Posted by JPiper on October 16, 1998 at 24:25:51:
I’d like to make a few comments here, not necessarily in disagreement, but to expand a few ideas.
The issue is one of risk versus opportunity. I don’t think anyone could possibly argue with the idea that if you can “SAFELY” invest money at a return higher than you could pay debt off at…you’d be a fool not to do it. The question that I would pose is whether this can be done “SAFELY”.
To invest safely takes knowledge, and a consciousness of the exact risk that one is taking. I have NO question that you John are very much aware of ALL the risks that you may take, and that you have taken ALL the steps necessary to mitigate against these risks.
But let’s take an example. How about a first mortgage with an acceptable rate of return, an acceptable borrower, at 70% LTV secured by a single family residence?? Does this look safe?? I think most of us would assume so. Let’s now step forward in time. The economy dips into recession. The borrower experiences downsizing at his company, and is laid off. He defaults. You foreclose to protect your investment. You pay the foreclosure fees, and lose the immediate cash flow on your investment. Meanwhile, you’re still paying on the debt that you DIDN’T pay off. Now you run a market survey of the subject property, and find that it has declined in value, and the time on market to resell has increased to 6 months. The borrower in the meantime has become angry that he is losing his home…he consults an attorney. His next step is to file a bankruptcy, thus stopping your foreclosure. I could continue on with this, up to and including finally foreclosing on the property and reselling…a time lapse of a year, a large repair bill (I’ve literally seen the kitchens gone in foreclosures, along with the bricks from the fireplaces)and reselling costs and drop in value can literally eliminate the ENTIRE equity that you thought existed…plus some. And again, for this period of time you’re losing the interest on your money. You could possibly obtain a deficiency judgment but if you’re included in the bankruptcy you can forget that. Heaven forbid some tax liens crop up. The question is, were you aware of these possibilities upfront?? Did you carefully consider all this prior to your investment?? Did you analyze what your potential actions would be if everything went wrong?? Are you the type of person who could come up with solutions to these problems, or possibly even remedy them prior to these dire endings?
I don’t write this to discourage paper investment at all. Rather I write it to encourage people to carefully consider their risks, and consider their personal knowledge and makeup. Are you knowledgable enough to evaluate the risks, or to be aware of ALL the risks??
There are few investments out there that carry a lower risk than paying off debt. And being debt free in a tough time is hard to beat. Is there an opportunity cost to being debt free?? Of course. But I think I can easily say that ANY opportunity in either paper or real estate carries risk…it’s simply a question of whether you can identify ALL the risk.
One of the questions I ask myself ALL the time is what are my risks, what am I overlooking, what’s happening in the world around me that might affect my investment? My ideas have changed considerably about risk over the years. I like having plenty of breathing room now, which I acknowledge probably costs me some opporunity at times. But I’ve been through a number of recessions, declining real estate markets, and general tough periods and situations. I’ve learned that breathing room is important.
There are some very bright people around who have run into some tough times…Donald Trump comes to mind. You can read his story in several books. It happens to the best and brightest…and sometimes it has a happy ending as with Trump. But then again, he had one hell of a lot of knowledge. If you’re going to take on leverage, make sure you have the equivalent type of knowledge.
Again, I want to stress that I’m not necessarily against opportunity or risk. I’ve made my living for years with both. But I would carefully consider the issue. If I felt I had to ask this question of someone else, I would definitely question whether I had sufficient knowledge to reduce my risk in being leveraged.