The foreclosure crisis has been going on for a couple of years now, but it wasn’t until this week that it really hit home. My wife called last night to tell me that our former neighbors – I’ll call them Bob and Sue – had lost their house and would be moving to another state.
For background, I should note that Bob and Sue were part-time homebuilders for the better part of the past decade. While Bob worked full time and Sue stayed home with the kids, they also built houses on the side. Every couple of years, they’d start building a new house. When it neared completion, they would put it along with their current house on the market, and then live in whichever one didn’t sell.
Raising the stakes
This worked so well for them for several rounds that they eventually decided to start building more expensive homes – homes that they couldn’t actually afford to live in themselves if they didn’t sell. Unfortunately for them, they made this decision right around 2007. I’m sure by now you can see where this is headed…
As their the mega-house they were building neared completion, the bottom dropped out of the housing market (and the economy in general). Real estate stopped selling almost overnight, and they were stuck with two houses. They put the new one on the market for awhile, but there were no potential buyers.
Eventually, they put their current house on the market in hopes of salvaging the situation. Their plan was still to sell the mega-house if they could. But if they couldn’t, they would buy time by selling their regular home and using the proceeds to keep themselves afloat. Since they couldn’t afford the mega-house in the long run, they’d move into it, but leave it on the market and move again went it (hopefully!) sold.
Hitting rock bottom
After a few stressful months, they sold their regular home and moved to the mega-house. Sue also went back to work to help makes ends meet, and it seemed like they’d be able to stay afloat, at least for awhile. Unfortunately, “awhile” recently ran out. They fell behind on their payments, and the bank ultimately foreclosed on them. They’ve lost nearly everything.
In retrospect, it’s easy to say that they should’ve just let the mega-house go when the market tanked. Sure, that would’ve ruined their credit, but they were already in a house that they loved, so why not dump the mega-house and move forward? Now they have no house, no credit, and presumably little to nothing in the way of savings.
Well, for starters, Bob and Sue were intent on “doing the right thing.” They got themselves into this mess, and they were intent on getting themselves out of it. I respect them for that even though they’re now paying a huge price. At the same time, I don’t think they wanted to admit to themselves just how big a hole they’d dug for themselves.
Lessons learned
With the story above as a backdrop, I wanted to share some financial lessons that can be learned from Bob and Sue’s plight. It’s too late for them to change course, but it’s not too late for others to learn from their mistakes.
Don’t be greedy
As much as it pains me to say it, Bob and Sue are victims of their own greed. Things were going so well for them that they decided to up the ante and start building huge homes that they couldn’t afford to keep. Sure, the profits would be bigger with their new strategy, but the risks were astronomically higher. In the end, they reached for the brass ring and wound up losing everything.
Respect risk
This is related to the point above, but it’s important enough to split out on its own… Risk is a funny thing. If you’ve ever read a financial book, you’re aware that “with risk comes reward.” But what many people often fail to realized is that investment risks are very real, and they’ll often rear their ugly head at the worst possible time.
It’s easy to be blinded by the potential upside, and to simply declare that they’re sufficiently risk tolerant to reach for higher returns. In Bob and Sue’s case, they let their risk/reward ratio got out of whack.
Let’s say they would’ve made $50-$100k by building and selling a “regular” house, and that the mega-house would generate $100-$200k in profits. In this case, they would’ve doubled their potential gain, but at what cost? Their downside risk went from being a manageable setback to complete financial disaster.
Leave a margin for error
And finally… Bob and Sue’s prospects apparently took a turn for the worse when he was laid off from his job. While they would have been able to pull this deal off if everything had gone perfectly, they didn’t have any wiggle room. And things didn’t go perfectly – the house didn’t sell, their income took a hit, and so on.
Unfortunately, even with Sue going back to work, they didn’t have enough cash reserves to carry them through the lean times. They took on such an extreme financial burden that they simply couldn’t make their plan work unless everything worked out perfectly – they had no margin for error.
Doable Finance – I read the story and the comments a few days ago, but felt that I should say something in response to your comment that greed was behind this debacle.
I rather saw a family that was trying to take care of their financial future by risking. Granted, the timing was horrible, and the risk too great, but I applaud their effort to make a solid future for themselves.
Many of us invested based on historical norms of good lending practices. The greed of the banks is what got most people in trouble.
The foreclosure debacle in recent years was just that, GREED and greed on the grand scale. Lenders helped in greed too. They had their own greed. They wanted to make a load of money. Greed played on both sides.
The difference between the borrower’s greed and that of the lender is that consumers did not have enough guidance per say about finances whereas the lenders especially the big ones had economists and finance gurus working for them.
Greed is one factor that doesn’t differentiate between consumer and the lender. It can and has engulfed almost everyone especially those who lost houses to foreclosure.
High unemployment played a big part too. But the pain could have been reduced if folks lived within their means to begin with.
hey thanks for the feedback BG. yeah my construction experience will greatly impact my success. when it comes to maintenance/building, there’s not much that i can’t do. i am very well rounded in this area, and have many friends in the indusrty as well.
i would like to semi retire by age 35-40, which is a very realistic goal. that will give me 12-17 years to accomplish this. of course i could keep on going, but i think i’d be happier enjoying my life while im still young.
my dream is to never wake up to an alarm clock ever again,lol. i’ll wake up when the sun comes out / when im good and d*mn ready :). my goal is to work for myself manging the property’s, thats why i say “semi” retired. also thinking about becoming a realtor later in life. it would be much easier and stress free if i didnt have to RELY on the income that being a realtor would offer. this is truly what would make me the happiest.
i agree with you 100% about the emergency fund. were trying to save up a year’s worth of expenses that will be set aside in a brokerage account, so that it can be working while it waits. one of my side “jobs”/interests is the art of technical analysis. if you dont know what this is, it is basically using charts (past history of a stock) to predict the future price movement. i have been studying this form of analysis for about 3 years now, and have found it to be extremely useful. whole notha’ topic though.
Thanks for your input, i appreciate it very much.
Dustin:
The HOA ins does not cover everything. U need to get a rental dwelling policy, which will cover the walls, flooring, lights, appliances, etc. U own from the wall in. The HOA ins will not cover u from the wall in. Also u will need to think of taxes. So these two expenses combined will drop your income by about $75 or so if u r in the 25% tax bracket. Im using the numbers from my rental which is about the same price. I live on the coast tho so my ins is $50.
Also even if u have reserves u need to keep some money out of your profit to rePlenish your reserves for when the house is vacant or things go wrong. I make about the same as u do from my rental with the same expenses, but I only count on $150, not $244 (I make $238 off of my rental property valued at $55k)
hey thanks for the feedback BG. yeah my construction experience will greatly impact my success. when it comes to maintenance/building, there’s not much that i can’t do. i am very well rounded in this area, and have many friends in the indusrty as well.
i would like to semi retire by age 35-40, which is a very realistic goal. that will give me 12-17 years to accomplish this. of course i could keep on going, but i think i’d be happier enjoying my life while im still young.
my dream is to never wake up to an alarm clock ever again,lol. i’ll wake up when the sun comes out / when im good and damn ready :). my goal is to work for myself manging the property’s, thats why i say “semi” retired. also thinking about becoming a realtor later in life. it would be much easier and stress free if i didnt have to RELY on the income that being a realtor would offer. this is truly what would make me the happiest.
i agree with you 100% about the emergency fund. were trying to save up a year’s worth of expenses that will be set aside in a brokerage account, so that it can be working while it waits. one of my side “jobs”/interests is the art of technical analysis. if you dont know what this is, it is basically using charts (past history of a stock) to predict the future price movement. i have been studying this form of analysis for about 3 years now, and have found it to be extremely useful. whole notha’ topic though.
Thanks for your input, i appreciate it very much.
dustin) ah, I see — you are going to be a landlord. With your construction background, you already have a huge advantage over your competition (doing your own maintenance/repairs).
Looks like you have the “Bob and Sue” risks sufficiently covered. Having everything able to be paid by one income is excellent! The only thing that can break your plan is if you BOTH loose your day-jobs simultaneously, and while unlikely it is still very possible. The best cure for that? Have at least 6 months (or more) of cash in an emergency fund — this money will buy you time when you need it.
hi BG,
thats exactly what bob and sue did. lol, i guess i should have explained my situation, as that was a very contradicting statement.
so i found this 1,100 sq. ft. townhome in a really good location. it is a forclosure, and they just lowered the price, again. this townhome has brand new carpet, paint, granite countertops. its in really good, move in ready shape. sounds like a great opportunity for a rental property.
i know i like seeing real numbers, and im sure everyone else does too. so heres the breakdown:
purchase price 66,000
downpayment 13,200
mortgage 52,800 @ 5.3%(going rate for invest prop)
monthly costs:
principal & int. $293.20
property taxes $42.00
hoa dues $71.00 (insurance included w/hoa)
total $406.00
thats it, that is the total cost every thing included. this is my total liability in the event that i werent able to have a renter. i haven’t factored in maintenance just yet because that isnt neccesarily a holding cost.
The going rental rate right now is $650 a month. there are sixteen townhomes in this development, and they are consistantly occupied. i stand to net $244 a month.
my wife and i are very comfortable, given these facts, to take on this very real risk. our ability to handle the amount of debt we will incur will be very easily absorbed in the absence of a renter. my total living expenses and total debts including 2nd property would be 32% of my gross income. my or my wife’s individual income could easily cover all these costs. i think this is how my situation and bob and sues differentiate.
i am trying right now to learn all i can about this business. i dont know anyone involved in rental property that i could talk to. if anyone could give any feedback it would be greatly appreciated. it would be cool if Nickel did an article on this subject. we could talk about it there instead of on a somewhat unrelated article.
i hope this clarify’s my debt bashing article above, i dont mean to sound like a hypocryte.
dustin) you had me going up until the point that you said you bought (are buying) two houses within 14 months…
hmmm — isn’t that exactly what “Bob & Sue” did to get over their heads?
“i once thought that i would never ever be able to afford a home in the town that i have grown up in and that i absolutely love. i bought a house in june last year. i am buying another one in august.”
so many people spend close to, or more than they earn. sure this guy had a plan, but most never did. they were ignorant, and were so over leveraged that anyone could have seen what was going to come of it. people like their toys.
i live in an area that was one of the fastest growing cities in the usa during the boom. i saw tons and tons of young people in their mid 20’s up to mid 50’s making hundreds of thousands to millions of dollars in construction. all of them had the same thing in common, they all lived like they were multi millionaires. it didnt take long for it to come crashing down. they lost everything they had. they didnt “own” anything, it was all borrowed. thats pretty sad. i have seen one working at a gas station, another living at his parents house collecting food stamps, another in the newspaper for stealing. i can count on one hand the amount of people that are doing just fine out of all of them.
im 23 years old, i have been in the contruction industry since 2005. first three years were incredible. tons of money, always busy. it has slowed down a lot but im still doing ok. i never got caught up in the rat race. financial awareness is my life. after all the things i have witnessed over the last 6 years, i can say that i am very grateful to have experienced this era. i have learned an incredible amount through the example and mistakes of others.
i once thought that i would never ever be able to afford a home in the town that i have grown up in and that i absolutely love. i bought a house in june last year. i am buying another one in august. i am very excited and grateful that i am able to take advantage of some people’s down fall. i dont live large, lol. i drive a 99′ honda civic and i have a beater &ss pickup truck that i use for work. its one year older than me, lol. my total monthly expenses including mortgage equal less than 25% of my monthly income. the rest is used to prepay mortgage. i feel very happy 🙂
good luck everyone
Unfortunately this story is something I hear almost every day. The economic down fall really pulled the retirement blanket out from under a person’s feet. The good thing about plans is they can be tweaked. Having a positive future with their finances is all about adjusting the plan.
It appears that they had successfully built and turned enough houses that a failure of this magnitude was not even on the radar. They were probably prepared financially to take a major loss on the sale of the mega-house if the market fell, but they were not in a position to have no buyer at all. With the loss of Bob’s job it was a perfect storm, all stemming from the same economic downturn and the “can’t-lose” mentality that got us all into it.
Hopefully the economy is truly recovering. I work in manufacturing and our sales is growing significantly right now. It would be nice to think that Bob and Sue are among the last casualties of this mess, but I’m sure there are more to follow.
Good grief, that’s a depressing story.
Well, what I don’t understand is why on earth they weren’t incorporated. Or were they? Did they drop the corporate veil somehow?
Clearly they were doing this as a business. They should have built a wall between their business finances and their personal finances. The timeline shouldn’t have mattered: any time you’re sinking money into a business that might, by any stretch of the imagination, fail, your business should be incorporated.
I LOVE stories like this. They are so helpful on my side. And on the part of the stars of the story, they get to help people by having their story told for others to learn from.
Kevin: Great response. I have to admit, I’m not 100% certain on the timeline. It could’ve been late 2006 when they started the new house rather than 2007. Either way, this is within the window during which you’re saying they should’ve seen warning signs.
Rough story, I think you give a good analysis, definitely supporting principle of moral hazard. As cold and callous as this could sound, this was probably more than a few bad choices but foolish business model.
I am in a housing related industry, not direct, but related. Technically, housing is a local market, but by changes in lending standards nationally, only northern mid-west seemed to escape the boom thus the bust, so I think my observations are applicable. Our company saw the work peek in ’03-’06 {maybe 200% over a base line}, then fall off by 75% in 2007 {maybe 40% of a baseline}, in late ’05 business sections were writing about the pull out of the more institutional investors (which at that time made up 10%-20% of markets. It was instantly felt. By 2006 the volume of sales had plummeted, not the price yet, but number of transactions. My company has been able to ride the downturn without a single lay-off (yet, but since work slowed late 2006) by attrition and smart acquisitions (mass equipment purchases at the beginning of the boom but none late (management rode the crashes ’88 & ’94 so cycles more institutionally apparent).
While I’d not fault ‘Bob and Sue’ for the same instincts, the crash was apparent for anyone in the industry. The business sections were full of the warning signs beginning in 2005. By 2007 the press was more pretty dismal and the foreclosure were beginning in dramatic form. So the timing of their decision is pretty inexcusable to me — That’s almost willful blindness since he was already in the industry and should have at least one eye on the western sky to see what storms might be on the horizon.
Second large mistake I see is more debatable, but at the point they decided to go into the high end market, they should have incorporated. There is so much liability in construction, both on property damage and contract disputes. The double taxation would be well worth the risk assumption of being able to build a wall between the mega-house and the family living situation. While no set rule of thumb in this area, for my state, I’d suggest anyone going from a “Class ‘B'” to a “Class ‘A'” license really should think about forming a type “S” corporation. The mega-house would probably trip the $750K in my state and would have required the Class “A,” which is a sign that you can end up in court in a big way and it’s a whole lot easier to restart another corporation after a catastrophic failure than a sole proprietorship.
That really is a terrible story!
This is what I often warn my friends of – taking on too much debt, even if it seems like a no-lose sitation.
It doesn’t happen very often, but when the market tanks, you are going to sink along with it. In order to avoid the ever-growing sink-hole, my wife and I are taking on side-jobs. We don’t do this to stay afloat – we are both currently working and have plenty of money left over each month. We started the side jobs as a just-in-case.
If one of us would lose our full-time job, the other side-jobs would replace the lost income. I think this message is important. It could really save people a ton of stress if they just planned for the downsides.
Thanks for sharing.
It looks like all worst-cases happened around the same time — especially the double whammy of real-estate prices falling AND the layoff. Had either happened in isolation, they might’ve been able to make it.
When planning for risk: plan for multiple worst-case scenarios happening at the same time — because odds are, they WILL happen at the same time, over a big-enough time frame.
In their case, it boiled down to them getting into mortgages that they couldn’t afford if Bob lost his job — their plan was to sell one of the houses, but they didn’t also plan for “what if we can’t sell it” == disaster.