Buying Real Devastation – Forget the “Dividends”

by FI Fighter on February 5, 2016

in Precious Metals, Stock Investing Thoughts

Well, just yesterday ConocoPhillips (COP) announced a substantial dividend cut which has now become the talk of the blogosphere. I can’t honestly say that I was the least bit surprised by the move… Matter of fact, I thought the writing was on the wall months ago, and in full disclosure I will confess that I had recently opened up a short position on COP prior to yesterday’s announcement…

But let’s set the record straight here — For the most part, I am a long-term investor/speculator. I am absolutely dreadful when it comes to market timing so the short game really isn’t suited for someone like me… Nevertheless, when one of those “brain dead opportunities” pops up every now and then, I’m willing to throw aside a small amount of gambling money in hopes of winning it big…

Just like Kinder Morgan (KMI) before it, one of the energy sector’s most beloved companies is now residing in the doghouse…

Hey, no one said investing was easy! In an era of Negative Interest Rate Policy (NIRP) and Zero Interest Rate Policy (ZIRP), you gotta do what you gotta do to try and secure some “stable” income! When it comes to stocks, most every retail investor has flocked to the high yielding energy stocks, despite the fact that the world is beyond oversaturated with oil right now, China is slowing down, global trade has grinded to a halt, and the world has essentially entered into a stealth bear market that is highly deflationary for all commodities.

Anyway, as readers are well aware, I hate chasing after assets that everyone else is fixated on… For example, once Bay Area real estate really caught fire, I said, “See ya later!

And right now, oil is still SEXY! Everyone and their mother is out looking to buy, with many claiming that the oil majors, such as Chevron (CVX), Exxon Mobil (XOM), and hey, even COP are “buying opportunities of a lifetime!

Hardly.

When the retail investor isn’t running for the hills in fear, I ain’t interested in buying! It really takes no skill at all for anyone to examine the balance sheets of many of these companies (not all) to find that there are some serious cracks in the foundation…

For instance, CVX has been cash flow negative for awhile now, and has even taken on debt to continue servicing their enticing “5% yield”.

From Seeking Alpha:

For instance, despite the reduced future capital expenses, their amount is still too high compared to the earnings and the free cash flow of the company. More specifically, while Chevron is expected to earn just $3.35 B this year, the expected capital expenses are $26.6 B for this year and about $22 B per year for 2017-2018. As the annual dividend of $8 B is much higher than the expected earnings, it is evident that the company will struggle to maintain its dividend this year. This is already evident from the free cash flows of the last 5 quarters (see chart below, assets sales are not included), which have been clearly insufficient to support the dividend.

1996871-1454505990552476_origin

Of course the company sold assets worth $6 B last year and plans to divest another $5-10 B of assets during 2016-2017 but still it cannot cover the wide gap between its dividend and its free cash flows. That’s why the company increased its net debt (as per Buffett, net debt = total liabilities – cash – receivables) from $65 B in Q3-2014 to $86 B in Q3-2015. Obviously, the company cannot keep adding debt at this pace for long. This is also confirmed by the rating cut of the company by S&P today.

 

Further, CVX has slashed CAPEX/exploration, laid off employees, and is basically doing everything possible to appease its shareholders.

No, no, no, no…

Dude, you’re doing it all wrong!!!

And I’m the Idiot?

First, let’s start with the insane idea of taking on more debt to fund a dividend… Call me crazy, but I thought that dividends were a function of POSITIVE earnings and free cash flow… I mean, that’s Real Estate Investing 101 for you… Never buy a rental property that doesn’t generate POSITIVE cash flow on Day 1!

Last year, I refinanced two rental properties to pull out ~$200,000 in capital… To do that, I had to take on more debt, which in turn increased my monthly mortgage payments. My rationale was that I was being “smart” because I was creating more liquidity for myself… In other words, I feared a prolonged market downturn and wanted to have lots of cash on hand to be more nimble (and more ammo to chase assets selling for pennies on the dollar).

However, despite the added burden created by refinancing, I was still very much cash flow positive on each rental (meaning my tenants serviced 100% of PITI and I still had $$$ left over each month). So, yes, the debt load went up, but it wasn’t me who was paying for it! Since my rentals are currently priced about $400-$500 BELOW MARKET RATE, I would say that I’m sitting in a comfortable position. Obviously, real estate and leverage are never without risk, but c’mon give me a break here!

In life, you know how freekin’ difficult it is to have all your ducks in a row?!?

When does that ever really happen!?!

So, I’m just doing the best that I can… And I’ve got over $400,000 in liquid funds, uncorrelated with real estate to help me out in case things get rough.

Despite my best efforts, I still received a ton of criticism and flak last year when I made the original announcement of my refinancing. Critics were calling me an idiot for confusing debt with “real cash”. In their minds, my $200,000 wasn’t legitimate, and if anything, I was just digging a larger hole for myself…

As I’ve always believed, and still do today, “It’s not debt that will destroy you. It’s the lack of liquidity!

Everyone knows that real estate is the ultimate inflation hedge. Unlike these private companies, my debt service for all my rentals are also 30 year fixed, low interest rates… And for these two rentals in particular, they are among my best assets and located in Class A locations…

So, long-term, I very much believe that I will come out of all this a mile ahead… But I’ll gladly confess that having an extra $200,000 in liquidity for a rainy day gives me a lot of peace of mind…

But going back to a company like CVX, their “cash flow” isn’t sufficient to service their expenses (debt, G&A, dividend payouts to shareholders, etc.), so they’ve been forced to get “creative”.

More debt!

And for some strange reason, most of CVX’s shareholders have no problems with that!!! The very same people who were giving me a hard time about my own financial situation are somehow able to turn away from these actions!

What? That makes no sense to me!

Dividends can be blinding!

As investors, we become so damn fixated by passive income that it distracts us from the underlying fundamentals… So many investors who are applauding CVX for being able to “navigate through tough times and keep the dividend intact” are the same ones who are now ripping COP management apart because of their prudence to eliminate an expense that they could not realistically hope to support…

Management lied to us!

That’s a COP out!

The writing was on the wall with COP… I don’t even follow the oil/energy space closely and I knew that the dividend was unsustainable…

And anyone who’s willing to spend 5 minutes going over CVX’s balance sheet would know that the situation over there isn’t all that much better either… Yes, CVX is more diversified and vertically integrated, but low oil prices are low oil prices… Unless you know how long this pain will go on for, why take the risk of jumping in right now?

 

If I continued to take on more debt, eliminated all my positive cash flow from my rentals, sold off my assets at the bottom of the cycle for pennies, do you think anyone would be interested in buying shares of FI Fighter LLC?!?

Real Devastation

Truth of the matter is, I am in absolutely no rush to load up on any oil/energy plays right now, especially not the majors.

Why not?

Simple. As a strong buyer of gold/silver mining stocks, I think I have a pretty good idea of what real devastation looks like in the commodities sector…

And what we are seeing in the oil patch is NOTHING!

In comparison, just take a look at all the gold majors: Barrick Gold (ABX), Newmont Mining (NEM), Kinross Gold (KGC), etc. who were forced to slash dividends years ago…

When an entire industry is in severe liquidation, the following will occur: dividends are slashed/eliminated, exploration grinds to a screeching halt, CAPEX is reduced quarterly, there are massive layoffs, the weak companies start dropping off like flies, juniors trade for less than cash in the bank, the retail investor has ZERO interest in the space, the conferences/events have declining attendance, and the share prices are absolutely decimated!

Will the same thing happen to oil/energy?

Maybe, maybe not.

If not, I don’t buy…

If you are a follower of deep value investing, you really don’t give a sh!t about dividends… Don’t get me wrong, I’m a financial freedom fighter, so I obviously recognize the importance of passive income to sustain early FI, but I couldn’t care less about it when I am hunting for bargains.

As I have stated before, I LOVE Dividend Growth Investing (DGI), but I just so happen to believe that it’s a most suitable strategy for an investor who is already in early FI… Since I’m not quite there yet, my focus is still on capital gains and appreciation.

Of course, I hope that will change in the near future, but until then… I’m shopping for assets with the most upside potential (which I hope to convert to safer, less risky investments, later).

The reality is, if companies are still paying (or even growing) their dividends, they haven’t experienced real devastation yet (this limits the upside potential)…

I would rather “back up the truck” and load up on COP shares at $25/share with a sustainable 4.0% yield, than to buy at $50/share with a fictitious “8.0% yield”. Hell, I would prefer $15/share and ZERO DIVIDEND!

Same with KMI. At around $13/share or so, even if the dividend is only 3.0%, that to me is a way better deal than before.

As if it wasn’t clear already, it’s not that I have anything against oil/energy, or the companies involved in that space, but as a deep value investor, I don’t discriminate!

Real estate, index funds, dividend stocks, gold/silver, oil/energy…

There’s a time and place for everything…

I even bet big on Tesla Motors (TSLA) once upon a time… These days, it’s one of my favorite SHORT candidates!

Look, at the end of the day, my allegiance is to early financial freedom… Whatever vehicle I can take to get me there, I will use.

I don’t get caught up in “shiny object” syndrome (dividends)… Although, gold is quite shiny and alluring in its own right…

Anyway, if you focus on deep value, you really can’t go wrong… I don’t lose any sleep with my gold stocks because they don’t issue any dividends to begin with (the companies I own most likely can’t afford to!)… They have NOTHING to cut! 😉

Gold stocks were already in the dumpster when I finally decided to start getting interested; I’ve been rummaging through the trash trying to find gems ever since…

And that’s just the way I like it!

When it comes to commodities, I will NEVER again invest in the space unless real devastation has already taken hold of the sector.

I’ve seen far too many people getting burned by buying at the wrong time (luckily I sold out of KMI, CVX, SDRL, RIG, LNCO, etc. before things really turned south!); with commodities, you should ABSOLUTELY ONLY buy at/near market bottoms.

I seriously dodged some major bullets there…

Lesson learned!

Lastly, when a sector struggles, it’s in our own best interest to target the companies with the best balance sheets… There’s a reason I’m a big fan of companies like: Lake Shore Gold (LSG), Klondex Mines (KLDX), Teranga Gold (TGZ.TO), Richmont Mines (RIC), etc.

I pay no attention to any majors who got reckless at the top of the cycle and are now encumbered with so much debt that they have to sell off assets at the bottom of the cycle.

That’s not creating long-term value for your shareholders!

On the flipside, a company like KLDX, cash strong and nimble, buying up Rice Lake assets for $32 million (C$375 million in capital investment had previously been spent on this project) might actually add long-term value for shareholders!

So, while the retail crowd chases after: Freeport McMoRan (FCX), BHP Billiton (BBL), CVX, etc., I look elsewhere…

 

But what do I know? I’m that crazy lunatic with far too much debt and no gameplan…

 

Fight On!

{ 26 comments… read them below or add one }

1 mikeNo Gravatar February 5, 2016 at 2:09 pm

Your gold stocks/miners have to be positive at this point with the run up we’ve incurred. Are you still lightening your load on rallies or holding tight?

just curious. I hope you are making bank.

In regards to your article, you can review your comments in the past (nov 2015) when I warned your readers about KMI BEFORE the cut to dividends. I could see through the smoke and mirrors much like your article is doing today. Thank you for that service, you could be saving people tons of money if they heed your call. People were fixated on a mirage and if they didn’t listen got left out in the desert with no water.

I highly recommend you do an educational article on payout ratios. By far the most important piece of data you can look at when examining a companies dividend stability.

keep up the good work old chap

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2 FI FighterNo Gravatar February 5, 2016 at 3:00 pm

Mike,

Thanks for the support buddy!

I closed out some positions recently, but I’m still not convinced this rally is legitimate, so I’m holding for now… My strategy has always been to sell-off some during mini-rallies, but to hold onto core positions for the long haul (TGM.V, IVN.TO, FF.V, NMI.TO, EXK, BTG, KLDX, LSG, PVG, etc.). Why am I ok with trimming some gains? My strategy has been to overload on the big dips when my portfolio is beet red.

Yup, you definitely did issue out a warning in November:

http://www.fifighter.com/finance/stock-investing-thoughts/2015/11/bottom-of-the-market-investor-psychology/

“Actually most oil companies have not reduced their dividends. It is my belief they will not be able to support those hefty dividends at current oil prices and the oil/gas stocks are not yet priced accordingly. They can drop much much lower. Some companies may take on massive debt to sustain the illusion of being able to ride out the storm and pay out dividends but this is ultimately a very bad long term strategy. Oil prices go down – you lose, Oil price stay flat – you lose. They can only go up and with a slowing global economy and a soaring USD I would not bet against that. Be warned and be careful.”

I hate to bring up COP after the fact (readers, please understand I don’t do so to gloat/brag/boast, etc… I’m the same idiot who bought BABA during IPO; I know a thing or two about humble pie!), but I only do so b/c it’s fresh on everyone’s minds right now… As you well know, I’ve been cautioning readers to be careful for a long while now (at least since last summer, go reference the many posts if you’d like)… I seriously do feel like a broken record from time to time with all my pessimism…

Seriously, I very much prefer to be a bull! I just can’t see how one can be bullish right now…

It’s not personal… I got nothing against COP, KMI, CVX, etc… But I’ve seen what a real devastation in commodities looks like, and things CAN get worse… No guarantees they will, but that’s why we need to be cautious during times of uncertainty… That’s why I keep referencing gold/silver miners for folks to research… That’s what type of fury a 4-5 year brutal bear market can unleash!

Payout ratios are worth paying attention to, along with free cash flow, debt, etc… Unfortunately in the commodity space, many conventional metrics go out the window when a prolonged period of low prices persist… Again, for anyone, please reference the gold miners and you’ll see what I mean…

All the best!

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3 No Nonsense LandlordNo Gravatar February 5, 2016 at 3:48 pm

Never under estimate the ability to tax the oil companies out of existence. There was a time we had a coal industry in the USA.

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4 FI FighterNo Gravatar February 5, 2016 at 9:32 pm

Eric,

Well, I guess anything is possible, really… but that thought probably lies at the other end of the spectrum.

I don’t see oil going the way of coal in my lifetime, but commodities are very interesting investments… They always overshoot and undershoot, boom and bust.

Gotta be careful with these, for sure!

Take care!

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5 Financial SamuraiNo Gravatar February 5, 2016 at 6:47 pm

Ever thought about quitting your job as an engineer and work in trading, financed equities?

Seem like you have a real passion for it, and you can also make a lot bigger compensation.

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6 FI FighterNo Gravatar February 5, 2016 at 9:35 pm

Sam,

Nope, never crossed my mind… Honestly, as I mentioned before, I am pretty sick and tired of the thought of money right now…

But later on, I do want to sell real estate, or get heavily involved with that sector. I absolutely love networking with real estate investors.

I’m still following up and updating this blog for readers, friends, family, etc… For myself, I’m just sitting in cash, mostly, so that’s not too exciting.

I’m looking forward to giving back and helping others… My own quest is almost done. Right now, oil is burning a lot of people which is very unfortunate and the reason for this post…

Take care!

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7 mikeNo Gravatar February 5, 2016 at 9:54 pm

I’ve thought about leaving the 9-5 and trading full time. I am actually very good at it and I am passionate about it. In fact the way you can tell if you love what you do is if you dread the weekends and anticipate mondays. I love mondays because thats when the US market opens and I get roll up my sleeves and get to work (in the markets). I don’t do investing for my full time job, I do it for myself.

The only problem is I have a lot of “fixed” cost and a family depending on me and a stable income. If I break even or God forbid take a loss for the month that would not be a good and would have a direct impact on our household budget.

what are your thoughts? Am I limiting myself on limiting false beliefs or being prudent provider for my family?

let me know.

thanks!

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8 FI FighterNo Gravatar February 5, 2016 at 10:25 pm

Mike,

That’s awesome, thanks for sharing! Would love to pick your brain about trading sometime if you got the time/interest.

Would be curious to know if you are playing the short game right now? 😉

I guess in your own situation, the closer you get to realizing early FI, the easier it will be to transition into full time trading… I know with real estate, I’ve seen co-workers who finally left for good when they 1) didn’t need any more loans 2) had a decent amount of cash flow rolling in.

99% of the time, if real estate retired them from corporate, they then decided to go after real estate full time. Obviously, they got the passion for it!

Replace real estate with trading in your situation.

Cheers!

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9 mikeNo Gravatar February 6, 2016 at 9:06 am

sure we can chat about trading as much as you like. In this comment post I put a better email to reach me at. Feel free to message me whenever works best for you.

In regards to real estate, I think those are good measures of when I can walk away. The dilemma I am in (as you posted in prior articles) is the fact that I am not sure if I want to pay down my loans. Yes it would enable me to have more freedom and flexibility but I lose the interest tax incentives and the benefit of long term principal pay down. I do cash flow on my properties without paying down loans but not enough to walk away entirely.

One strategy I am heavily considering is to wait until the housing market takes a nasty down turn and dollar cost average down (or buy when I think a bottom is close – I don’t have to hit the exact target but close enough is good enough for me). The problem is I am beholden to factors outside of my control (macro housing environment). Which means my “growth” is delayed for half a decade or more. I agree with the sediment that now is not the time to be greedy.

One fear with being top heavy in real estate is if there is a major game changer. I wonder if people even think about what would happen if the government stopped wanting to back mortgage loans. I believe Fannie Mae owns 95% of all US mortgages. I heard murmurs over the past few years that they want to reduce their exposure and in order to do that encourage private lenders to step up and hold the bag. Private lenders will be far more strict on who they lend to if they have to hold it on their books. All of the people now bidding up real estate prices won’t qualify for loans and prices will plummet. Its the easy money that enables easy lending. If that spigot gets turned off no one will have $400,000 in cash to pay for our properties. Maybe I am just over thinking things and I am not saying this is eminent but just something to consider and keep a watch on.

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10 Midwestern LandlordNo Gravatar February 6, 2016 at 10:35 am

Mike,

IMO the focus on real estate should be cash flow for early retirement / vocation flexibility. Not on other speculative factors. You indicated that your real estate cash flow does not quite meet all of your expenses at this time. Obviously it would be better if it did before you make a risky change.

I don’t see an issue with having loans at all if they are 30 year fixed loans. If not, then yes that adds a little risk to the overall profile.

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11 mikeNo Gravatar February 6, 2016 at 11:27 am

I am interested in what you are saying and thank you for taking the time to respond.

When you say not on speculative factors what do you mean?

Option A: Pay off all my loans hyper aggressively > more cash flow, more peace of mind if property is vacant. Flip side > No tax incentive (interest write off), no letting inflation wash away the debt, lose out on locking in historically low interest rates.

Option B: Accumulate more properties when the time is right > greater cash flow with quantity. Flip Side > Real estate cycles move much slower and it could be another half a decade before this gift horse comes back to town. Meanwhile properties could reduce in price but not “crash”. As FI points out, its the crash you want not the slow drip. I would be sitting on the side lines and postponing FI waiting for this opportunity. That entry point would be just to START part 2 of accumulating. Add on the next decade of paying off all the loans.

See the catch 22?

(All of my loans are 30 year fixed.)

12 Midwestern LandlordNo Gravatar February 6, 2016 at 12:04 pm

Mike,

Regarding speculative factors I probably misread what you were saying in your original post.

Under no circumstances would I pay off low interest 30 year fixed rate debt early. For all of the factors that you have already noted. It is just too valuable of a financial instrument. And what return would you be getting if you did (3% to 4% range?). I would much prefer to accumulate cash then pay down this type of mortgage debt. Based upon your post, it sounds like you live in an area that has already seen a large amount of appreciation and buying more rentals at this time is not feasible or not a good strategy given the price point. If that is the case I would probably hang tight (unless you are inclined to buy out of state rentals like Jay in areas that are much more affordable and cash flow positive). Keep adding to your reserve and invest in assets that are on sale. But to use any extra money to pay off low interest 30 year fixed debt to me is just not a good strategy. Also, the 30 year fixed loans that you have that have been sold to the secondary market (fannie, freddie) are contracts. As long as you pay as agreed, it is all good. There is no issue with a private company coming in and changing terms. The terms are set for the life of the loan irrespective of who the owner is. What private player would buy that contract? And even if they did, they have to abide by it.

13 Midwestern LandlordNo Gravatar February 6, 2016 at 12:28 pm

Mike,

If you are concerned about RE prices going down because the government may at some point get out of the 30 year fixed business, I would suggest the following points:

1) The 30 year fixed interest rates that you have are now even more valuable because they are not available in the marketplace anymore.

2) As long as you have cash flow, who cares what the price of real estate temporarily does. I assume you have cash flow on your properties.

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14 mikeNo Gravatar February 6, 2016 at 1:52 pm

Ok I see the confusion here. The Fannie comment was a side ramble from me. It is not influencing my decisions today. I was just saying that the only reason that housing prices can stay at these elevated levels is because there is easy money and fannie will buy the loan. In my finite understanding they own over 90% of all US mortgages.

If I convert a majority of my net worth into real estate to capture cash flow. I am playing a very dangerous game if Fannie decides to take away the punch bowl. It would be cataclysmic for real estate in the US. I would not avoid buying more properties out of fear of this materializing, I am just saying don’t put all your eggs in one basket (just real estate) because things can happen.

15 FI FighterNo Gravatar February 6, 2016 at 7:10 pm

Great discussion and I am inclined to agree with Midwestern Landlord. As usual, when it comes to real estate, he’s got sage advice for all of us.

I view the 30 year fixed low rate loans much the same way — an absolute gift to investors during this era of free money.

Of course, nothing is ever really free, which is why I’ve been so concerned the last year with people losing their heads and getting drunk off of this free money. I really do believe the markets need to crash b/c if they don’t, people will keep over leveraging and taking out more risks…

Of course, there are those of us who are responsible and realize that leverage is a double edged sword. Like you Mike, I would relish the opportunity to add more 20%+ cash on cash return rental properties to further supercharge the early FI progress… You raise a good point that these loan products may not be around next time around though, because if another crash the magnitude of 2008 hits, there may be a massive reform in the system… Obviously, the banks, Wall Street, Fed, government, etc. haven’t learned a damn thing since 2008…

I guess the above points further reaffirm my desire to hold lots of cash/gold… It’s never fun interrupting the early FI/cash flow progress, but there is a time and place to be more conservative. For myself, I have absolutely no plans to pay off any loans, again they are a wonderful gift…

One scenario I play in my head is this — Imagine if I had bought the same 8 properties in 2000. Let’s say I had $200,000 parked in gold when it was trading at $250/oz…That gold would be worth $936,000 today… But those mortgages would still be fixed rate…

An inflation hedge on top of an inflation hedge that is forever tied to a fixed rate nominal debt service… As long as the world doesn’t fall apart, how can you lose?

10 year debt elimination plan? Or you could be less conservative and redeploy the gains elsewhere (what I would do/ am trying to do now)…

Waiting for the next real estate cycle may be agonizing indeed, which is why I tried very hard to find another asset class that was in just as much, or more liquidation than real estate in 2009-2012.

I think I found that in the form of gold stocks.

16 FI FighterNo Gravatar February 6, 2016 at 7:20 pm

Also agree on not putting all one’s eggs in real estate, especially if each piece of property is tied to debt service.

No one can predict the future, but leverage is a dangerous game to be playing so we have to be 10x more careful than other investors who don’t utilize it.

17 george puckNo Gravatar February 6, 2016 at 10:12 pm

Here is the thing, IF say Freddie and Fannie stopped providing loans, sure it would be more difficult to get loans.

but the flip side is that you would have a much larger pool of renters.

From a cash flow perspective, you might actually be better off as fewer people would own and more people would lease driving up the rental market.

PLus one thing you have to remember especially in rental markets, a huge portion of properties purchased were purchased in cash. I forget the exact number but 3-4 years ago, S. Florida properties were something like 70 all cash. And nationwide purchases were something like 50 or 60% all cash.

YEs perhaps single family home prices might be hurt a little, but I think from a RE investor standpoint, properties will still cash flow. Unless you intend on selling, there really wouldnt be any impact on home prices dropping

18 FI FighterNo Gravatar February 7, 2016 at 12:00 am

George,

Yeah, there are a lot of things we can speculate about… It really depends on what happens to the current system. The debt based economy of today requires consumers to take on more debt everyday (home loans, auto loans, student loans, etc.), as it cannot sustain itself without ever increasing debt…

If there is a severe crash and the rules change, well, I guess anything would be possible.

In the current environment, the government wants to encourage/promote more home buying, so restricting the rules of the game wouldn’t help that cause. You need more buying to stimulate the economy!

In a reset, if there is a severe deflation, home prices/rents would get cut drastically… But again, can anyone really see that persisting for long? Everyone would be begging/demanding the government to do something to immediately fix the problem…

As for all cash, it depends on the area. In expensive cities like SF Bay Area, Seattle, NYC, Vancouver, etc. you have/had plenty of all cash Chinese buyers, but most everyday folks need a loan to afford such a purchase. It’s simply too expensive, otherwise.

Will be interesting to see where this all goes…

Cheers!

19 The DudeNo Gravatar February 5, 2016 at 9:16 pm

At these interest rates, why not take out $200k to have extra liquidity? Seems completely rational to me. Especially, to reduce risk of declining rents in the Bay Area, which could be precipitated by layoffs resulting from lower valuations in tech both in public and private markets. I suspect we’ll start seeing pressure on valuations in 2016 in the private sector as we’ve begun to see a change in valuations in the public sector. Since tech employs roughly 13% of San Francisco’s workforce (2012 number so it’s probably larger now) and there is roughly a 2x multiplier in employment for non-tech jobs for every tech job created, then a 10% reduction in tech could result in a 4% reduction in workforce overall in San Francisco, which, all things remaining constant would push unemployment to Decatur, IL levels. I don’t think we would see a mass collapse in rents like in 2001, but if there was a 45% growth in tech from 2010-2014, and from 2011-2013, there was a 33% increase in rents (10x inflation), I would expect to see some downward pressure on rents in scenarios of moderate layoffs, which could intensify more if private equity either begins to dry up, or demands much lower valuations.

I am with you on the oil majors. It seems like a lot of risk to take when we’re probably a way out from oil recovering and there are much higher quality opportunities available. I think I’ve mentioned it before, but short term first position real estate debt is looking good (although I’m personally starting to phase my investment out) as well as unsecured consumer debt, the latter having the advantage of low correlation with the market during recession.

What is your take on gold demand relative to China’s slowdown. 6.9% GDP in the report, but what has been more telling has been a reduction in energy usage signaling a sharp slowdown in manufacturing. We saw a slowdown in iPhone sales in Apple’s report signaling a slowdown in consumer demand. Will jewelry also see a slowdown in demand, and if so, will this out downward pressure on gold prices? Could a similar slower in India compound this or do you think an increase in investment gold would be enough to offset this? Just curious as I always have trouble comprehending the gold market, but I do know that half of all demand is jewelry and the top two demand countries are China and India.

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20 FI FighterNo Gravatar February 5, 2016 at 9:41 pm

The Dude,

Thanks for your thoughts and comments… Definitely, I would expect the collapse in equity prices to heavily weigh in on real estate, especially in a tech-centric region like SF Bay Area. Lots of wealth was destroyed in January, and even this past week…

With regards to rents, I always try to hope for the best but plan for the worst… In my own case, I’m making concentrated efforts to lock up multi-year leases NOW as opposed to LATER. 2+ years of fixed income is just fine by me… During a crash, you just gotta stay afloat, forget trying to maximize profits.

China and gold are interesting… Right now, the Chinese don’t trust the government and stock market… That market is totally uneducated and unsophisticated… To many, the stock market is a casino, and it sort of is in China… Fundamentals don’t matter, it’s like rolling the dice in Vegas… and Chinese people love to gamble… But when they get scared, and right now everyone is scared of further yuan devaluation (thanks Soros, Bass, etc.), they will flood into hard assets like gold and real estate (which finally looks like its drying out, maybe due to much tighter capital control by the gov), and even other paper, particularly USD… So, regardless of GDP, I think gold is more a fear trade with the Chinese people.

With India, I’m not so sure as I’m not as familiar with that region. Russia is another country in the East to watch out for. Like China, the East has been a big buyer of gold over the past few years.

But if you ask me, 7% GDP is TREMENDOUS (provided those numbers accurate), as the base of the growth is much larger than say a decade again… That’s still a ton of growth… and not at all an end of the world scenario we keep hearing on the mainstream.

Cheers!

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21 The DudeNo Gravatar February 5, 2016 at 10:21 pm

Yeah, exactly. Liquidity is key and having the extra cash to ride it out is really smart. Private equity isn’t going to stop and the Bay Area get 25% of GLOBAL private equity, so even if there is a short term slowdown (2-3 years), the investment community in the Bay Area is would be difficult to replicate elsewhere.

Like China’s numbers, India’s numbers are met with a degree of skepticism. But now that I dig deeper into the gold numbers I’m understanding it a lot more and can understand the thesis much better. Let me lay out my thinking and you can tell me if this is right or wrong.

Gold is a commodity with a more or less fixed and stable supply/production. However the demand side is highly variable. While jewelry demand in India and China alone accounts for about 35% of global demand (which appears to be more or less stable), the most variable component of gold demand is investment, which has had a high fluctuation right now and is currently 20% below five year trends. So I could see the case of an increase in gold for investment driving a much higher price of gold. However, what I don’t yet get is how recycled gold plays into the larger picture. It seems the supply of gold is increased to meet demand and when mine product dips, recycled gold appears to fill this gap. Here is the file I’m referencing for this data: http://www.gold.org/download/file/4457/GDT_Q3_2015.pdf. Do you know of sources that show more than a few year view?

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22 Income SurferNo Gravatar February 6, 2016 at 4:41 am

Hey buddy. I saw the interview below, last night and thought of you. I always enjoy Kleinschmidt, like most of the eccentric contrarians….haha. If I was wealthy, I’d probably be considered one myself. Since I’m not, well I might just be crazy. Hope you have a great weekend. Next week I’m digging into uranium
http://wealthtrack.com/kleinschmidt-exclusive-strategy/

-Bryan

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23 Budget NerdNo Gravatar February 6, 2016 at 4:55 am

Thanks for the article! I honestly haven’t even considered looking into resource investments, although I can see how important it is to diversify.

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24 Midwestern LandlordNo Gravatar February 6, 2016 at 10:54 am

Jay,

Yea, I finds posters thinking its risky or illegitimate pulling out $200K in cash on long term 30 year fixed low interest rates on property that pays for itself odd as well. I guess some people are just really debt averse but this is the best debt that you can have. An extra $200K in the bank is an extra $200K in the bank. It does not matter where it comes from as long as the fundamentals are still good.

Obviously you are not going to blow the $200K. You will keep it for reserves / investing purposes. The people that get into trouble with real estate are always the ones that are liquidity poor and / or have properties that are not fundamentally sound (highly speculative that do not cash flow).

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25 george puckNo Gravatar February 6, 2016 at 10:42 pm

I have three issues with cashing out equity in RE at a top, especially in a ovlitile market like SF.

1) It lowers your cash flow. If the market really does turn down the ability to be cash flow positive become nearly impossible.

2) if rents and home values drop say 40%, then you end up unable to sell your property if needed because you would be upside down.

3) you make less money because you are paying interest on the additional money.

I applaud Jay for laying his finances out there, but I still think his best move would be to have sold the side hustles, if he believes (and I think he is right) that the Bay area real estate is in a bubble.

That would be locking in profits and would set you up with a war chest in a downturn.

My wife and I have 3 properties total, we are thinking about selling one or more of our rentals in part because they have had a huge run up. (our single family home has gone up 25%+/- since the Fall of 2015. Just so we can have a warchest during the next downturn.

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26 FI FighterNo Gravatar February 6, 2016 at 11:23 pm

George,

Thanks for the comment. Here are my thoughts:

1) This is relative to when you bought. Even after the refi, my 2 properties are cash flow positive and still priced $400 to $500 below market rate… I have cushion there because of that.

Imagine a SF Bay Area real estate investor who got started in 2014-2015… They would have had to fork over say $75,000+ for a rental downpayment that generates roughly the same cash flow my 2 units bring in today… The difference is they are out $75,000+ but I am out $0 and got a refund check on top of that… That’s essentially what happened b/c I got in at 2012-2013. As I mentioned before, from that sense, I have no skin in the game. My downpayment was ~$50k-$75k for each rental and I got back ~$200k.

If there is a downturn and rents contract by greater than $500, well, many landlords will be in trouble in SF Bay Area.

2) This makes the refi all the better of an idea… If I can’t sell, well I better be able to keep renting it out, which is the plan anyway for Buy and Hold. If the rents for some reason dip below break even, well I better have a lot of cash to ride out the storm, which the refi provided. As Midwestern Landlord pointed out, as long as you aren’t taking the refi money out and blowing it on new toys, you’ll have plenty of cash buffer.

3) I’m not paying interest, my tenants are. Long-term, real estate is inflation protected and the mortgages are fixed rate 30 year loans. I don’t see how I won’t come out ahead, long term, unless the world falls apart and the SF Bay Area becomes an undesirable place to live. As The Dude pointed out above, the Bay Area is the mecca of the world for venture capitalists and tech start-ups… I really can’t see this changing too drastically over time. I try to plan for a rainy day, but realistically speaking, I think the Bay Area is strong and robust. People desire to live here and will fork over the rent to do so. Especially for Class A rentals located near the big companies: Google, Intel, Oracle, Samsung, Brocade, Broadcom, Levi’s Stadium, etc.

Selling real estate isn’t ideal due to all the fees/taxes/commissions/etc. I’ve always rationalized that my rentals are Buy and Hold Forever investments… If these were stocks, yes, trimming some of the portfolio would be prudent… With real estate, if I sell and quit my job, I might not be able to get back in later. That’s also something to consider…

I posted this earlier, but here’s why I love 30 year fixed rate low interest mortgages:

One scenario I play in my head is this — Imagine if I had bought the same 8 properties in 2000. Let’s say I had $200,000 parked in gold when it was trading at $250/oz…That gold would be worth $936,000 today… But those mortgages would still be fixed rate…

An inflation hedge on top of an inflation hedge that is forever tied to a fixed rate nominal debt service… As long as the world doesn’t fall apart, how can you lose?

Thanks for the thoughts!

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