So, recall that we had a list of questions from a coworker. Last time we covered the first question: Why do this? And we covered part of the second question: Why not borrow money instead of working from a cash-only basis? We believe that this is such an important topic that we decided to work it into the first two answer posts.
We have a friend, an acquaintance that we like and like to be around. We'll call this person, Mr. X. Mr. X had a booming business on the coast. He had a business that was growing by leaps and bounds, tons of rental properties, and very nice toys. The only problem he really had was that he had borrowed a lot of money on his rental properties. His reasoning was that the coastal properties would always be in demand. Good times or bad, people would want to rent a place at the beach. He was partly right.
He was only stretched thin in a few places during the housing boom that preceded the recession. After all, wasn't it true that you had to spend money to make money, and wouldn't it be better if it was someone else's money? But as the clouds and thunderstorms grew just out of sight off his personal empire's shores, Mr. X started to see his main business wain. The thin cash flow that he had on his rentals allowed him to keep the doors of the business open, but little more. Then the storm grew into a tropical depression and a couple of his rentals started to suffer from lower occupancy rates. When people get scared, they tend to batten down the financial hatches.
Suddenly Mr. X was saying goodbye to some of his toys. He had to save his empire, after all, so he could always pick up those same toys later on -after the clouds passed. Goodbye, Cadillac Escalade, Goodbye, beautiful boat. He sold them at a price that was decent, but he ended up with a new problem; what should he do with the cash? Should he put it into his business? Keep the doors open and hope for the best? Should he pay down some of his debt? Should he sock it away under the mattress and hope for the best? Here's the deal: Hope is not a strategy. Mr. X was suddenly watching the sky very closely.
The tropical depression turned into a tropical storm and was on the cusp of becoming a full-blown hurricane. The water was rising and the waves were shooting over the breakers. He jettisoned one rental that had always been borderline. On paper, Mr. X was still profitable. But then the hurricane actually developed and assumed an identity. The public called it the "Housing Bubble," and suddenly many, many people, including Mr. X were sitting on property that was not only worth less than they had paid, but truly out of the bounds of affordability. This was a class five hurricane, and she was shaping up to be a real bitch.
Believe it or not, even with the upside down property values, Mr. X was still profitable on paper. However, the weak cash flow on his properties was now anorexic and soaking wet. The 220 pound bruisers had turned into a 90-pound weaklings under the pummeling they received from this hurricane. His business was in even worse shape. Located directly on the waterline, it suffered from an eroded foundation of confidence in the market. People were walking away from upside down properties. Unfortunately, in addition to rentals, Mr. X's main business was in real estate. Teetering on the edge of insolvency, he once again hoped that he would be able to weather the crisis at hand, and emerge solvent on the other side. He may have been partly on the right track. The worst of it seemed to be behind him.
Mr. X was right, there was a little, tiny, minuscule amount of sunshine peeking around the clouds on the far horizon. But where he was very wrong was in the assumption that profitability, no matter how meager, equates into solvency. In the end, the cumulative effect was a loss of his business, of his rentals, and his toys, and all of this because of cash flow issues. He was profitable until the end, but he could no longer make payments and keep up with payroll. On paper he was scraping by. But in reality he was losing ground quickly. And all it took was not a hurricane, but a few small inconsequential gusts of wind in the form of late rent on the heels of the housing bubble hurricane. More than a handful of units not paying on time, and he started to sink.
No debt for us, please. It is hard enough to hold it altogether without the burden of debt and the certainty of economic cycles coming to bear on our small holdings. We would rather stay on the high ground. Mr. X is a real person. And if you ask him what happened he will tell you first and foremost that a housing bubble sunk him. But in quieter moments of honesty, he will tell you that his over-leveraged position did him in. And once that debt-cash-payment-repeat-cycle begins, it is a mother to stop. Why, it's almost like trying to stop a hurricane.
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