A Tale of Vitality
There are few things in life as sad as a past-his-prime professional boxer getting in the ring for one last fight. The crispness and swagger of youth are gone and what remains is hope of the one-punch knockout. We all secretly hope that he lands that one lucky punch so that we can witness a minor miracle and capture a piece of our own youth, but more often than not, we are disappointed. This tale speaks to the recent retiree who feels the need to be vital.
Many recent retirees defined their value by their career, and once they retire, they must find a way to refocus their energy. They are lost and sometimes they go down the wrong path. I have unfortunately observed more than one situation in which this need to feel vital creates a very negative outcome.
In 2000, Francisco and his wife Greta sold their business, their house and all their other belongings in the Washington, DC area. He was 65 and so was she. They were moving to Florida to live the good life. All told, they had almost $3 million in investments and combined had Social Security benefits of about $25,000/year. By most measures, they were wealthy. Since I had played an important part in helping them amass this wealth and they were long time clients, they came to see me regarding what they should do with their money.
I was happy to see that they had done so well on the sale of their business and assured them that I could maintain their portfolio in Florida with the same care as in Maryland.
My recommendations were simple. I asked them to limit their home purchase in Florida to a home below $600,000. I would invest the remaining $2.5 million in a portfolio with a total return objective. I believed a total return portfolio would grow over their lifetime and last them the rest of their lives. Additionally, it could provide them with $10,000 per month and would keep pace with inflation. This is a standard recommendation for folks in this situation. I gave them the same advice I gave my parents when they retired and moved to Florida. Imagine living in the location of your choice, with no mortgage, minimum expenses, and with $10,000 per month plus $25,000 per year from Social Security. This is a good retirement for most people and, in their case, it represented more money per year than they had made in any of the last five years they ran their business. They were delighted, and the plan went well for the first 3–4 months. Then the trouble started.
At first it was innocent enough. I got a call from Francisco, and after a few minutes of catching up, Francisco said, “Carlos, I’ve found a piece of property that one of my friends tells me I can buy and turn around in a few years for triple my money. Can you send me $100,000?” After some discussion, I recognized that Francisco wasn’t asking me for my opinion. He had made up his mind and he wanted the money. Out went $100,000. Not long after, I got the call for an additional $400,000 to invest in an art gallery that was poised to take off in the “sizzling” Florida market. I was skeptical and let him know it. Soon there was the additional $200,000 to purchase four townhouses, which were also appreciating to the tune of $5,000 per month, that they would rent to retirees. Remember, Florida real estate was going straight up at the time, and the stock market was going straight down. Next, I got the call for an additional $300,000 to invest in six condominiums in six different buildings that were bargains because they could purchase them at preconstruction prices. The intent was to “flip” or sell the condominiums at a profit to another interested investor when they were finished. Again, I was skeptical and let them know it. Where did this leave us in early 2003?
We had started with $2.5 million under a total return portfolio, and in about 2 years, the portfolio was worth $1.2 million. They had invested close to $1 million in real estate and businesses, had spent about $240,000 and there were about $60,000 in losses in the portfolio. The losses were attributable to the severe stock market decline we saw in 2000 through 2002. It was at this time that we had a face-to-face meeting.
I explained that with $1.2 million I could no longer provide them with $10,000 per month since it represented 10% of their total portfolio and was no longer feasible, and that we would have to cut back to $5,000 and wait for some of their real estate and business investments to pan out. This went over like a lead balloon. My recommendations ultimately led to another disastrous idea from the mind of Francisco. Francisco informed me that the rates that I was making on the CDs and bonds in his portfolio were ridiculously low and that we needed to increase the yield. He could make 9% per year by investing in private mortgages. These mortgages carried a high interest rate and had a 12-year term. He would lend the money to credit-worthy borrowers and they would pay him 9%. Furthermore, the cash flow would be almost immediate and would sustain the $10,000 monthly income that I could no longer safely provide. Despite my exhaustive explanation and protestations, out went another $800,000.
At this time, I no longer managed any of their personal money, just their IRA money. They allocated all their personal or non-qualified money into real estate, an art gallery, some art works and now mortgages. I was effectively out of the loop, and my advice was as welcome as a hurricane in Miami. At least I knew they had no mortgage on their house and that the investments, although concentrated in real estate, barring a catastrophe, were sound, so eventually, things would work out in their favor. Unfortunately, there was a catastrophe. Here’s where things get worse. I characterize it as the perfect storm. The events that led to their financial demise were in place. How did it transpire?
Francisco’s need for vitality made him plunge head first into the Florida real estate market. In much the same way that the stock market calls the amateur into investing near or at the top, initially Francisco met with success. He was able to sell the lot he bought for $100,000 a few years later, for almost three times his investment. Because Francisco was well versed in tax code, he initiated a tax-free exchange instead of taking proceeds from the sale and paying capital gains taxes. The proceeds went to purchase more Florida real estate. This time he did something different, however. Instead of putting substantial down payments on the real estate he was purchasing, he purchased multiple rentals with as little money down as possible. After all, he reasoned incorrectly, real estate only goes up in Florida as baby boomers retire and seek a warm climate.
What happened next? Again, the real estate market sucked Francisco into its warm belly. He sold the six preconstruction units for a substantial profit. Once again, he took the proceeds and invested in rental properties with as little down payment as possible. By this time, Francisco owned so many rental properties that he was spending a good part of each day catering to tenant complaints. Francisco was effectively in the real estate business, and to make matters worse, his entire business plan depended on the false premise of perpetually rising real estate prices. Because nothing that exhibits price volatility goes up forever, and Francisco had bet heavily on real estate prices going up for what seemed like forever, he was poised for financial failure.
Once again, I met with him and Greta. I explained their situation from a risk management perspective and outlined a specific plan to begin selling rental units. It could have prevented disaster, but Francisco would have no part of it. Greta was receptive and understood the risk, but he was certain in his belief. Prices were still going up, and I was a fool to tell him to sell, he boasted. He was proud to tell me that he had gone to Florida with $3 million in 2000 and that he was now worth many times that amount. The rest is history. Florida real estate prices would peak in the next few months and would soon drop precipitously. His rental income dropped, Francisco couldn’t refinance his properties and the banks wanted their money. Francisco was in full panic mode.
What came next? They sold the private mortgage at a loss to pay debts and put the rental units up for sale. Naturally, they set the prices too high and the units wouldn’t sell. They subsequently sold them at a steep loss. They had so much debt that their obligations exceeded their income by $40,000 per month. They took out a home equity line of credit on their “paid up” house and when they ran through that money, all they had left were their IRAs. They liquidated those as well to pay their debts. To make matters worse, they closed the art gallery because it was losing money. I was completely out of the picture by this time. I think they were embarrassed to speak with me for fear I would give them a “told you so.” I calculated they had about 10 months left before they ran out of money entirely and were unable to pay even the interest on their home equity line of credit.
What happened to Francisco and Greta is not very different to what happens in every boom/bust market cycle. You make a lot of money on the way up, you are lulled into a false sense of confidence and then if you’re not careful, you lose it all on the way down. I don’t fault a younger man for falling victim to this cycle as he tries to make his fortune. However, it is unforgivable in the case of a retiree. Francisco could have removed himself from the situation many times, and many times I pleaded with him, but his need for vitality kept him in the game for too long. He violated the “once wealthy, stay wealthy” principal. His need to get into the ring one last time for one last fight knocked him out. I heard it through the grapevine that Greta left Francisco and they were both back at work. Thus is the problem with vitality.
In case you think I’m picking on the real estate market, don’t. The same thing can happen in the stock market.