Once you’ve acquired some wealth, we’re guessing you probably want to keep it. Here’s how.
In our last post we introduced the 3 Phases of the Wealth Cycle, beginning with wealth creation.
In this initial phase, we tend to take on more risk and experiment with different investment vehicles and strategies. We can do that because we are generally younger and have the time to make mistakes and recoup our losses. It isn’t a license to be reckless with our decisions. Rather, it just means we can afford ourselves more latitude to make mistakes as we try to make it big. If we stay focused on new opportunities as the market presents them, we can build a broader base to build on as we move through life.
Now on to the second phase…
In our most recent post, we told you about our friend, Rob who owns several industrial buildings with his father. Rob is still in the wealth creation phase and wants to refinance the properties to acquire additional assets. His father, who is in the wealth preservation phase, is content to pay off the low loan balance and enjoy the cash flow from the fully leased buildings.
Rob’s dad is in his early 80’s and has accumulated enough wealth to enjoy his current lifestyle. Unlike Rob, he isn’t willing to take on the risk of refinancing the property, reducing his cash flow and taking a chance on feeding the property if tenants are lost with debt to service. This posture defines the wealth preservation mentality, and that is to take a safer and more defensive approach to managing our investments.
In the case of Rob and his dad, neither of them wants to sell their properties. They just have different uses for them. They both understand the underlying value of the buildings and both have good historical perspective on owning industrial buildings in Orange County. So, their respective strategies have that common element. Chances are good that they will reach a compromise and find some middle ground that gives Rob a chance to parlay his ownership into a bigger portfolio without putting his dad’s cash flow at risk.
They are talking things through now, and we will let you know how things turn out. No matter what they decide, we see the opportunity to learn a good lesson that we can pass along to all of you.
Now, let’s take a harder look at wealth preservation. In the case of Rob’s dad, he chooses to maintain ownership, which still, even in the best of circumstances, involves risk. We all remember the 40% to 50% decline in property values that resulted from the biggest recession since the Great Depression. They didn’t name it the Great Recession for nothin’.
It was ugly and let’s hope the next down cycle is kinder to us all.
Our team was on the front line back in 2008, and we are not fond of the idea of a do-over. But, what we hope for has nothing to do with what will happen the next time the market hits the brakes. Hopefully, it will be orderly and less severe, and that hard-fought gains will not disappear as they did the last time around. We will be weighing in soon on current events that may or may not be indicative of the next correction, but this is not the time.
Let’s assume for the moment that the market will correct and will begin a correction in Q1 of 2017. And, let’s assume that market values pull back roughly 25% during the correction, a reasonable assumption based on our own experience. That means a building worth $180 per square foot at the peak will be worth $135 at the bottom of the next cycle. A decline of that magnitude is worthy of any investor’s attention.
Now let’s assume that the owner of a certain 20,000-square-foot building in Anaheim is 63 years old, has owned his own business since the 1970’s and bought his building 25 years ago for $55 per square foot. That means he paid $1,100,000 for a building that is now worth $3,600,000. Good for him, and good for you if this hypothetical scenario resembles your current situation. But, a 25% correction would equate to a $900,000 loss of equity. Ouch. If you were this investor, what would you do? Good question.
If we assume the peak of the next cycle to be 10 years from the peak of this cycle, our building owner would have to hold the building until age 73 to recoup the value lost during the correction. However, if he sold the property before the correction, he could realize a massive gain, stash a pile of cash in insured accounts and not put himself at risk of losing hard-fought gains. After all, he worked hard to get where he is today, and he took risks in the wealth creation phase to get to where he is.
This is an owner profile that is very common today, but most of those in this situation refuse to sell because they either see the market as having more juice in it, or are loathe to pay the taxes associated with realizing such an enormous gain. This may be something you are wrestling with yourself. While we agree the tax hit may take your breath away, it may be just what the doctor ordered if you are an investor in the wealth preservation phase of your life.