To invest or not to invest: that is the question!

Sherman, Herbert ; Rowley, Daniel J.

CASE DESCRIPTION

This case describes a real estate rental startup venture with a twist; renters select their house to rent and then enter into a three-year contract and earn a $100/month credit to buy the house at the end of the contract period. The problem for the characters in the case is whether or not they should enter into this venture and how they should then proceed given their decision. Several factors complicate this business startup decision, including: their lack of business experience, one of the character's prior negative experiences with being a landlord, the need for further information in order to calculate costs (and therein profits), and the need to examine the potential risks associated with the venture. The case has a difficulty level appropriate for junior level or above. The case is designed to be taught in one class period (may vary from fifty to eighty minutes depending upon instructional approach employed, see instructor's note) and is expected to require between two to fours hours of outside preparation by students (again, depending upon instructor's choice of class preparation method).

CASE SYNOPSIS

Derived from observation and field interviews, the case describes how two English professors, Stephen Hodgetts and Richard Davis, are lamenting their losses in the stock market and how these losses have negatively affected their retirement funds. Davis's solution to working past retirement age (or praying for a miracle turnaround market) is to take control of his investment funds by becoming a landlord and developing a rental scheme which caters to lower income households and/or families with bad credit. Hodgetts has a visceral negative reaction to the plan, given his politics and prior experiences as a landlord, but intently listens as Davis describes in detail how a $10,000 investment per home will yield over $20,000 of profit within three years. Hodgetts is incredulous and wonders why more knowledgeable business people have not constructed a similar business. The case ends with both professors quoting from Shakespeare to support their positions. Hodgetts is willing to get involved in the venture if Davis can provide him with some assurances as to predictability of the success of the business venture.

CASE STUDY

It was August of 2002 and there seemed to be no help in sight for the ailing stock market. The Dow Jones had plummeted from over 10,000 in May to under 8000 in August, a 20% drop, while the total volume of the market dropped by over 10% (1) Professors Richard Davis and Stephen Hodgetts (2), long time friends, colleagues and co-authors, were commiserating their respective losses over a glass of fine wine. Both had taken major hits in their personal stock portfolios and retirement accounts and, overall, had lost at least a third of the value of their estates. For college professors on a fixed income, with at most 3% annual raises, the prospects for a comfortable retirement were looking dimmer and dimmer.

Richard had been hoping to teach only a few more years (he was in his late fifties) and had hoped to have built up a large enough nest egg to retire in comfort. Comfort meant living at his current standard of living, at least one trip to Europe per year with his wife, Rachel, and the wherewithal to be well stocked in good Merlots and Cabernets. Hodgetts, on the other hand, was in his late forties yet he too dreamed of early retirement. He wanted to write his great novel, join Richard Davis in his European adventures, and go on a cross-country speaker circuit.

"Well Stephen," Richard sighed after a moment of deep reflection on his situation, "it looks like I'll be spending another few years in the company of Shakespeare and Chaucer. I was really hoping to retire from the Chair in the Classics Department and let Llewellyn take over for me. He's a fine young man with excellent prospects, but I don't see how I can lose my stipend while my personal investments and college retirement portfolio have suffered badly from this declining stock market. I want to protect my principal investment, I can't afford to lose any more money in the market, yet if I were to liquidate my entire portfolio and put my retirement funds into a money market fund, I would only earn about 2% interest. That's barely enough to keep up with inflation."

"I know" replied Stephen thoughtfully, as he sipped another drop of wine from his glass. "All the money I've made in the market over the last few years is long gone and, of course, the money that I made in my side business (buying and selling used textbooks) I invested in the market, and that's disappeared as well. Luckily, since I'm only 47, and I do not have to retire for at least another fifteen years, so I have a chance to recoup my losses. But I agree with you. I have the same dilemma--where do I put my money so that I can obtain a decent return, at least 7% per annum, without greatly jeopardizing my principal?"

Stephen's question brought on a long, silent pause, and the hushed raising of their glasses. It was a silence that seemed to linger forever. Davis pondered his Pinot Noir, staring longingly into his glass, and examining the fine texture of this magnificent red wine. Finally, he set the glass down and turned toward Stephen, "OK, enough already". This change of tenor in the conversation drew Stephen out of his reflections and he quickly turned toward Richard. "I am tired, so tired, of feeling powerless about my financial situation. Other people are playing with my money and losing it hand over fist. Like Oedipus, I feel like the Gods have conspired against me and have wrongly punished me for something I have not done." He sat up even straighter. "Well, I'm tired of feeling helpless and I'm not going to take it anymore! I am going to take charge of my investments, take full responsibility as to how these funds are to be employed, and avoid the stock market at all costs. There's got to be another way I can use my assets to earn a decent return while protecting my principal!"

"Bravo, bravo" exclaimed Hodgetts, with a bit of sarcasm in his voice. He was enthusiastically clapping while grinning from ear to ear. "Well said indeed! Did you steal those lines from King Lear, or perhaps Hamlet, or perchance even Richard the Third. I do even recall a line from the movie 'Network' sneaking into your soliloquy. I didn't realize that you were going to launch a stage career as your alternative means of fund raising." Both looked at each other for a brief moment, then laughed. Then, Hodgetts continued in a more congenial tone, "But seriously, Richard what can we do? I'm too old to go back into the used book business and our books, although heralded by some as masterpieces in the field, produce very little income. How are a couple of decrepit English professors going to increase their worldly means without giving up their profession?"

"An excellent question, my dear Hodgetts" stated Davis in a Sherlock Holmes-like parody. "We will get to the bottom of this for the game is afoot." Turning more serious, he added, "I need to think about this for awhile but we'll chat once I have some cogent ideas as to what we can do."

THE PRELIMINARY CONCEPT

About a month later, Professors Hodgetts and Davis were discussing the finer points of Sartre's "No Exit" over yet another vintage bottle of chardonnay, when the discussion circled back to investments and the stock market. "It is as I told you" exclaimed Hodgetts in his most professorial tone "we can make an analogy to Sartre's play 'No Exit' and the current stock market. No matter what you do, no matter where you put your money, you really can't get out of the way of the stock market. If you opt out of the market for a safe investment, say like money markets, you'll barely earn enough interest to keep up with inflation. One could, of course, buy gold, or silver or buy any other commodity, but speculation has never been my forte and I do not intend to take a crash course in the futures market. So you see, we may be stuck with living with the whims of the market. Our investments will wax and wane as the large investment houses and mutual funds buy and sell hundreds and thousands of shares of stock, not based upon the true value of the stock (as measured by price per earnings) but upon technical trend lines and computer simulation models."

Dr. Davis seemed contemplative as he rolled a rather pricey chardonnay around in his glass in order to allow it to breathe better. He sniffed it first, took a minuscule sip, savored the flavor for just a moment, and then finally took a hefty swallow. Replying in his best Sherlock Holmes style, and brandishing a fake pipe in his hand, Davis retorted "My dear Dr. Hodgetts, you have overlooked the obvious answer to our investment dilemma, one which is as old as the Sphinx, as wide as the Mississippi, and as deep as the ocean. You have forgotten the basis of economic development both here in the U.S. and in Europe, the foundation of our capitalist system, the premise behind a democratic society...."

Davis unfurled another five minutes of explicative comments, stopped to catch his breath, and took another tiny taste of his highly enjoyable wine. His pause was so well timed that Davis could catch, from the corner of his eye, Hodgetts' rumbling like a volcano, a volcano ready to explode--and explode it did! Hodgetts could no longer contain his excitement and his desire to reach the end of Davis's gambit and to uncover this mysterious investment opportunity. He rushed over to Davis, secured his wine glass with one fast swoop of his hand, and stared at him straight in the face. "Well, well ... what are you waiting for? The coming of the Messiah? Godot? Come, come man. You just can't leave a fellow hanging like that. What is this secretive and mystifying investment?"

"Why, I believe we should become members of the bourgeoisie" answered Davis, "the nobles oblige, the ruling class."

"You can't mean......" started Hodgetts, half-dazed from the possibility that he could never contemplate in a thousand years.

"That's right" continued Davis. "How often have I said to you that when you have eliminated the impossible, whatever remains, however improbable, must be the truth?" "Indubitably" chuckled Hodgetts "but I never thought that you would want us to own property and become landlords!"

WE HAVE MET THE ENEMY AND THE ENEMY IS US

"Landlords, landlords" moaned Hodgetts as if he had just learned about the death of a dear friend. "How could you possibly entertain the notion of being a landlord? European and American literature is abound with examples of greedy and miserly landlords. Shakespeare, Dickens, Pushkin, Steinbeck, Alger Jr., the list goes on and on. These writers have sullied the rental profession and anyone who practices it. Why don't we just become money lenders and factory owners for G-d sake and change our names to Fagan and Shylock?"

"Calm down, Stephen. Besides, you're missing the point. You have yet to hear me through. My idea is to not become just any type of landlord but to focus on those individuals who, given their economic situation, will take a long time or never have enough money for a down payment for a house. There are a number of people in this community who are economically stable enough to always pay their rent and their credit card bills but for some reason have had a bad credit history or cannot save enough money to even put 5% down on a home. We ..."

As Davis was talking, Hodgetts' face turned redder and redder as deep concern turned to anger. "Hold on!" Hodgetts bellowed. "You're suggesting that we're not going to be just any sort of landlord. No, no that's not just good enough for Davis and Hodgetts. We're going to become the best type of landlord there is, SLUM LORDS!"

THE STORY BEHIND THE COMMOTION

Hodgetts looked like he had blown a gasket. His face was several shades of red and it was clear that his breathing was fast-paced and shallow. Davis patted him on his shoulder as he caught his breathe, then urged him to sit back down. Davis gave Hodgetts a few minutes to gain his composure and encouraged him to take a few sips of wine to help him calm down. Davis knew that although Hodgetts was an overly emotional individual, that there was more going on than just his knee-jerk reaction to his proposal (especially since Davis had not even been given the opportunity to explain the details of his plan). Once the tension had eased, and Hodgetts was more relaxed, Davis asked Hodgetts what was really going on.

Once Hodgetts had settled down, Davis asked with a very concerned tone in his voice, "What was all that about? I haven't seen you get that aggravated for a long time, especially over something like this."

"I'm sorry," Hodgetts mused as he swished the red liquid around his glass. "The idea hit me wrong, I guess. I wasn't expecting it." He tried to smile a bit as he regained his composure. "I am ashamed to admit it" said Hodgetts sheepishly "but the idea of being a landlord hits a raw nerve with me. You remember that summer two years ago when I was especially hard to find. I did answer my e-mails but I tried to stay away from campus and did not answer my phone calls. Well, I had rented my house for the summer--I was desperate for cash. Unfortunately my original tenants backed out of the deal in the last minute and I had already rented a very small place for myself. I ended up having to rent my home to anyone who could meet my price and I ended up with the tenants from hell. Not only did they wreck my place above and beyond what the deposit could cover, but they put individual locks on each bedroom door, had made-up mattresses in the two walk-in closets, left drug paraphernalia including used syringes all over the house, and were a week late in moving out. I was at the point of calling the police when they finally threw their things into a U-Haul and took off. I swore never again to rent my house, and never, ever to be a landlord again." He smiled at Richard in apology, "I am sorry that I had such a visceral reaction to your proposal but it cut to my very core. I am sure that if I stay calm and listen carefully that your idea might make much more sense than what I did two summers ago."

THE CONCEPT GETS FLUSHED OUT

Richard nodded as his friend explained himself. "I had no idea you had rented your home," he replied after Stephen had finished. "I can see that you would have some concerns. But, I'm not talking about that kind of rental at all. What I am talking about is helping young couples and young families, people perhaps in their twenties or early thirties, who have very good references except perhaps a minor past problem with their credit." Davis let that statement settle in for a moment before he moved on to explaining the details of his plan.

"Go on" chortled Hodgetts "I follow you so far."

"We would then work backwards--working with a real estate agent, who I have already lined up by the way, we would identify the rental range that these individuals could afford. After some thorough research, Norma, the agent, believes that we could rent a three bedroom two bath house for between $1,100 to $1,400 a month, based upon location and house amenities. Most of our target group already pay this kind of rent for apartments or trailers and many live in slum conditions."

He sat up on the edge of his seat as he continued, his excitement growing, "She also tells me that three bedroom homes sell new for around $175,000, with real estate taxes of around $1,000/year. David, my mortgage lender, tells me that we could put as low as 5% down and qualify for a 5%, 30 year mortgage if we bought this property as a second home. The monthly mortgage payment would then be around $900/month. Variable mortgages, like a five year adjustable rate, would have even lower monthly payments."

"You've obviously done some homework on this" commented Hodgetts "but I would think that there are other costs that we have to consider. For example, what would closing costs run us for a mortgage? What costs would we have to put into this new home to make it livable, i.e. appliances, a yard, etc ...? I do not want to sound negative, but we need to delineate all of our costs before we walk into this venture." Davis could tell by Hodgetts' last comment that his old partner was becoming interested and decided to forge ahead with more details.

"Yes, as always, you are right on the money, if you will pardon my pun. We'll need to work out the particulars before we forge ahead. However, I want to explain the big picture to you of our operation. We will not be like normal landlords--first, our objective is to sell these homes within three to five years to our renters. Our renters will hence be only those people who are serious about entering into a three year rental arrangement with us with the long-term goal of buying their rental property. In order to accomplish this task our real estate agent will work with potential customers to find them a home that they would like where the rent is affordable yet they do not have the economic wherewithal to purchase the home outright.

"Over this three year period they will be building up their credit rating, assuming they pay their rent in a timely manner, and earn a $100/month credit towards the purchase of their home. In the interim, David, our mortgage lender, will work with the renters to help them clear up any problems with their credit reports and work with them so that they may qualify for special loans requiring very little down payment for first time home buyers (such as FHA and Fannie Mae)."

"That's nice" sarcastically interjected Hodgetts "we're not going to be slum lords, oh no, we're now going to become philanthropists and social workers. We're going to help the poor and downtrodden become homeowners while putting ourselves out of business and with nothing to show for it once they bought our homes--what is in this for us?"

"My dear Hodgetts" countered Davis "if you would just give me a chance to finish I'm sure you'll see where this arrangement is mutually beneficial to both us and the renters. As much as I strongly believe in social capitalism, I am in this to make a profit!"

"First, of course, we will have developed a rental formulae that will translate the buying price of a home into a rental price that will yield us a profit of at least 20%. My goal is to make at least $200/month per rental, not counting administrative costs associated with managing our operation. Second, homes in our area are appreciating in value about 5% every year. A $ 174,000 home today will be worth slight over $200,000 at the end of a three year lease. Selling the home back to the homeowner will yield $26,000, a 13% profit. If you add up all of the profits, we would make $7200 dollars on rental fees over the first three years, and lose $3600 for rental credit towards home purchase; all told, we would make over $20,000 dollars in three years with an investment of less than $10,000 (the mortgage down payment). That's certainly better than the stock market during its best performance in 1999! Think of it, if we buy ten homes between us, that's only $50,000 per person, we each could make over $ 100,000."

ENTRY OR EXEUNT?

After a long pause, Hodgetts gathered his wits and exclaimed "This all sounds very well and good, too good in fact. Nothing personal Richard, you are very bright, but if an English professor with no experience in business could figure this out for himself why haven't savvy business people jumped onto the same band wagon? I am not an avid reader of either the Wall Street Journal or Investors Business Daily but I do read the New York Times and I have yet to hear of such an easy money-making deal. I cannot believe that such an simple scheme has not reached nationwide proportions or does not have an obvious flaw or two."

No one spoke for just a moment as both men thought over their arguments. Finally, Davis sat back and uttered, "Me thinks thou doest protest too much," in his best Shakespearean tone. He continued to combine rhyme and verse of the great bard in order to make his point. "For there are more things in heaven and earth, Horatio, than are dreamt of in your philosophy. Thou know'st we work by wit and not by witchcraft, and wit depends on dilatory time. Yet how poor are they like yourself that ha' not patience! What wound did ever heal but by degrees? I have come to live it wealthily in Padua; If wealthily, then happily in Padua."

"Hooray, hurrah" exclaimed Hodgetts. He merrily joined in the Shakespearean quote fest. "Cromwell, I charge thee, fling away ambition. By that sin fell the angels. Away, you scullion! You rampallion! You fustilarion! I'll tickle your catastrophe! For when sorrows come, they come not single spies, but in battalions ... The fault, dear Brutus, is not in our stars, but in ourselves ... Men at sometime are masters of their fates. We know what are, but know not what we may be. But if you can look into the seeds of time, and say which grain will grow and which will not, speak then to me. For then we will venture once more into the breach, dear friends, once more. We'll cry 'havoc!' and let slip the dogs of war."

ENDNOTES

(1) https://www.dwdean.com/DWDean/Secure/AuthFrame/ frames.asp?ID=233&EXID=&Language=en&ENID=17425&Account=232016409&month=, April 3, 2003.

(2) The names have been changed at the request of the subjects.

Herbert Sherman, Southampton College--Long Island University

Daniel J. Rowley, University of Northern Colorado