When to hold them depends on the deal - Denny Grimes and Company: MarketWatch Update

Apr
22

When to hold them depends on the deal

Remember the ABC television show The Wide World of Sports? Their classic introduction to the show was the line "the thrill of victory and the agony of defeat." Now we live in a day where one of the fastest growing "sports" is a card game called Texas Hold'em. Maybe it's me, but watching someone fold after the pre-flop isn't as cool as watching the poor skier do more cart wheels that Mary Lou Retton while traveling 90 miles an hour down the ski jump. Now that's sports!

Now there is Florida Hold'em and it's played by thousands of sellers in our market. It's not a sport or a game, but there will be winners and losers. The players have already anted up and the cards have been dealt. Players only have one decision, either stay in the game or fold. The twist in this game is you don't necessary lose if you fold and you don't necessary win by staying in the game. And, unlike real poker, there can be more than one winner.

This isn't a game for sissies, because the stakes can be enormous, such as one's life savings or future credit worthiness.

Let me illustrate:

One of my associates just met with one of the "players" who is ironically from Texas. For privacy issues, etc., let's just call him Tex. Tex was lured into buying one of those often talked about pre-construction homes because he heard his buddy made a killing on the one he sold. The problem is, his buddy's timing was better. Tex has a total of $327,000 into the home in a market that will only allow him to sell it for $225,000. He has already closed on the home and has a mortgage balance of $323,000. OK Tex, it's your turn, do you want to hold or fold?

As the camera zooms in on Tex, even the sunglasses can't hide the "why me" look in his eyes as he ponders how he should play his hand. His options are: sell it today, rent it out and hope the market improves or give the cards to the bank and let them finish the hand. He doesn't want to ruin his perfect credit, so for the time being he has eliminated the foreclosure or a short sale option.

If he sells it today, he will have to bring $115,000 to closing. This is a financial impossibility for most buyers in this situation, but Tex is fortunate because he could come up with that amount of cash, although the thought of it makes him sick. He feels his best option is to rent it and wait for a more favorable market. Is that really the best option? The question Tex should ask himself is "how much am I willing to lose?" Because staying in the game may cost him a lot more than the $115,000 he has already lost.

There are thousands of sellers that are or will face this decision in the coming months. This decision should not be made in haste because it is very possible that the seller will lose more money by waiting. It's easy to quantify all of the carrying cost, although most sellers underestimate the total cost or ownership and they forget things like allowing for vacancy and that someone will have to cut the grass.

The element of risk isn't lessened much, even with a perfect pro-forma. Because as in the game of poker, the cards you can't see are the ones that can beat you. The cards nobody can see are when will our market start appreciating again and at what rate.

Tex's cost of ownership is about $30,000 a year (without a renter). Assuming the market drops another 5 percent this year and is flat for one year and then begins a rational growth rate of year 5 percent a year, the cost of ownership will always outpace the growth in value. With these assumptions, if Tex decided to sell the home in five years for $236,000 he would have lost a total of $236,550. The $115,000 loss is starting to look pretty good! Renting will help slow the bleeding, but it will not stop it. If the total cost of ownership, which is about 7.5 percent, and the average growth rate is 5 percent, Tex's loss will grow each year. Bluntly put, he could own this home for as long as he has a mortgage and unless we have an aggressive spike in the appreciation rate, he will never lose less than what he can today.

All sellers should take heed, even those that can sell today and make a profit. Many of these sellers can walk away a winner, but in their minds, not a big enough winner.

They remember how big the pot used to be and they wonder when those days will return. Most of these sellers will end up losing because they won't do the analysis we just did for Tex. Kenny Rogers said it best with his hit song "The Gambler," "you got to know when to hold em, know when to fold em." For most sellers, including Tex, it's time to cut their losses and wait for the next deal.

Originally published on April 22, 2007 in the News-Press

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