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by Paul Kindzia in Happiness, Health, Personal Finance
October 25, 2021

I remember vividly the time I was walking out of work and ran into my friend and client Daniel.  It was in the early 2000s after the tech bubble burst and the tragedy of 9/11 rocked us along with our domestic economy.

Daniel and I were exiting the building at the end of the workday.  This is back in the day when people used to go to work in offices rather than work from home in their pajamas.  Daniel worked in the same building as I did, and we would frequently bump into one another in the parking lot and on the elevators.  We didn’t work in a big high rise skyscraper office building.  The plain red brick building was three stories tall in the suburbs of North Atlanta.  It was the type of building that you could drive by each day for twenty years and never notice it.  Being such a modest office building, many of the tenants were reasonably familiar with each other through these parking lot, lobby, and elevator run-ins with each other.

But on this day, Daniel walked me over to show me his new car, which he did with a big sense of pride.  It was a Jaguar sedan.  This is back in the day when Jaguar still had hood ornaments on their new cars.

On a side note, if you are wondering what ever happened to automobile hood ornaments like those found on luxury Jaguars, they became a large theft risk in the United States and thus were discontinued from the factory.  In Europe, regulators mandated that they no longer be used as they were deemed a safety risk to pedestrians when they got hit by a car (as if being hit by a car without a hood ornament is extra safe?)  But I digress…

Fast-forward to late 2005.  I received a phone call from Daniel.  We didn’t have texting back in 2005.  People actually called each other up on this thing called a telephone and the participants would converse with one another.  It was wild technology, but that’s how information was shared between one another.

A super sweet Grandma talks to her grandchildren on antique telephone.

At this point, I had known Daniel for several years.  Daniel had a very good job at a very reputable technology company.  I would ask him periodically “what he did” and although he would tell me his job title, roles, and responsibilities, I never really understood what his job was.  It was just a lot of techno-babble with some fancy management buzzwords spread around.  I only knew that he made about $200,000 annually because I prepared his tax returns each year.  That was a lot of money 16 years ago and it’s still a lot of money to this day.

Daniel was in his mid 40’s, was married, had children, graduated from college, and had what appeared to be a pretty nice life going for himself.

But back to the phone call from Daniel.  Daniel was excited when he called.  I could tell he had big news that he was just dying to share.  After exchanging pleasantries, I came right out and asked, “What’s going on Daniel?”

He replied, “I just bought two pre-construction condos down on the Panhandle of Florida!”

Sometimes as a financial advisor (or any counselor/advisor for that matter) you aren’t quite sure how to respond to certain client disclosures.  This was one of those times.  I was quite familiar with beachfront real estate on the Panhandle of Florida.  I had multiple clients that began investing in vacation rentals in the late 1990’s in an area stretching between Panama City to the East, all the way over to Orange Beach, Alabama and Gulf Shores, Mississippi to the west.

But now the year was 2005, I still had my CPA and tax practice up and running.  I did the tax returns for my clients that owned the rental properties, so I knew what they paid for them.  I had firsthand knowledge of how much rental income they brought in annually.  I knew the expenses including taxes, insurance, association fees, utilities, maintenance, management fees and most importantly, the net cash flows at the end of the year.

The phone call and breaking news from Daniel was quite alarming to me for several reasons.  First, the supply of new construction along the Panhandle of Florida was unbelievably massive.  If you looked down the beach, all you saw was construction cranes poking up out of the ground over the entire horizon.  There wasn’t just a little bit of new supply coming down the pipeline.  There was going to be a MASSIVE supply of new condos coming down the pipeline over the next 12-24 months.  Everybody wanted a piece of the action from real estate agents, investors, developers and municipalities looking to increase their tax base.

Build a new house, crane construction site. Blue sky and clouds

The second reason that the phone call from Daniel was alarming to me was because although I knew that Daniel had a good job with very good compensation, he was for all intents and purposes, “all show and no dough.”  He had a nice house in Dunwoody, an expensive place to own a home in Atlanta.  He had toys.  He had a mountain cabin.  He had kids and a stay-at-home wife.  He took nice vacations and he drove that brand new Jaguar.

He fancied himself as being a success.  But I knew that behind all those objects of financial success, Daniel’s financial situation was quite FRAGILE.

That put me in an awkward situation.  So, I played the “surprised-vague” card and responded with, “Wow, I had no idea that this was something that you were working on.”  Then I started with my finance and accounting questions;

  • “What were the purchase prices?”
  • “When will they be complete?”
  • “How much rent will they generate?”
  • “Who is going to manage them?”
  • “How are you going to pay for them?”
  • “What motivated you to buy these condos?”

I had an endless list of questions.  Daniel had very few answers.  But he was excited, and I didn’t want to totally burst his bubble, so I stuck with neutral statements like, “This is so interesting.  You sound excited.  This is definitely going to be new adventures and experiences…”

Now behind the scenes, I was cringing.  I knew that the new supply of condo’s was literally going to be in the thousands and thousands of new units along that stretch of the Panhandle of Florida.  Unless thousands and thousands and thousands of new renters were going to come out of the woodwork each summer, many of these wouldn’t have enough rents coming in to meet the required annual expenses including the basic mortgage, taxes, and insurance.

Daniel raved about what a “can’t miss investment opportunity” this was.  He previously took a vacation to the beach, saw all the construction cranes littering the coastline, saw many of the sales brochures from the development companies, and immediately saw dollars ringing his cash register.

The gimmick in the early-to-mid-2000s was that developers only needed to show a bank, “investor commitments” of a certain percent of the eventual development to get funded (i.e. receive huge loans) for construction and to start pouring concrete.  Condos were sold “pre-construction” based upon architectural pictures and mockups of the proposed developments which showed pictures of beaches, women and men with 6-pack abs wearing swimsuits, high-end community swimming pools, workout gyms, beautiful lobbies, and balconies that overlooked the emerald waters of the Gulf of Mexico.

A smiling attractive young man is turned back to makes acquaintance with the sexy young woman on the beach. Horizontal view.

Investors often only needed to put down a 5% to 10% “deposit at the time of making a purchase of a unit in a new development.  For a $275,000 beachfront condo, you only had to put down $27,500 (often much less) in cash up front to reserve your unit.  The rest wasn’t due until the condo was complete and then investors would choose between one of two alternatives;

  1. Finance the remaining 90% with a mortgage from a bank and then live the awesome beach life happily ever after.
  2. Flip the rights to the condo which was brand new to other buyers who didn’t want to wait for another building to go through the entire construction process which often took over a year (i.e., be a real estate speculator.)

By 2005, the real estate market in the Panhandle of Florida for condo’s was in a full frenzy of #2’s, which were real estate speculators.  People that bought units in 2003 for $225,000 were now selling them for greater than $300,000.  $75,000 is a nice profit but even more impressive when you only put down $22,500 (or less) as a deposit and immediately flipped the condo once it was complete with a simultaneous close to another owner/investor who then intended on flipping quickly again.  That’s over a 300% return on your invested capital.

Now to fill in some of the blanks on Daniel, he didn’t even have the funds to put the 10% down on the two condo’s that he committed himself to.  Each of his condo’s required about $35,000 up front which put him on the hook for $70,000 of upfront capital.

I know what you are asking, “Where did Daniel get the $70,000 from?”  (I was asking the same thing…)

He told me that he took out cash advances on some high-end credit cards that he had access to, and he was able to secure low interest rates for the first 12 months for cash advances.

If Daniel had a nickname for this investment project, it would have been Murphy for “Murphy’s Law.”  If something financial could go wrong, it would go wrong with Daniel (let’s just now call him Murphy shall we).

  • By late 2006 the condos were still not completed. They were still wrapping up construction.  Murphy’s 12 months of low interest on his credit cards was up.  It was time to start paying the piper.
  • By early 2007, the real estate market was already exploding to the downside. Market prices would eventually fall between 50% and 66% for most of those Panhandle properties.  There was just too much supply and eventually zero demand from new owners once the market started tanking.
  • Murphy used a technique at that time broadly used by today’s meme stock investors referred to as, “HODL” (Hold on for dear life.) He used his high employment compensation to borrow mortgages at the time of closing once the construction was completed.  That put him with four mortgages; his primary residence in Dunwoody, his mountain cabin in North Georgia, and now two beachfront condos that he thought he was going to flip for quick and large profits.  With the large change in market conditions, Daniel now decided to turn his quick flip condos into rental properties.  He thought this would buy himself some time to make up the losses that were staring at him if he sold at that moment.
  • Murphy found a management company that was more than willing to act as leasing manager for the two vacation properties. Management companies on these types of properties took 10% of revenues off the top (not 10% of the net profits, 10% of the top line rental revenues before any expenses are paid).  One of their first official value add tasks was to inform Murphy that rental season really picked up around Labor Day.  That was bad news for Murphy since he learned this news in November.  Now he had seven months of carry costs entirely out of his personal cash flows which were already busting at the seems with his prior lifestyle commitments.  Who does’t want four mortgages and a Jaguar payment with a wife and kids at home?
  • The first-year rental season was underwhelming. The stock market peaked in October of 2007 and the global economic collapse began to unfold for the following years.  Less people had the funds to go on vacation (many didn’t even have a job) and there were THOUSANDS of brand-new condos to choose from if you did have the money to go on vacation.  Rent prices tanked for a few years.  It was simple supply and demand at work.  The old laws of economics were back in play.
  • Murphy soon found himself to be cash flow negative on the entire operation. But he wouldn’t sell and cut his losses.  He couldn’t bring himself to admit defeat.  “HODL!!!!” He told himself.
  • Murphy had no emergency funds and no extra liquidity. He was getting squeezed from every direction from a cash flow perspective.  He only had one remaining place to tap into and keep himself afloat: his company 401k.
  • Bleeding cash, Murphy began a series of withdrawals on this 401k plan which in hindsight was far more costly than using a credit card at full tilt to finance his cash flow problems. Liquidating stocks in 2008 and 2009 during a market collapse meant that he got less than 50 cents on the dollar for his stock holdings.  The NASDAQ 100 fell during that stretch well over 50% and Daniel (I mean Murphy) held a lot of high-flying tech stocks in his 401k because he was so anxious to, “get rich and build wealth quickly.”  Stocks that he paid top dollar for were now being liquidated on Wall Street at huge discounts.
  • Murphy found out that when you take out funds from your employer 401k (which were less than 50 cents on the dollar) you not only have to pay federal and state taxes, but you must pay an extra 10% for early withdrawal penalties since he wasn’t at least 59 ½ years old.
  • Eventually, Murphy bottomed out. His funds were now depleted.  He could no longer HODL.  I’m not exactly sure how he did it, but Murphy managed to keep his primary residence.  But, the mountain cabin, the two condos, the Jaguar, the 401k, those were now GONE.

This all brings up an interesting question, “How does one go belly up financially?”  The answer is, “First slowly, then all at once…”  It’s what happens when one lives in a financially FRAGILE household and the tide turns against you.

If there was one behavior that stuck out with Daniel, it was his lack of faith in proven principles of success related to wealth building.  If you tried to explain to Daniel about cash flows, earnings, accounting metrics, it was all just nonsense to him.  None of that mattered when the casino lights of Wall Street were flashing, and easy money was to be made in a real estate boom.  The dollar dinner bells were ringing loudly!

Living below your means, avoiding leverage, having emergency funds, investing prudently were all just things that were going to slow him down from reaching his financial goals.  Sure, these were PROVEN methods of building robust and ANTI-FRAGILE wealth, but to Daniel, they were anchors and certainly not useful methods and processes in his mind.  Trying to get Daniel to think about real estate investments from a perspective of positive cash flows over many years (like decades) wasn’t of any interest.  To him, he never had any intention of being a long-term holder of real estate.  Long term to Daniel was the minimum time required to make a fast buck and bank a huge return.  All the other kids playing in the beach sand were getting rich and he wanted to be a part of that sandbox.

To Daniel and the thousands and thousands of other real estate investors in the Panhandle of Florida, it never was about investing based on fundamentals.  It was always about speculation.  He just assumed that there was going to be a buyer down the road that would pay an even crazier price than he did when he bought an asset, whether that asset was a beachside condo, a mountain cabin, or a technology stock.

Daniel not only lacked faith in proven principles of wealth accumulation, but he had no confidence in a system that focused on wealth preservation.  Again, that was all a waste of time while everybody around him was making huge returns.  The money was flowing, and he believed that all he had to do was put himself in the middle of that flow.  Everybody else was doing it, why not him?

Building wealth is a hard thing to do which requires a lot of time.  But building wealth is only half the battle.  Preserving that hard earned wealth is the second half.  Becoming financially “ANTI-FRAGILE” requires a strong foundation to prevent the structure from tipping over.

Daniel committed a lot of investing sins during his plunge into real estate investing;

  • He was a speculator that was counting on ever increasing prices that would be paid by someone else after he bought in.
  • He never equated the price he paid for the assets compared to the underlying fundamentals of the asset in terms of potential and likely revenue, earnings, and cash flows.
  • He never left himself a margin of safety.
  • He used excessive leverage.
  • He never considered downside risk.
  • His exit strategy was only based upon one scenario – getting out with large profits that required very little effort on his behalf.
  • Never considering the balance between supply and demand in the actual marketplace.
  • Getting wrapped up on the hype of a bubble. He gained comfort and a false sense of confidence since it appeared that everybody else was doing it, so he concluded that it must be safe.
  • He knew very little about the industry or the how the assets actually worked in real life.
  • He put his own head in a liquidity squeeze when he operated with no emergency funds to begin with.
  • All of Daniel’s financial processes were based upon FRAGILE His household was run using FRAGILE financial processes and his net worth was back up by FRAGILE investments.

When making an investment, it helps to always imagine the scenario where you must hold onto the investment for at least a decade.

  • What would that do to your liquidity?
  • How profitable is the underlying investment so that if you can’t sell at an immediate profit, you can at least enjoy your share of the profits and cash flows?
  • Could competition impact your investment in the future?
  • Is your investment managed by experienced, reputable, and morally sound management?
  • Are you just being sucked into something that makes no mathematical sense just because everybody else seems to be doing it? (If you follow the crowd, you normally get swallowed up by the masses.)

Here’s the interesting part that many of us could relate to; why did Daniel and everybody else make the decisions that they did during the real estate bubble of the early to mid-2000s?

The simple answer is, “They wanted to be happy.”

That’s it.  They wanted to be happy.

They wanted the money so badly that they couldn’t think straight.  All they could do is focus on what they wanted the money for.  They wanted nice things for themselves.  They wanted nice things for their spouse and kids.  They wanted peace of mind knowing that they were going to be financially successful and secure.  They dreamed about upgrading their lifestyle.  They wanted that feeling of being a financial success like others who they imagined to be their peers.  They wanted to be happy.

All those happiness drivers are perfectly understandable drivers of behavior.

There’s only one problem.  The actual behaviors of Daniel and all the other real estate bubble participants deviated from proven principles of not just wealth creation, but wealth preservation.  Most people want to accumulate more wealth.  Most people want to achieve financial security.  Most people want nice things for themselves and their loved ones.

That’s one of the behavioral problems in personal finance – Very few people can live their lives around proven principles of success, especially when the world around them is going crazy with speculation and nonsense.

Investing is about buying quality assets at good prices.

Investing in stocks is not really any different than investing in a business or in real estate.  The price you pay for the asset relative to the revenues and cash flows has far more to do with your success than any other factor.  It’s the golden rule of investing.  If you pay too much up front for an asset that you hope generates profits and earnings, you are only diminishing your rate of return by overpaying for those future earnings.

One of the worst things to see as a financial advisor is a younger person who is just starting out in investing “win” early in their investment career by speculation.  It just reinforces bad habits that have nothing to do with repeatable processes.  If your entire investment thesis revolves around, “Someone else will pay me a much higher price regardless of how well this company/asset performs as far as profitability,” it’s speculation.  It’s not investing.

If you speculate long enough, you are going to generate some really large losses.  You may temporarily build paper wealth.  But it’s rather unlikely that you will preserve it since your paper wealth was built upon a foundation of speculation that was FRAGILE in nature.

Often people ask me when this speculative bubble that we are currently in will be over.  I like to think that the time is getting close mainly because it’s never been a more difficult time to be a rational value-based investor.  When there are no more speculators coming into the game with fresh cash and no more ability for those same speculators to borrow more money, the end is near.

Have faith in proven and timeless principles of financial success.  Have the confidence that your logical approach to investing and money management will stand the test of time for your remaining years on earth as markets go through crazy times.  There will be more crazy times and crazy bubbles ahead of us into the future.  Have the confidence in your investing discipline.  Make your household finances ANTI-FRAGILE.

If you can do this, I firmly believe you have the highest chances of being happy with your long-term success.  I can tell you this from seeing it happen to far too many people; losing money never ends up making someone happy.  It makes them extremely unhappy.

AFTERMATH

It should be noted that after the real estate bubble popped which preceded the global economic meltdown (the same global economic meltdown that central bankers could not prevent might I add), Daniel not only took large losses on his 401k, his beachside condos, and his cash flows, but he also was still left with the $70,000 in high interest credit card debt.  That was the same debt he thought was going to be “low-interest” or even “interest-free” for the length of time he thought he would have the debt outstanding.

I can’t say with 100% accuracy what happened to the investor that bought Daniel’s condos out from under him during his own personal financial meltdown.  I can only guess.  But knowing that banks changed their lending standards after the meltdown and bust, buyers of investment properties were required to put down substantially more capital up front (often a minimum of 20%.)  They also were screened much more diligently for financial stability during the underwriting process before being offered investment mortgages.  Thus, I assumed that they buyer of Daniel’s condos was purchasing from financial strength rather than financial weakness.

Over the next several years a few things happened.  The first is that as the global economy started to recover, more people started returning to the beaches during summer vacations and holidays.  Rental income began to increase as demand increased and as prices increased.  The second thing that happened is that prices for beachside condos started to go up again after bottoming out 50%-66% below their previous high-points.

Eventually, the prices for those same condos continued along the path of higher prices.  Yes, it took several years to do so (over 10 years) but prices were much higher a decade later.

The interesting lesson in looking at this exact example is that we had two investors who owned the EXACT same condos.  One basically went bankrupt while the other made very impressive profits and gains.  Since both investors had the exact same condos, the thing that made the greatest difference between great success and great failure was THE PRICE PAID FOR THE ASSETS.  Sure, the second investor had better financial stability.  They didn’t use as much leverage.  They probably had greater emergency funds.  But those were secondary to the price paid for the assets themselves.

One invested in a very FRAGILE capacity while the other in a very ANTI-FRAGILE capacity.  One failed miserably while the other achieved great success.

Both wanted to be happy.  Only one followed the crowd.  The other went against the crowd and bought when the crowd was all trying to sell at the same time.

I ended up losing touch with Daniel.  He no longer had any need for a financial advisor.  He no longer had any finances and capital to invest.  He believed that he no longer had any need for an “ANTI-FRAGILE based wealth advisor.”  But, if I had to guess, in his quest for happiness while breaking proven principles of wealth building left him to this day like this;

side profile stressed sad young crying man sitting outside holding head with hands looking down. Human emotion feelings

Follow the proven principles of success over decades;

  • Make a substantial living
  • Live below your means and control spending
  • Save consistently. Make savings a priority by paying yourself first.
  • Eliminate debts.
  • Always keep adequate emergency funds
  • Invest prudently over a lifetime
  • Use proper risk management in all areas of your life.

Good habits lead to good behaviors.  Good behaviors lead to good decisions.  Good decisions lead to a good life.  Live by principles and choose wisely.

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