Drug Dealing For Risk Management
March 10, 2009 by Vagabond Investors · 1 Comment
I thought I would share a little story with you guys. I had some headwind with one of my properties. It’s funny how unexpected and improbable things can turn out to be a real pain in the rectum.
I.
When the bill arrived in my mailbox, I was shocked to see the bottom line. One of my investment properties had been renovated. To be accurate, it wasn’t merely renovated. It was completely rebuilt from the inside. Everything - and I mean everything - that could be torn apart was torn apart and rebuilt. My tenant had thrashed the place and disappeared. He did a decent job at it. Needless to say, this meant losses to me as a landlord.
This was after I received a phone call from the narcotic police, which informed me that they had raided his home with some kind of a tactical team and found guns and heroine. The African guy, my tenant, had turned out to be a drug dealer in Helsinki. After he was arrested, he had been temporarily released until further evidence could be found. During this time he had played around with a water hose in his home (my property) and wetted everything in sight. He had especially taken the time to destroy the bathroom, which was under renovation anyway. He disappeared very quickly and went undercover. Nobody, not even the police, had any idea where had gone.
II.
Until there were any problems, I was happy to own the place. When I bought the property, I was aware of the fact that the property manager was going to renovate the bathrooms in the block. There had been a water leakage and many bathrooms needed to be dried before anything else could be done.
I knew there was an African guy living the property, which was fine with me. He had a good track record of paying rent in time. I even phoned the guy to make sure he didn’t use the bathroom, since it was strictly forbidden. He seemed a little shy as he said that he was using his friend’s bathroom next door. He didn’t have a criminal record. His credit score was fine. Of all I knew, everything was in good order. Yet something was bothering me.
The property manager informed me that they were not in schedule with my apartment. There were some legal problems that needed to be solved before they could move on. I thought that there was nothing I could do about it. So I kept buying new properties and enjoyed my life as a real estate investor. Meantime the tenant lived in an apartment without a bathroom.
Then hit the subprime crisis, which was easy to see before it happened. After all, it was a classic pattern of a crisis. What surprised me was the pace at which wealth disappeared and how quickly the financial sector began to tear apart. So far I had made no connection between my African tenant and the credit crisis. I thought I was properly protected.
My phone rang on an idle Tuesday when I was preparing to go train Krav Maga. The property manager told me that he had visited my apartment. He was taking the drying equipment out when he realized that something was wrong with the tenant. There were burned knifes and bent spoons all over the place. He also said that he felt a little dizzy because of a strange smell.
“Must be some kind of African herbs”, I said as I was putting on my gear.
“Yeah”, the property manager replied. “” wonder what they did with those spoons, though. Anyway, the neighbors said your guy is keeping noise with his friends. You might want to tell him to be quiet at night.”
“I’ll give him a call.” I put the phone down and took off.
I wasn’t used to restless tenants because I was extremely strict with tenant selection. I usually didn’t have tenants in my properties when I bought them. This way I could be more accurate with the selection. I had overlooked this factor when I saw the numbers of the deal (it is funny how I would advise every client to check and re-check everything but didn’t do it myself!) I thought that even though the tenant didn’t pay their rent, I could always replace them and it would still be an excellent deal.
The next day the phone rang again. This time it was the narco police. They said they had raided the house based on a hint. They had found a good deal of heroine and some weapons. They suggested I kept an eye on the tenant. I remember thinking to myself that what the heck could I do about something like that. I remembered, though, that I had a statement in the lease agreement about controlled substances, including drugs and guns. Based on that I decided to evict the tenant. So I did.
The good part was that the guy left. The bad part was that he thrashed and watered the place which the property manager had taken time to dry during the past three months. Oddly, he cleaned everything before he left! He took with him every piece of wood that came out of kitchen doors - which he had torn with his hammer. He even wiped off the dust! The property was clean but… it was in a completely useless condition. I have never seen anything like that.
The tenant disappeared. Nobody knew where he went. The insurance company decided not to cover any losses. This was because the tenant had obviously done the damage intentionally. I wasn’t happy about that.
I had a renovation team get to work as soon as possible. They had to virtually rebuild the whole property from the inside. The window and front door weren’t broken so they could be left in place. Everything else (or what was left of it) had to be taken out and built over.
Here’s the twist. I had always thought that if ever something as unlikely as this would happen, I could always borrow the money to fix the property and have its value increase in the process. However, now that the financial crisis had become a full scale systemic banking crisis, nobody trusted anybody and that included me. The bank wouldn’t lend me any money “due to company policy in times like this.” I had to dig in my pockets. To finance the whole thing, I even had to sell a portion of my gold. I was miserable the day that I sold it.
Eventually the property got fixed. The cost was astronomical compared to the value it created. I was happy to have the property give me positive cash flow again but I was very unhappy about the losses it had given me.
The mistakes that I made with the property have taught me priceless lessons. Maybe someday the financial crisis is over and I have the chance to borrow money to cover my losses. Until then, my portfolio is lighter in gold but personally I am rich in lessons in wealth.
III.
Of all the factors that contributed to my losses with the property, perhaps the most obvious variable was the lack of proper tenant selection. This is of course apparent afterwards. I was so excited with the motivated seller and her low asking price that I bought the property unseen as soon as I had completed my due diligence.
Still, the real reason why I got into such trouble was not the tenant. It was me, the investor. It was my lack of proper asset allocation.
Remember, I thought I had protected myself. I had always thought that with a strong cash flow I could finance all kind of unexpected costs and simultaneously increase the value of my property. I assumed this, because in the past I could always get financing.
It turned out that every bank rejected my loan offer. The whole banking sector was in a systemic crisis. It was this lack of access to capital that caused me the trouble. I had to dig deep into my pockets to finance the rebuilding of my property. This severely unbalanced my asset allocation to meet any unexpected losses in the near future.
Every investor has to come to terms with losses. In my case, it is of no use to blame the tenant. It is also a waste of time to justify the loss with some kind of a tax deduction. It is only necessary to take responsibility and learn something from the experience. I certainly learned a ton of things about asset allocation and risk management. The lessons go well beyond the scope of that particular property.
From now on I am much better at recognizing possible bottlenecks with risk management. I learned a bitter lesson about the importance of a large enough safety basket. I will never run out of quick liquidity again. As an investor, I am prepared to go whichever way the economy goes. No matter what happens, I will be in a position to protect myself, exit or take advantage of the situation.
Those are some of the things I learned. Then there is a whole list of personal attitude changes I do not wish to address here. I have to tell you, this experience has changed my plans radically for the better.
Still, I got to tell you, I miss those gold coins every time I think of Mr. Bernanke’s money printing press.
Jaakko
The Architects of Re-Inflation
March 5, 2009 by Vagabond Investors · 1 Comment
It has become a somewhat popular sport to bash the European Central Bank for not acting fast enough to save the system. Many say that the ECB should take similar actions as the Fed has. That, at least, is the common viewpoint.
What Caused the Crisis?
The widespread view is that the cause of the current crisis is this. The people and the government do not borrow and spend enough on consumer goods. Therefore the government must force us all to borrow and spend more. This is as ridiculous as it sounds. It seems that today’s best comedians are not found in the theaters anymore. They are in the economic and financial arena and, for some logic that evades me, are taken as honest people. After all, a smiling central banker should scare you at least a little.
Let us not forget that it was exactly the government and their agencies around the world who constructed the crisis in the first place. It is these people that did not know how to prevent the current crisis. Instead they provided a massive credit bubble and allowed the asset bubble to get out of hand. Now we advocate the same people who caused this mess to fix it - with the same tools they created the mess!
The Free Market Did Not Fail
It is important to recognize that it wasn’t the free market that failed. The root cause of the current crisis is the same as it has been for decades: massive credit creation and government intervention. The architects of the current crisis are found where political and monetary powers bind together today. That is in the Treasury and the Federal Reserve. I should like to point out that central bankers aren’t completely useless people. Especially in times like this, we require what only they can provide: their absence.
The Fed and the US government seem to think that the way to solve the problem, which was caused by printing too much money, is to print more money. In case it should not work out as planned, their backup plan is to print even more money.
The point is, while money creation may help on the short term, they will indisputably overdo it. While many economists see light at the end of the tunnel, it may only be the headlamp of the upcoming train.
Even every ordinary person could immediately see that when debt growth enormously exceeds nominal GDP growth, sooner or later the party will come to an end. Yet even more massive money creation is the road the government and central banks have taken to combat the problem. I suspect that it will lead to even greater problems in the future.
The Road to Ruin
I believe that most people, including Mr. Bernanke and Mr. Geithner, do not fully realize what gigantic money printing will cause. The problem will be especially acute and severe in the US because of its colossal debt burden. Since half of US federal debt is held by foreigners, what happens when they realize that the US government has no intention to pay back? You see, the US is about to repay debt with the issuance of new debt. I suppose these gentlemen do not suffer from insanity, but enjoy every minute of it.
This is as hilarious and as frightful as it sounds. I would like to stress that now is the time to take care of proper asset allocation in your portfolio. Personally I continue to like gold as Mr. Bernanke is flooding the system with money (Mr. Geithner is doing his share by using taxpayers’ money to help out his friends on Wall Street). It could be wise to protect oneself from these financial predators. To do that, it is best to keep an eye on the macro data.
You Have To Do Your Share
I am doing my best to provide you occasional insights and investment considerations. Despite that, you have to make your own financial decisions. Instead of waiting for anybody to save you, I suggest you get educated and leave gentlemen like Mr. Bernanke and Mr. Geithner do their tricks. Luckily, it is easier to adapt to and take advantage from the circumstances than it is to change the whole world.
Jaakko
(C) Copyright Vagabond Investors 2009
