wealth to retire at the same income. So if you make $50,000 annually you would need $1.25 million in accumulated wealth to replace your present income. If you earn $100,000 annually, $2.5 million dollars is the recommended savings to replace your current income. In Contra Costa County the median household income was $82,641 according to the Bay Area Census website. At that income level it would require $2,066,025 of investments to sustain a 4% withdrawal rate.

(Side-note: These calculations do not take into effect inflation. For every year until retirement your annual income should be increased by a factor of 2%-4% annually to negate the effects of inflation.)

The destination (number) should be in your mind. Now that you have it, how do you get there? You need a financial plan that will assist you towards your goal.

Developing the Strategy

The first part of your strategy should be a budget. You need to plan how you are going to spend your money this month. Spend less today in order to enjoy a better tomorrow. This is the process of delayed gratification. Put off an immediate reward for a greater reward in the future, namely retirement.

The second part of your strategy is your accumulation and growth plan. This is the longer-term plan. Hopefully, it involves a strategy that takes place over multiple years to accumulate and grow your wealth. This part of the plan should take place with a coach or adviser that will help you prepare, show you the pitfalls, and provide encouragement along the way.

Choosing an Investment Vehicle

If you are a baby-boomer, the retirement train will soon overtake you. Do you have the wealth to ride it comfortably?

There is hope, wealth can be built with the help of a solid plan and creativity. You may be wealthier than you think, if you own your home. You must choose a vehicle that will help you to arrive at your retirement destination quickly and comfortably.

One of the benefits of real estate is leverage. The wise use of leverage can dramatically increase your return on investment if done with a professional.

Don’t leave your retirement up to wishes on a star. Make a plan, get some help, and achieve your goal. Too much is at stake to leave it to chance. Take an active role in making your dreams come true.

Strategy Links

Below is a list of links to various resources that discuss developing a retirement strategy.

• Jeff Brown has some wonderful articles on what a good plan involves.
• The Financial Planning Association has a retirement planning checklist available.
• The National Endowment for Financial Education also has links to various resources and planning articles.
• Yahoo! Personal Finance has a retirement calculator to estimate your retirement savings needs.

My post “Investing is a Luxury” is listed in the Festival of Frugality at Money, Matter, and More Musings!

Go check it out for a frugal way of life.

Today, in the United States investing is assumed for those earning a regular salary. We have 401(k)’s, IRAs, brokerage accounts and more. The options for investment abound: stocks, bonds, mutual funds, hedge funds, real estate, businesses, classic cars, etcetera.

Investing is a Luxury

We frequently miss the fact that investing is a luxury. Living in one of the richest nations in the world causes us to be jaded to the realization that the majority of the world lives day to day. They do not have the luxury of saving money. Nor does the majority of the world have the added luxury of choosing the vehicle in which they invest their money.

This is not to say investing is wrong or bad. Investing needs to be treated as a luxury in our thinking and practice. Luxuries come after we have taken care of the necessities of life.

A Plan to Invest

If you are going to begin investing, here is a recommended plan to get there.

1. Live within your means. - If investing is a luxury, it means that you should be making more money than you are spending. It also means that at the end of the month you should have some money left over to save. The best way to do this is to set a monthly budget and stick to it.
2. Reduce consumer debt. - Paying interest on things that depreciate like clothes, cars, televisions, and stereos is the best way to stay broke. It is a glittery road that leads to bankruptcy. Applying any leftover money at the end of the month towards debts is the quickest way to reduce them.
3. Save for a rainy day. - God forbid an unforeseen need arise, however it does occur. Bad things do happen and it is best to be prepared. Most financial experts recommend 3 to 6 months of income in reserve.
4. Assemble a team of professionals. - Having an accountant, an attorney, and a financial planner in your corner can make all the difference in the world. Choose professionals that are also investors. Your team members should have your financial health as their goal.
5. Invest wisely and often. - After paying off consumer debt and saving for a rainy day, invest the leftovers each month. There are many options for investment. Choose an investment vehicle that is understandable and that has a comfortable level of risk. Staying awake each night sweating your investment is not worth it.

What Are Your Dreams?

Where do you want to be in 5 years? 10 years? 20 years? What kind of life do you want for yourself and your family? What do you want to enjoy in retirement?

With those dreams in mind, how will you get there? “Failure to plan is planning to fail”, the saying goes. These steps above can serve as an outline for your plan. There are many nuances and intricacies in each step, far more than can be covered in this article. Dave Ramsey, an author and radio host, has written on these and other topics. His book The Total Money Makeover is a good resource for more information.

-Peter

Reading the Contra Costa Times does have its rewards. Last week I read about a six week training program sponsored by the City of Walnut Creek and the Contra Costa County Fire Protection District called C.E.R.T. or Community Emergency Response Team.

C.E.R.T. is a program that has been put in place all across the country. Hurricane Katrina has raised awareness to the need for community members to be prepared to assist others in a disaster.

According to the Citizen Corps’ website:

The Community Emergency Response Team (CERT) Program educates people about disaster preparedness for hazards that may impact their area and trains them in basic disaster response skills, such as fire safety, light search and rescue, team organization, and disaster medical operations. Using the training learned in the classroom and during exercises, CERT members can assist others in their neighborhood or workplace following an event when professional responders are not immediately available to help. CERT members also are encouraged to support emergency response agencies by taking a more active role in emergency preparedness projects in their community.

This past Wednesday night the class began. It was very interesting and I am glad to be taking part in it. I am one of about 40 people currently enrolled in the program. It was interesting to see people from all walks of life. Senior citizens from Rossmoor were there as well as other young professionals like myself.

Our first class covered the topics of terrorism and a general outline of C.E.R.T. Training. Mike Marciano from the Office of Emergency Services spoke about terrorism. The information he provided was very informative and not alarming. Thankfully we do not yet live in a country where terrorism is a daily threat.

Mike Forster from the Contra Costa County Fire Protection District outlined the general overview of CERT Training. He also provided us with an extensive list of the necessary items for a disaster kit. California doesn’t experience hurricanes and tornadoes are unlikely. The most likely natural disaster to afflict Walnut Creek, Concord, or Pleasant Hill is an earthquake. Having a disaster kit prepared in advance increases the likelihood of surviving such an event. He recommends having a large kit in your home, a smaller kit in your car, and a third kit at your workplace.

This class is highly informative and is a great way to get involved in the community. It is also a great way to prepare your family for a disaster. Next week we will be learning to extinguish small fires.

The City of Walnut Creek is sponsoring two more C.E.R.T. training sessions this year. The first will begin July 24 and the second will begin September 19. For more information visit the City of Walnut Creek’s website. To enroll in the class contact Community Relations Manager Gayle Vassar at (925) 943-5899.

With all the press generated about sub-prime mortgage failure and defaults, many more people are curious to know about buying a foreclosure home. Most people hope that by purchasing a foreclosure home they will be getting a better bargain and saving some cash. This may or may not be the case.

Unfortunately, when people begin to neglect their bills they also begin to neglect their home. Frequently a home that is in a state of foreclosure has deferred maintenance and is in need of repair. The amount of disrepair varies from home to home.

If a person is willing to put in some “sweat equity”, then this type of home can be a good buy. It will take either time devoted to the repairs, or additional funds to pay for the repairs. However, if a person has a history of failing to complete tasks and is short on cash, this is not good choice no matter how great a deal. It is very likely that the house will stay in a state of disrepair, and make home-life unbearable (Husbands read UNHAPPY WIFE).

Three Phases of Foreclosure

Pre-Foreclosure

When a homeowner fails to pay their mortgage, the bank or lender will send them a notice of default and file this with the appropriate government authority. The notice of default begins the foreclosure process and the homeowner is in a state of pre-foreclosure. The pre-foreclosure period varies from state to state. In California the borrower or homeowner has 90 days to bring the account current, called the reinstatement period.

If after 90 days the account has not been brought current, the lender will file a notice of trustee’s sale. This notifies the home owner and the public that the house will be sold at public auction. The homeowner has until 5 days prior to the trustee’s sale to redeem the house and pay off their loan. The trustee’s sale ends the period of pre-foreclosure.

Buying a Home in Pre-Foreclosure

There are varying views on buying a home in pre-foreclosure. When you buy a home in pre-foreclosure you are usually buying the home from the homeowner. Some people question whether or not this is ethical because you are profiting from another’s misfortune. Other’s will argue that assisting the borrower in their time of need can actually help them. It can prevent them from having a foreclosure or bankruptcy on their credit record.

Homeowners can be in foreclosure for a number of reasons many of them unpleasant: divorce, job loss, medical bills, death of a bread-winner, etc. Contacting a homeowner in any of these distressed states can be touchy. One must tread carefully and attempt to provide a win-win situation for the homeowner and buyer alike.

Trustee’s Sale

The trustee’s sale occurs after the notice of default and the notice of trustee’s sale has occurred. The auction often takes place on the steps of the county courthouse. The notifications of these sale dates and times are frequently obscure. The house is sold to the highest bidder. At many trustee’s sales the lender buys the home back to cover their losses.

Buying a Home at a Trustee’s Sale

A trustee’s sale does offer bargains, AT TIMES. However, most of the time a buyer is not able to inspect a home prior to purchase. What appears to be a good deal, may not be. The cost to repair the property combined with the purchase price may exceed the property’s value. This can make buying a house at a trustee’s sale a risky endeavor for the novice.

Bank Owned or REO (Real Estate Owned)

At many trustee’s sales the bank or lender will repurchase the house to minimize their losses. Most banks are not in the real estate business but in the lending and interest business. If they have money tied up in real estate, they have less money that they can lend to borrowers. This costs them money in interest earned each day they hold the property.

Banks will list the property for sale on the local MLS with an agent. Many of these are sold “as is”. Some lenders require that the purchaser be pre-qualified for a loan through them.

Buying a Bank Owned or REO Property

There are many good deals to be found at this stage of the process. The benefit for the average buyer is that because the homes are listed, they can be visited and viewed. Visiting the house with a carpenter or repair man, provides an estimate of the cost of repairs before the purchase, not after. An initial offer should be adjusted to account for repair costs.

The beauty of investing at this stage is their is no “emotional attachment” to the home by the current owner (bank or lender). For these owners it is a simple business decision. They want to minimize their loss. As time passes their loss grows and they are more likely to lower the asking price or accept a lower offer.

Summing Up

Buying a home in foreclosure can be rewarding. The homes are often below value. If you are willing to add value to the home through repairs and upgrades, you may be way ahead at the end of the game. However, it is not for everyone.

Always remember the real estate mantra “Location, location, location.” Don’t buy the best home in a bad neighborhood, rather buy the worst home in a great neighborhood.

- Peter

Better is a poor person who walks in his integrity, than one who is crooked in speech and is a fool.
A good name is to be chosen rather than great riches, and favor is is better than silver or gold. - Solomon (Proverbs 19:1; 22:1)

The Merriam-Webster dictionary defines integrity as: 1) firm adherence to a code of especially moral or artistic values - INCORRUPTIBILITY 2) an unimpaired condition - SOUNDNESS 3) the quality or state of being complete or undivided : COMPLETENESS. The third definition is extremely important to the understanding of integrity. It has the idea of not being two-faced or containing two sides. What you see is what you get.

Solomon said a good name is better than great riches. It is more valuable to be thought well of and respected than to have great wealth. Why? Because great riches will not follow a person to the grave, but a good name will. It is about legacy. How do you want to be remembered?

Earning money deceitfully is easy. It is easier to steal from your client than to earn money respectably. It is easy not to disclose that one thing, or to be a little misleading about the features of your product. It is easy because you may get an immediate reward from the dishonesty.

It is much harder to be completely honest. To disclose all things and to possibly discourage a potential buyer is hard. It is hard to focus on the long-term results of an honest and truthful career and the potential rewards that come from those choices.

A real estate agent that has integrity will warn you about your “Dream House” even if you do not want to hear it. A real estate agent with integrity will warn you about getting too big of a mortgage. A real estate agent with integrity will not lie to you and will not lie FOR you. It is part of their fiduciary duty to represent what is in your best interests.

If this sounds like someone you would like to work with, then call me at (925) 324-8626.