My Kindle as a Financial Consideration

I love my Kindle.  I was an early user of the product (I received my Kindle just a few months after the product’s introduction).  I read, and purchase, far more content through this medium than any other, including physical materials (books, magazines, etc), online, and audio services, such as Audible. 

To me, the Kindle’s benefits far exceed the costs.  I can generate long lists of these benefits, which helps me justify owning a Kindle.  For example, I read a lot of content simultaneously.  I’ll switch from a newspaper to a magazine to a book within a 30 minute span.  With my Kindle, I bring all this material in one convenient package.  I can go on: it saves paper; it allows modification of annotations; I can browse a bookstore right from my chair, and so on.  A few years ago, during my Kindle honeymoon, I excitedly thought of another benefit: I don’t need book shelves or a library.  I have most of my content on my Kindle.  Now, this might not seem like a big deal, but in a cramped apartment, I tell you it is.  I save about 10 square feet of space, which is now filled with junk mail to be shred, but that’s another story. 

Ten square feet has value.  I bought (or saved) that space, for a fraction of its cost.  Or so I thought.  I am now on my fourth Kindle, though I only bought three (one was replaced soon after I found it to be defective).  Of course, if I simply had ten square feet for book shelves, I wouldn’t have to keep purchasing the space. 

So I found another way to reason Kindle ownership from a financial perspective.  I’m leasing this library space.  The lease is renewed with a purchase of a new Kindle about every eighteen months.  For approximately $150 (with extras, such as a book cover) every 18 months, my lease rate is about 83 cents a month per square foot.  Where I live, on a per square foot basis, the cost would be about $2.  And not nearly as convenient.  Still a bargain.

How to Value a Home

Many people assess home values by looking at comparable sales.  Perhaps you are looking at a 3 bedroom home in a cozy suburban community, and you see a similar property located 2 blocks away which sold last month.  There’s your value!  If they are truly similar properties, this is probably a good proxy for the market value of the home at which you are looking.

But you ought to know its value as an investment.  This is a called a fair value assessment.  Though a home is an essential good, like clothing, cars, and computers, it is a financial investment, and evaluating it as such makes perfect sense.  Consider that you can purchase a home and rent it to others with the expectation of income.  Or that your alternative to owning is renting.  Home ownership should always be a buy versus lease decision.  There is a line which favors ownership on one side, and renting on the other.

Housing has traditionally been considered financially safe.  That is, until the recent bubble popped.  As Professor Robert Shiller has long contended, residential real estate is far riskier than conventional wisdom assumes. 

Real estate ownership is not a high flying investment.  For investors, it is principally a source of income, more bond than stock.  While it does have some business (equity) characteristics, like operating expenses, on the whole, it is a bond type investment.

Some might ask why they should worry about overpaying, since most of those costs will be spread out over a long period of time via financing.  In addition, there are tax benefits to ownership.  Such people may be more interested in owning because they fell in love with a particular property, or feel they need to get in before prices head higher.  I offer the following reasons to hold your wallet and not to overpay:

·         Overpaying will increase your mortgage payments. For example, consider a home with a fair value of $300,000.  If you overpay by ten percent—in other words, you pay $330,000—then financing 80% of the purchase value with a four percent 30 year fixed mortgage will cost an additional $115 each month.

·         Given the example above, you will also pay an additional $6,000 in cash for your down payment.  You could otherwise invest this money, or use it for an emergency fund.  Now it will go into your overpriced home.

·         Prices in your neighborhood may “correct.”  In other words, after you overpay, other buyers may adjust and pay less for similar properties in the future.  If you go to sell shortly thereafter—for example, in an emergency—you may sell at a loss, if you can sell at all.

·         Even if you sell a decade later, for say, $400,000, your return on asset (the return on the total purchase price), will be about 2%.  If you had paid $300,000 to begin with, your return would have been 3%.  I don’t know about you, but I’d rather have the higher return.  It matters.

·         If home values adjust downward or flatten, you may not be eligible for a home equity loan, since you might have little or no equity.

I hope I have convinced you that overpaying, even by just 10%, is not such a good idea.  But how do we assess a fair value?  You will need to collect the following information:

·         Rental rates for homes similar to that which you are looking at purchasing.

·         Estimated operating expenses (utilities, repairs and maintenance, insurance, local taxes, and supplies) for local property rentals.  As of this writing in February of 2013, typical operating expenses range from $4.50 to $5.25 per square foot per year, depending on local taxes, property condition, utility rates, land area, and other factors.

·         Local cap rates (discount rates for multi-family—or apartment—buildings in your area.  You can find these by asking local realtors or real estate investors)

·         A basic outlook for the area in which you are looking

o   How is the local job market?  Are people earning enough to sustain the rental rates you’ve researched?

o   Is there a local building boom bringing new supply of real estate to the market?  This might be a sign of unsustainable supply, which will apply downward pressure on rental rates.

Armed with this information, we can now look at a hypothetical example.  I will use the following as my numbers:

·         Rental rates for a 2,100 square foot, 3 bedroom, 2 bathroom property are about $2,200 per month.

·         Operating expenses are about $4.52 per square foot for a total of about $9,500 per year.

·         The local cap rate is 6.5%

·         Your area looks stable, with moderate job growth, some higher wage jobs coming to the area to help buttress support for rental growth, and reasonable municipal finances for stable real estate tax outlook.  Water and Sewer taxes, however, may rise in the coming years to support upgrades to the county storm system.

With this information, you make the following calculations:

1.    Annual rent: at $2,200 per month, annual rent is $26,400 per year

2.    Annual operating expenses: given above, these are $9,500 (this includes real estate taxes, repairs and maintenance, utilities, and other basic expenses)

3.    Net operating income is $16,900 per year (this is the annual rent from the first calculation, minus the annual operating expenses from the second calculation—or $26,400 - $9,500)

4.    Valuation is $260,000, which is about 10X annual rent (this calculation is made by dividing the annual operating income from the third calculation by the cap rate of 6.5%—or $16,900 ÷ 6.5%. In other words, you expect to get an average return of 6.5% per year)

For this home, a price above $260,000 means you are better off renting.  This methodology is a good gut check, will force you to do some basic due diligence, and make some financial considerations. 

Regarding some considerations you might make, you may decide that a 5% return is reasonable, in which case this home is worth $338,000. If you go through this process, however, at least you've conducted research and thought it through in a structured manner. 

There are other valuation methodologies, such as DCF, which allow you to model factors like renovations, but they are superfluous in this example.  I also didn’t mention other, even more basic considerations, such as whether you plan on staying for a while.  This was only meant to introduce the concept of evaluating buy vs. lease decision and homes as investments.  Approaching home ownership in this way will help you make better decisions. 

The Sorry State of the Investment Industry

Today’s New York Times reports on how financial advisors sold so called sophisticated and complex investments to investors who didn’t understand them.  The types of investments mentioned aren’t suitable for most people, and should never be marketed to mom and pop savers.  But, of course, salespeople always have a catch with which to lure prey.  The catch is usually topical, a need common to most people.  Today, that need is for a better yield for income (How would you like to earn a better yield on your savings?).  Tomorrow, it’ll be something else.  But we should always be skeptical and on guard.  I hope to cover appropriate due diligence in future posts, so stay tuned. 

Refinancing (Part 1)

If you’re a homeowner with a mortgage, you may have an opportunity to lower your monthly mortgage payments.  The ability to fix and perhaps even lower a large portion of your living expenses is a key benefit of home ownership.  (Of course, this must be weighed against some of the negatives, such as property tax, maintenance, and a large, illiquid investment.)  But how do you know if refinancing is a smart decision? 

Mortgages are like bonds.  In financial parlance, a mortgage is an annuity like cash flow stream.  Like a bond, which (usually) disburses interest semiannually (twice a year), mortgages provide cash flow (usually) once per month.  If mortgage rates fall, many homeowners have the option to refinance for lower payments.  If you could lower your payment by $300 per month, that is a bond like stream of income back in your pocket.  You’ve just saved $300 per month.  But there is a cost.  Fortunately, like bonds which provide coupon payments, your $300/month savings can be valued.  This is what is known as the present value of future cash flows.  This is a classic investment decision.  The value of your mortgage savings (or bond), should exceed the cost of refinancing, and other costs as well.  Let’s look at an example.

Barbara financed 80% of the purchase price of her home with a mortgage five years ago.  She borrowed $225,000 in a 30 year fixed rate mortgage at 5.5%, and can now refinance at 3.25%. Is it worth it?  Here are some considerations and numbers she needs to evaluate:

• She should be reasonably certain she will remain in her home for at least 7 years
• Her current monthly mortgage payments are $1,277.53
• She’s been paying for 60 months, and her outstanding principal (assuming she has only paid the actual amount due, not more, not less) is now $208,036.36. 
• Refinancing costs will be $7,500, and she will roll these costs into her new mortgage
• The new rate will be 3.25%
• Instead of paying her mortgage off in 25 years, she will now be back to square one, and her payoff date will be pushed back to 30 years (she is extending mortgage payments an additional 5 years)

If she rolls the closing costs into the equation, she needs to borrow about $216,500 (I rounded up a little from what she actually needs).  Her new payments will be $942.22, for a monthly savings of $335.30.  Every month.  For 25 years.  If this were a bond, this much money received each month would be worth about $68,800.  Think about that.  You can get a bond worth more than $68,000, which pays more than $330 per month for 25 years, for just $7,500.  Of course, that’s not the whole picture.  There is one last cost which is not explicit in this picture.  That cost is the extension of five years of additional payments that the borrower (mortgagee) needs to pay.  We need to calculate this value and deduct it from the value of the savings.  The value today of an additional 5 years of payments of $942, beginning in 25 years, is $23,426.27.  This cost will need to be deducted from the $68,800 value of the savings.  When you also deduct the $7,500 in closing costs, you are still left with a benefit of $37,879.89.  That’s no small amount.  But the real benefit is felt month after month, in the form of $335 of savings, for 25 years.  This is definitely a good deal. 

I’m sure many will have plenty of questions regarding my example.  I plan on revisiting this topic in the future to help clarify the concept.  Feel free to comment and let me know what you think.