One Last Attempt At Understanding [investment] Risk

Great Debates
1

Johny bought a condo for $100,000. His 30-year-mortgage, taxes, insurance and association fees cost him $900 per month.

He rents it to Timmy for $1000 per month. A rate determined by the free market, based on available property for rent, and one that both parties consider fair.

**Scenario 1: **After a year Johny sells the condo for $150,000. He spent $5,600 on taxes, insurance, and interest. Another $1,200 on association fees. And makes $12,000 from Timmy.

After the dust settles Johny walks away $55,200 richer. But Timmy is unhappy. He feels he risked a lot renting from Johny, so he wants part of the sale of the apartment. Based on your own personal definition of risk, how much should he get?

**Scenario 2: **After a year, the market goes to shit, and Jimmy is forced to sell the condo for $80,000. He spent $5,600 on taxes, insurance, and interest. Another $1,200 on association fees. And makes $12,000 from Timmy.

After the dust settles Johny walks away $14,800 poorer and he’s pissed. He wants Timmy to share in his loss. How much should he get?

Do the answers to 1 or 2 depend on how rich or poor Johny is in relation to Timmy? Do you find you naturally assume Johny is rich and Timmy is poor?

2

Scenario 1: $0

Scenario 2: $0

In each case, people enter into contracts aware of the risks that they are taking, so in buying and selling real estate, you should be aware of the risks that the property will go up or down in value. However, the owner takes all the risk, unless he/she has a contract sharing that risk with someone else. A renter normally does not share in that risk – and if the renter wants a share, it should be put into the contract renting the premises.

And it does not matter how rich or poor each of them are.

3

Johny took all of the equity risk. He deserves 100% of the return and bears 100% of the loss. Timmy had a contractual arrangement to pay a fixed amount. He absolutely should not bear any risk of loss or share in any upside of returns. How rich or poor has nothing to do with anything. It seems incredibly clear cut, and I see no logical way anyone could come up with any reasonable alternative argument.

I do not assume Johny is rich and Timmy poor. I have personal experience of renting a home from someone that could no longer afford their payments and needed to downsize but didn’t want to sell their house. I was significantly better off financially. However, I would say that odds are that the owner is better off financially than the renter. It’s definitely not something I would assume in a real world situation though.

4

Johny’s entitlement accrues from ownership, not risk. He’d have the entitlement regardless of his personal investment in the condo. If he was bequeathed the property, won it in a sweepstakes, built it with his own hands, acquired it in an estate sale for $20,000 or spent $2M on shoddy contractors and legal fees, he’d have the same damn entitlement.

Timmy’s entitled or obligated based on his contract with Johny, unless superceded by extant law.

5

Are these statements in agreement or conflict? Does risk amount to entitlement or ownership, can you have one without the other?

6

Giles and I appear to be in agreement with those particular statements. LonghornDave appears to agree with you that risk (not ownership) => entitlement; IOW, that ‘desert’ based on risk determines reward.

You can have ownership without having borne the full risk of production. You can have entitlement without ownership. You can have risk without either.

7

Yes, you can form contracts to share the risk. For example, if I own land with a building on it, I own the risk that the building will be burned down or otherwise destroyed. But I can contract with an insurance company, to pay them so much per year if they agree to pay me the value of the building if it is destroyed.

Similarly, in scenario 1, Johny and Timmy could reach an agreement that, because the property is run down, Timmy will renovate the property while living in it, and at the end of the year Johny will sell the property and give Timmy half the increase in value. That means that J & T have a contract to share the risk of the property market. But that wasn’t in the original scenario.

8

Note that I didn’t say that he took the financial risk (although he did in this case). I said he took the equity risk. Equity is synonymous with ownership.

9

Can’t have ownership without risk, that’s true. So you’d agree that holding the deed, rather than having made the investment, is what both entitles and obligates Johny in the two scenarios of the OP?

10

What about the bank that provides the mortgage? Johny didn’t actually put up any equity, it was all loaned.

11

If Timmy renovates he’s putting in some form of something, but it appears the English language is without a word for it.

I’d say Timmy shared in the risk, but I’m afraid now to use that word. To me he put in skill, time, and perhaps some cash. Seems like he should get something back for his “sweat equity.”

So now, what does he get in return? What is he entitled to? And what would he lose?

12

Did the sale of the property not satisfy the loan conditions? Did Johny default in scenario 2? Or are you asking what entitlements and obligations the lien holder has? I’m not sure what your point is.

13

Point was that Johnny didn’t put in any initial equity, the bank did. Further to that, the bank’s equity came from investors. The resulting equity after year one (just over $1000) came from Timmy (who perhaps works at the bank).

When we walk our back back through the list:

  1. Timmy got a place to live for a year, which fairly compensated him for the $12,000 he paid.
  2. The investors get 4% on their mortgage backed securities.
  3. The bank gets 6% (less 4%) from the loan.

And in scenario 2, Johny didn’t default, he had to cough up the $18,000 to cover the short sale.

He could have just as easily claimed one of a million excuses and walked away leaving the bank as “owner” of the property, and the only one with an equity stake. Timmy just happens to be the guy living there, but he risks losing his home!

In short, it seems people are always eager to shirk responsibility, while trying to attach themselves to someone else’s gains.

14

Again, I’m not seeing how the question relates to your thesis.

You understand that the lender’s risk is limited by the mortgage; their equity is likewise limited, and backed by the property as collateral. The owner’s equity in the mortgage must be earned through payback, his possible return on the sale is not limited in the same way, but his risk includes the loan, insurance, maintenance & etc. The renter’s risk includes security and advance payment. None of which deals with either legal or ethical deserts.

15

When I asked the same question involving a restaurant, the relative wealth of the owner vs the dishwasher was the most important variable. I find it strange that isn’t a factor this time.

16

It wouldn’t be a factor for me ever. It is all based on contracts even if they aren’t written but enforced by the state. A dishwasher typically gets an hourly wage. That has to be paid on time and given legal working conditions. The End.

The contractual obligations in the OP were equally clear. I don’t understand how there could be any confusion. I currently lease 1/3 of a large house. It doesn’t matter if they find a huge gold deposit under the house tomorrow. I don’t own it. I just paid for a place to live and I may have to move if they need to get the gold out. It is all very simple and stated up front

17

That’s what I thought, but some how that turned into 5 tear filled pages.

A lot of people manage to create a scenario where Johny is a slumlord who buys and sells houses at whim. While Timmy spent is last $5 on the bus to look at this place. Timmy risked everything, Johny risked nothing, and now Timmy is out on the street with no place to live.

Oddly enough, in that same thread, home owners were made to be victims when their house value fell. Logic was twisted and turned until it wasn’t their fault. Surely Johny is as much a victim as anyone else. Why should he have to pay $18,000 when he didn’t understand what was going on?

In this OP it’s nice and clear, Timmy pays rent and gets nothing from the profits, nor does he lose anything in the crash.

There is a disconnect I don’t quite understand, and it seems to drive people either Republican or Democrat depending on which person you vilify.

18

Timmy decorates according to his taste and for his personal benefit. Decorations are not an investment. He’s risked nothing and at no time assumed any of the liability or reward of risk.

19

He’s risked nothing?

Now he’s out on the street with no where to live!

Surely he risks as much as a dishwasher at a restaurant. What makes this situation different?

20

The OP seems to imply that all terms of his agreement with Johny have been met. If so, he has no valid moral or legal grievance.

It’s easy to imagine that he thought the condo rental was a good deal and hoped it would continue indefinitely. Life often fails to work out as people hope, and such failure does not create any sort of entitlement.