I’m Making Them Birds

While you can't just paint over all your mistakes or confusion, you can choose how you let them affect your mindset. Photo by Suna

This post originally appeared on the Hermit Haus Redevelopment website on 2018-10-06 .

Starting with Why: Every day in business, you encounter things that annoy, frustrate, or confuse you. I wanted to talk about how I've chosen to accept some of the things I cannot change.

One of the more frustrating points about running a business is that you can either know what it’s really worth or keep accurate books for taxes. And never the twain shall meet.

Businesses are punished on their balance sheets for being good negotiators. At the same time, they are required to take totally fallacious “expenses” while being forbidden from taking real ones. Here’s a few examples:

• Cost basis
• Depreciation
• Capitalized expenses

Cost Basis

We recently bought an asset from a motivated seller for much less than its appraised value. We got our loan based on the appraised value, but we are required to book the building at the purchase price. As Zacks explains:

Under corporate accounting standards, when a company acquires an asset, it puts that asset on its balance sheet with a value equal to its "historical cost" – what the company paid for it. If it's a fixed asset with a limited lifespan, such as a building or a piece of equipment, the company gradually depreciates that asset over time, which reduces its balance sheet value. Even if the company has good reason to believe that an asset has risen in value, it still cannot increase that asset's "book value," the value reported on the balance sheet.

So we have a $120-thousand building we have to book as an $80-thousand asset. And we have an $85-thousand loan against that asset. So our books show us with $5-thousand of negative equity instead of $15-thousand it positive equity. Our books show us making a stupid purchasing decision instead of a really good one.

Depreciation

Now factor in depreciation. Nobody doubts that assets (be they machines or real estate) eventually wear out. Rather than qualifying that wearing out, businesses are required to take what I like to call “stylized depreciation.” (“Stylized” sounds so much better than “fictional.” Doesn’t it?) I think the real term is “standard depreciation.”

The IRS assumes a 39 year life for commercial buildings and a 27.5 year life for residential rentals. For the asset I mentioned above, we’re required to write down 1/30 (2.654%) of the $74-thousand valuation of the building—not the land—every year until we eventually show no value for the asset except the cost of the raw land at purchase. And remember depreciation affects value. So our building will be worth about $1,900 less every year. It will show negative equity for 10 to 15 years.

We must really suck at business! We don't, but that's the story our books will continue to tell about this building.

The only good thing I have to say about depreciation is that it also reduces my net taxable income. Maybe not as much as my actual expenses would if they were not capitalized, but every little bit helps.

Capitalized Expenses

Capitalized expenses are pretty much what they sound like—expenses businesses are required to show as assets. Sometimes that makes sense. One of the first things we’re going to do with our new building is to spend about $6K on a new HVAC system. That’s money we have to spend (an expense) but it also pays for an asset that should last a few years—probably longer than its depreciation period. That means it increases the value of our building until it doesn’t. (I don’t know how long that is, which is why we pay a good CPA firm lots of money every year. Luckily, I think that counts as an expense.)

But sometimes it doesn’t make sense to capitalize expense. All or the settlement costs, including legal fees, we paid to buy that building are capitalized. We spent the money on a one-time service with no ongoing value, but nope! That’s an asset, not an expense.

All these (and other) factors encourage businesses to churn their holdings. If you hold a building long enough, it looks like you are broke no matter how much the building is actually worth. But if you churn your holdings, you can make it look like your business is growing, even if you pay too much.

As I write this post, I’m wearing a T-shirt with a picture of Bob Ross painting. The caption talks about repainting mistakes to make them into birds. So rather than get all “Back in Black” about these accounting idiosyncrasies that make it so hard to know how well my businesses are doing, I’m making them birds. I like birds. Birds make sense.

Inflated ARV: Market Timing

Source: Austin Board of Realtors® It’s much easier to predict market cycles in real estate than in the stock market (where many would say it’s impossible), but you can still lose your shirt by assuming the market will always go up.

This post originally appeared on the Hermit Haus blog on 2016-10-24.

One of the easiest mistakes to make in renovating houses is to overestimate their After Repair Value (ARV). In this post, I’m not going to delve into motivations for inflating a house’s ARV. After all, I’ve done it to myself, so far be it for me to cast asparagus on anyone. I’m just going to talk about how it happens, and there are only a few ways:

• Use the wrong comps.
• Mis-time the market.
• Make the numbers fit the model.

I originally planned to talk about all three of these risks in one post, but I soon figured out it would be way too long. Click here to open all posts on this topic.

Mis-time the market

In the stock market, they say the fastest way to go broke is to try to “time the market”—that is to buy when the market is lowest and sell when it is highest. Real estate markets move much more slowly, and we have leading and trailing economic indicators to help us time the market. Some things to consider are:

• Special uses
• Seasonal differences
• Renovation time
• Market cycle

Special Uses

Unless you really know what you’re doing, owning a farm or ranch can be very expensive. For example, a gate won’t stand up to a tractor. Oops!

Special use properties make it easy to misjudge their value.

Farm land is cheaper in bulk; buying by the acre gets expensive. But farm or ranch land doesn’t produce any income unless you actively work it, and—while it does appreciate over time—you can be looking at decades to see significant improvement.

Offices, industrial space, and recreational properties exaggerate swings in the local business cycles. You must have a really good finger on the local economy’s pulse to play in this park—or need the office space yourself. It also costs more to get into this game than standard housing. That said, there is plenty of money to be made if you find a property where the use is about to change—like along the perimeter of where a new Box Store is going in.

Seasonal Differences

We missed the sale window for this lake house because of a combination of factors. We’re now holding it over the winter and using it as a vacation rental to make the mortgage payments until we can sell it in the spring when people are thinking about life on the lake again. Always have more than one exit strategy.

Housing in general sells better in the spring and summer, but resort housing exhibits this behavior on steroids. Many fewer buyers even think about buying a lake house when it’s too cold to get in the water or a house on a golf course when the greens turn white with snow.

We also know that water frontage adds considerable value. But what happens when a drought sucks the lake’s shoreline a quarter mile out? During the last drought, the receding shoreline exposed everything from illegal sewer lines to missing persons still sitting in their rusting cars.

Renovation Time

This is a big one—and one that has bitten every investor I know. You expect a project to take 90 days, but it actually takes six months. Maybe you find unexpected conditions. Maybe it takes longer than anticipated to get permits. Maybe you contractor flakes out.

At a minimum, that means you have additional holding costs for each of those three months, and that can really add up on a big project. At worst, it means you may miss the selling season or even hold a property into a down cycle.

Market Cycle

Given time, real estate will probably appreciate. But never assume appreciation in your purchase decision. If you do, you may wind up holding the property for decades or centuries to recoup your investment. Just look at the Rust Belt or Detroit.

The rule of thumb in Austin is that we have a five year cycle. The market goes up for three years and slumps for two. But the market is unpredictable. As my friend Shenoah Grove likes to point out, “We are now six years into our five-year cycle.” While this prolonged up-cycle is being driven by bigger economic trends—growing population, strong economy, oil boom (yes, the price per barrel is down because we have so much production right now.)—the likelihood of an adjustment makes longer renovation project much more risky.

Given the human trend to assume an up market will last forever, I’d be extra careful about every buying decision.

Oops! Wrong Color

It’s the Great Pumpkin, Charlie Brown!

Yesterday ended and today started poorly. Suna didn’t sleep last night worrying about the house getting painted the wrong color, in spite of my saying repeatedly that we would get it fixed. The way the world works, we are extremely lucky to be this far into the project before the first miscommunication happened.

And I take ownership of this one. She told me what color she wanted the house, but I got confused when we only picked out two colors. That was because she didn’t realize we were painting the body of the house as well as the fascia, sophets, and trim. Sigh.

The fascia looks good…better when it’s painted.

The contractor was very nice and volunteered to eat part of the cost of repainting since he was involved in the miscommunication—even though I had already told him it wasn’t his fault. He even said it wouldn’t throw us that far off schedule. He will pick up more paint and have it fixed by the time we get home from work tomorrow.

I guess it’s part of getting older. I make more mistakes than I used to. Or maybe I’m just more willing to admit them.

While we were talking about the paint, he also pointed out that one of the vent caps on the house was missing. I guess it blew off in one of the storms. We hadn’t noticed because you can’t see it unless you are standing in the neighbor’s driveway looking at the chimney. At least we know how the squirrels were getting into the attic.