Article: "If you own a small business, you already know it's possible to be very successful and still have little to show in the way of liquid wealth"

Article: "I confess: I Rent"

If you own small business, you already know it's possible to be very successful and still have little to show in the way of liquid wealth. When you sell out, it's a vastly different story.

Whether it's a desire to retire, an urge to move on or a family situation that necessitates a business sale, the sudden shift from illiquid assets to a sometimes quite substantial pile of cash brings with it a new set of investment concerns that often requires professional advice.

Though most small businesses sell for less than $10 million, according to Matthew Tuttle, a financial planner in Stamford, Conn., that one cashier's check can catapult shopkeepers, restaurateurs and service professionals from a string of lean monthly profits to the ranks of what the financial-services industry calls the mass affluent, meaning they've got a liquid, investable net worth of anywhere from $500,000 to $3 million.

It's quite a shift, and it requires lots of support. Cashing out comes at the end of a long string of big decisions, often including difficult negotiations to value and sell what amounts to the sum of a life's work — and a life's net worth. It means big changes in your life, and bigger changes in your assets.

You see a lot of small-business owners who may have a very high net worth on paper, but don't have two nickels to rub together," Tuttle says. "You may know what your business is worth, and know that it's worth a lot, but it may not seem real to you because you've been so busy running it. All of a sudden, you have a whole pile of money. From a financial-planning perspective, it brings up a whole lot of issues."

The process worked pretty smoothly for Kevin and Gloria Fear, who founded the Fear & Fear insurance agency in Syracuse, N.Y., in 1980 and sold it in January for $4.5 million. Kevin Fear, 70, says the couple had cut back their roles over the last few years and hired a financial planner after the sale. He says their financial plan was a simple one that put much of the proceeds into a mutual fund portfolio, which his advisor did after Fear filled out an extensive questionnaire about his financial goals. Now the Fears are free to travel at their leisure, and can visit their daughter and grandchildren in the San Francisco Bay area more frequently.

The hardest part is getting used to not going to work every day," he says.

It's not always so simple, cautions John Dini, a business broker with San Antonio-based MPN Brokerage. The effort of running a small business can create a kind of tunnel vision, he says. Without a post-sale plan — and sound legal and tax advice from a certified public accountant and an attorney as the deal goes through — the light at the end of the transaction tunnel may be a train.

So many sellers are clueless until about five seconds before they're ready to go," Dini says. "A lot of entrepreneurs got into their businesses without a whole lot of up-front planning, and, unfortunately, too many of them exit the same way."

Quite often, there's baggage along with a pile of cash. Many business sales are tied to one of the "Dismal Ds," says Dini, meaning death, divorce, dissension between partners, declining sales or debt. Also, many younger sellers simply plow the proceeds back into another business, staying true to their entrepreneurial orientations. But once the decision to cash out is made, it's a big shift, he says.

"The sales process can be very distracting, and the psychological effect is immense," he says. "We're very reluctant to take on a client who has no plan for after the sale."

That plan doesn't have to be all that complex, but it does have to get worked out in advance, says Kirk Francis, a financial planner with Cross Financial Services, a San Antonio company that's worked with some of Dini's clients. He says it's not radically different from any initial meeting with a financial planner — you're better off if you know what you want to do and how much risk you can tolerate before you walk in the door — but a business seller's perspective is a singular one.

"It's hard to plan how to manage your assets when you're running a business, because a majority of them are tied up in the business and fairly illiquid. All of a sudden, that money is reality," Francis says. "Now you have to figure out how much is enough to live on, and how do you diversify."

Tuttle says sudden wealth, from an inheritance or a Lotto jackpot, rarely leads to financial savvy, even when someone works with an advisor. But he says the methodical approach to financial issues cultivated by successful small-business operators makes them great clients.

"They tend to follow your advice more, and they don't end up blowing the money," he says. "In a lot of cases, the lottery winners or the inheritors do."

I confess: I Rent

I HAVE SOMETHING un-American to confess: I rent an apartment, despite having enough money to buy a house. I plan to keep renting for as long as I can. I'm not just holding out for better prices. Renting will make me richer.

I normally write about stocks for SmartMoney.com, but the boss asked me to explain to readers my reason for renting. Here goes: Businesses are great investments while houses are poor ones, so I'd rather rent the latter and own the former.

Stocks vs. Houses: Returns
Shares of businesses return 7% a year over long time periods. I'm subtracting for inflation, gradual price increases for everything from a can of beer to an ear exam. (After-inflation or "real" returns are the only ones that matter. The point of increasing wealth is to increase buying power, not numbers on an account statement.) Shares have been remarkably consistent over the past two centuries in their 7% real returns. In Jeremy Siegel's book, "Stocks for the Long Term," he finds that real returns averaged 7.0% over nearly seven decades ending 1870, then 6.6% through 1925 and then 6.9% through 2004.

The average real return for houses over long time periods might surprise you. It's zero.

Shares return 7% a year after inflation because that's how fast companies tend to increase their profits. Houses have their own version of profits: rents. Tenant-occupied houses generate actual rents while owner-occupied houses generate ones that are implied but no less real: the rents their owners don't have to pay each year. House prices and rents have been closely linked throughout history, with both increasing at the rate of inflation, or about 3% a year since 1900. A house, after all, is an ordinary good. It can't think up ways to drive profits like a company's managers can. Absent artificial boosts to demand, house prices will increase at the rate of inflation over long time periods for a real return of zero.

Robert Shiller, a Yale economist and author of "Irrational Exuberance," which predicted the stock price collapse in 2000, has recently turned his eye to house prices. Between 1890 and 2004 he finds that real house returns would've been zero if not for two brief periods: one immediately following World War II and another since about 2000. (More on them in a moment.) Even if we include these periods houses returned just 0.4% a year, he says.

Between World War II and 2000 house prices beat inflation by about two percentage points a year. (Stocks during that time beat inflation by their usual seven percentage points a year.) Since 2000 houses have outpaced inflation by six percentage points a year. (Stocks have merely matched inflation.)

Stocks vs. Houses: Valuations
But while stock returns have come from increased earnings, house returns have come from ballooning valuations, not increased rents. The ratio of share prices to company earnings (the price/earnings ratio) has remained relatively steady. It's about 16 today, close to both its 1940 value of 17 and to its 130-year average of about 15. Not so, the ratio of house prices to rents. In 1940 the median single-family house price was $2,938, according to the U.S. Census, while the median rent was $27 a month, including utilities. That means the ratio of prices to annual rents was 9. By 2000 the ratio had swelled to 17. In 2005 it hit 20. We can adjust for the size of dwellings, but it doesn't make much difference. The ratio of single-family house prices to three-bedroom apartments is 19. In SmartMoney.com's home town of Manhattan, where more detailed data is available, the ratio of condo prices per square foot to apartment rents per square foot is 22.

Two main events have caused house valuations to inflate since World War II. First, the government subsidized housing by relaxing borrowing standards. Prior to the creation of the Federal Housing Authority in 1934 house buyers who borrowed typically put up >40% of the purchase price in cash for a five- to 15-year loan. By insuring mortgages, the FHA permitted terms of up to 20 years and down payments of just 20%. It later expanded the repayment periods to 30 years and reduced down payments to 5%. Today down payments for FHA loans are as low as 3%. Aggressive lenders offer loans with no down payments or even negative ones so that house buyers can borrow the full purchase price plus closing costs. Some require little documentation of income, assets or ability to pay.

That means more Americans can win loans for homes, and they can win them for far more expensive (larger) homes than their incomes previously allowed. Two-thirds of American households own homes today, up from 44% in 1940, even though the percentage of Americans living alone has tripled during that time. The ratio of house values to incomes has risen 260% in just under four decades.

A second event helped boost house demand in recent years. Share prices plunged in 2000. The Federal Reserve, fearing that the decline in stock wealth would cause consumers to stop spending, reduced the federal-funds rate, the core interest rate that determines the cost of everything from credit cards to mortgages, to 1% by the summer of 2003 from 6.5% at the start of 2001. Since most of the cost of financing a house over 30 years is interest, monthly house payments shrank and demand for houses soared. In some markets a string of big yearly increases in house prices led to panic buying.

Stocks vs. Houses: Conclusion
For house returns over the next 20 years to match those over the past 20, the government and private lenders would have to "up the ante" by relaxing borrowing standards further. Given the recent attention paid to swelling foreclosures, that seems unlikely. I suspect real returns will turn negative over most of the next two decades, but that house prices won't necessarily dip. Since 1963 they've done so in only two years, vs. 18 for stocks. That's because homeowners mostly just stick it out rather than sell during soft markets. But if house prices remain flat, they produce negative real returns due to the creep of inflation. According to calculations made by The Economist in the summer of 2005, house prices would have to stay flat for 12 years with annual inflation at 2.5% for the ratio of prices to rents to fall from its 2005 perch to merely its 1975 to 2000 average.

On the following page I've tried to anticipate and address questions and objections.