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| Be very careful when using leverage… |
Warren Buffett: “When you combine ignorance with leverage, you get some pretty interesting results.”
Recently, I was reading about the whole Evergrande fiasco that is happening in China. For those of you that don’t know, Evergrande is the second largest real estate developer in China. They became a household name (well, at least finance interested people like me) when they failed to make their bond payments that were due in September.
Like what has been happening in China for the past decade (or longer), Evergrande has been using tremendous amount of leverage to build more apartments/condos/high end homes. China’s speculative real estate market, where buyers would buy these real estate thinking they’ll always go up, is a common theme found in bubbles.
I’ve personally lived through two of these bubbles in my lifetime. One was the ‘dot com bust’ in the early 2000’s, when everyone and their cousin was buying stocks thinking the new technology (the internet) couldn’t possibly go bust. Back then, any internet company could get funding as long as it was somehow related to the internet! All this optimism eventually led to a burst in that bubble, wiping out many dot com companies.
The other was the ‘Great Recession’, where everyone thought the real estate market will never go down. Everyone thought the ‘American Dream’ to want to own a home of our own would mean everyone would do everything in their power to keep making mortgage payments.
When the bust came, as more and more homeowners couldn’t make mortgage payments, millions of people lost their homes, and many lost their jobs. This bust also brought down one of the biggest investment companies in the world, Bear Stearns.
It’s always interesting to me how we never seem to learn from our mistakes. I’ve been following China’s real estate market for some time. I learned that many apartments/homes were empty (not lived in) because many of these were bought on speculation that the market will always go up.
This way of thinking worked great until China’s government started to crack down on real estate developers to rein in their leveraging habits. They could no longer borrow money easily to build.
Up until then, everyone in China believed that the government would come to the rescue of these giant developers if they ever default. How could they let these giants default when that would mean the real estate sector, responsible for about 30% of their GDP, would suffer?
As of this writing, another real estate developer Fantasia became another one of these distressed companies when they couldn’t make their bond payments. I’m not sure which way China’s government will go. They may choose to bail them out or not.
What is important to understand is that to use leverage, is a scary way to invest. Nothing lasts forever, even something as ‘solid’ as real estate. The more money you borrow to buy something will inevitably lead to dangerous situations when market conditions sour.
What seemed like a sure thing, won’t be, when you realize the home you bought with money borrowed to the max, goes DOWN in value. Same goes for stocks.
Someone I know lost almost everything when economy tanked and bills came due on multiple business ventures and homes/condos bought on borrowed money. Because this person didn’t have any liquid (cash), he had to sell his assets at huge discount, to pay his bills. It was literally robbing Peter to pay Paul…
Eventually, all the assets amounting to about 10 million dollars went up in flames. Of course, the lenders (banks, mortgage companies, etc.) did ok, as they got discounted assets in return, when those bills weren’t paid. It was my friend who got nothing to show for all the years of building up his mini kingdom…
Here are some important lessons to learn about using leverage:
- Don’t borrow too much money to buy your primary residence home
When you borrow too much to buy your home, a job loss would mean you’ll have a difficult time making mortgage payments. I always preach having a backup plan(s) for living, and this applies here: PLEASE have an emergency fund in case something happens!
You don’t want to lose your home because you’re house poor, with no liquid savings! Have at least several months worth of cash in a savings account in the event life throws a curveball at you.
Buy enough of a home, and don’t buy too much home. Just because the mortgage company will lend you $500,000, doesn’t mean you need to borrow that amount!
Practice the concept of ‘enough’ in living your life. Do you really need a 5,000 square feet home for 4 people, when a 2,000 square feet home will do? Bigger home means more maintenance and more cost. Don’t underestimate the total cost when buying a bigger home.
These added fees are to be expected for bigger homes:
- Insurance (bigger the house, bigger the insurance costs)
- Utilities (bigger the house, bigger the cost to cool/heat)
- Appliances/HVAC system/plumbing/etc. (Bigger means more cost to replace or repair; bigger the HVAC unit, the more expensive it is to replace/repair)
- Paint (bigger the house, the more it costs to paint the home)
- Higher mortgage payment per month
- Higher property taxes
- Higher HOA fees, if applicable
- More furniture and knickknacks! (bigger the home, the more you have to buy to fill up that space!)
- Don’t borrow money to buy investment properties
I know there are plenty of people who are making a living buying investment properties, fixing them up, then selling them, at profit. Unless you know how to fix a home yourself (or know someone close who does), I do not recommend borrowing money to do this.
If you can pay cash for a small condo or a home, that’s one thing. If you’re borrowing money to buy these, then you’re just one step away from losing everything, including any assets you borrowed against, when market conditions sour.
Remember, what goes up, must come down. This is true for real estate as well as for stocks. Always keep this in mind…
- Don’t borrow money to buy stocks
As for stocks, using leverage is what some investors do to quickly realize a profit. This is all great as long as your hunch is right. If it’s not, then you would be in a hole trying to pay that back. Most big losses occur when you’re trying to make back the smaller losses in the first place.
This mindset, is very similar to what gamblers do. They’ll lose money, then they’ll withdraw more money from the ATM machine (or borrow from their credit cards!) to make it back. This usually means they’ll take even bigger risks to make the money back plus trying to turn a profit. I’ve seen many people do this at casinos, then lose even more money…
Don’t borrow money to buy stocks! Always invest the right way even if it’s boring at times. Remember, invest for the long haul, buy when market is up and buy when market is down, and consider holding your investments and not sell!
These simple, boring, yet effective strategy is what got me to early retirement, as well as for countless other FIRE (financial independence retire early) movement followers.
In conclusion:
The lessons learned from studying the Evergrande fiasco (as well as Fantasia) should be taken to heart when living your life. Just because money can be borrowed, doesn’t mean you should.
Always practice the right way to invest, whether that’s buying a home or stocks. When you are too greedy, bad things usually happen. Taking risk is good, but taking too much risk is bad. Borrowing is ok to buy your ‘enough’ home, but borrowing too much to buy ‘too much’ home or investment property is bad.
Keep up with finance news always so you can learn the right way and the wrong way to invest! Thank you all for reading!
Jake
Wandering Money Pig
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