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Real Estate

What Drives the Prices of an Asset?

One is missing a very big part of the market if one restrict themselves to investing in stocks.  While it is obviously true that some companies bring in more profits than others, and subsequently their company’s stocks perform better, just as importantly (if not more) is what is happening to the entire asset class as a whole.   If the entire residential real estate market is crashing down where you live, installing new hardwood floors and granite countertops isn’t going to help you recover what you paid.  In the same way, your stock doing 20% better than its peers isn’t going to help you much if the whole market has dropped 40%.

How an asset class performs is generally based on a few major factors.  Is the supply of money in the world increasing or decreasing?  Are people throwing said money around more often or less often?   And, obviously, what are they throwing that money at?

Much of the time, you’re going to get conflicting signals.  Maybe the money supply is shrinking, but stocks happen to be the most popular asset class.  In fact, rarely will you find all the signals pointing in the same direction.  One of those rare times was the run-up to the beginning of our current depression towards the asset class whose bubble ended up bursting… real estate.  When more and more money was being pumped into the system, via the federal reserve, people had more and more money to spend.  Banks were issuing more and more credit (more on credit creation later), and interest rates were dropping, meaning that people could afford to borrow more and more money.  Now that lead to an increase of price in most asset classes, but none moreso than the favorite asset class of the middle class, residential real estate, for the simple reason that your “investment” is something that you live in.

And as long as all of those factors stay moving in a forward direction, you can rest assured that prices will keep going up.

But of course interest rates can only go so low.  One can only take so much debt before they reach a level that they cannot pay back.   And when some of those factors that push the amount of money in the asset class’ system start to turn to the other direction…  well, you know what happens next.

Income: The Final Nail in the Coffin For Inflation

Last week we covered how we can use debt to fight inflation, not only by requiring less money to secure possession of an appreciating (at least in the eyes of inflation) asset, but by shrinking the debt that we take out to secure it.  While that shrinkage usually does not make up entirely for the interest payment, it usually will take a rather large chunk out of it, resulting in a real interest rate (interest rate minus inflation rate) of 1-3%.    That combined with the “appreciation” of the asset (the nominal value increasing not because the asset is becoming more valuable, but because the dollar is weakening), leads to a small gain in real terms (after inflation is factored in).

But there is one last thing that you can do that will take your returns from gaining slightly against inflation to shooting it through the roof.

Income.   Income doesn’t just kinda-sorta keep up with inflation like most asset’s value does.  It keeps up with it absolutely.   Have your electricity and water bills stayed constant over say, the last 5 years?  Hell no!  Have restaurant prices?  Get outta town!  Has the price you’ve paid at the gas pump stayed constant?  Girlfriend, please! (OK, I’ll stop now.)

If you find yourself an asset that produces income that keeps pace with inflation, while simultaneously “appreciating” (see above) over time, you’ve got yourself a winner!   You couple that with the power of inflation to shrink debt, and your investment is flying!

For example, say you take a loan at 4% interest.   You put down 25% of the value as a down payment, using the loan for the other 75%.

While your last payment will be the same number as the payment is worth today, but that number of dollars will be worth much, much less by then. If the average rate of inflation over the life of the loan works out to be 3%, you’re going to have paid roughly 1% more than you took out in terms of today’s 2018 dollars.  At 4%, you break even, at 5% you’ll have paid less than the value of the loan and so on.      Ditto for how much your investment has appreciated.  If the value of your asset has gone up 5% in one year, but inflation was 4%, you made real value, if it only went up 3%, you lost it.   Depending on what kind of assets you choose, we’re hovering around breakeven territory.

But now… let’s add income from say, a rental property.  Let’s be conservative and say that it generates 2% of the value of the building after expenses and the mortgage service.   Since you’ve only put 25% down, that’s actually an 8% return cash-on-cash.    And here’s the real beauty…. the value of your rents go up every year with inflation, but the debt payment doesn’t.   That 8%?  That’s year one.  By the end of a 20-30 year loan, your debt payment will be half to one third the size relative to the rents.  Your yearly return on that down payment will be much, much higher.  

You’ve borrowed money from the bank which you’ve paid back at a tiny real interest rate to make a great return on investment.  And if inflation spikes at some point in that 20-30 years because, say, our government has debt payments that are way too large to service any other way, you may even be paying a negative real interest rate.  To make money!

Everybody dance now!

How Counting Chickens Before They Hatch Can Kill You

I recently found out that a house that I had bought in a small town for my mother to run a small business in has since tripled in value since I bought it 12 years ago. (It’s not in America.)

Does that mean I’ve made three times my money? Not even close.

There seems to be a prevailing myth out there that a home is a terrific investment. While it can be ok, it’s certainly not a no brainer. In fact, it is not unusual to only break even on a house EV-wise (expected value… in this case, inflation adjusted profit) even when you haven’t lived through a massive housing correction like America just has.

There are all sorts of expenses that go into the care and maintenence of a house that eat into your “profits”.

For example’s sake, let’s say I purchased the house at 33k, and is now “valued” at 100k. “Gross profit”: 67k.

First, before you even walk in the door, there’s taxes. Depending on what state or province you live in, you are probably going to have to pay 5-15% sales tax to get ahold of a piece of property. Selling with a real estate agent? Tack on an extra 4-7% in commission. Then there’s property taxes and homeowner’s insurance. Typically around 1-2% of the home’s value combined. Paid every year. 12 years. Ouch. Home maintenence. Say another 1% per year to keep everything in shape and keep up curb appeal. Most years will be less, but some will be a lot more.

Finally, you didn’t buy that house cash, did you? Uh oh. Then you’re paying interest, and a lot of it. With a 20 year loan at 4% interest, expect to pay more than 40% than the value of your loan over the period of the loan. Want 30 years? Better bump that up to 75%. And if you need 30 years to pay off a mortgage, believe me, you can’t afford whatever home you’re looking at. You’ll be paying so much interest that even a small increase in interest rate is going to have your mortgage underwater. That’s how the American housing crisis got started in the first place.

Now the wild card in all of this is inflation. It works on several variables of the equation. Let us assume that we will see an average of 3% inflation per year, which over 12 years means that the value of a dollar declines by one third. Your yearly expenses keep up with inflation, which means that every 12 years, you’re going to be paying 50% more for them. So does the value of the house. In fact, it’s a major driver of the appreciation of real estate. If a $33k house is worth $50k 12 years later, it may have “made money”, but it hasn’t appreciated a single iota in real value. So in EV terms, my gross profit is only twice what I paid for the house (before expenses), not triple.

So take a 100% gross profit, and take off say 10% for commission and taxes. Then 3% (proerty taxes, insurance, maintenence) times 12 years, reduced to 1/2 to account for appreciation/inflation (because 3% when it was worth 33k is not as much as now that it’s worth 100k). No, that’s not the exact math. It’s just ballparking, but it’s close enough. That’s another 18%.

Then there’s the interest on your loan. Your payment does not go up over time unless interest rates do. But inflation marches on regardless. A $200 payment per $30k of loan may suck now, (it will really suck), but 12 years from now, it’s going to feel like a $100 payment. Of course, you’re paying an inflated price for your home because of the interest you pay. But when your interest rate and inflation are equal, (which is pretty close to the case these days) they effectively cancel each other out.

But when the interest rate you pay is higher than inflation (most of the time), then you’re losing value by paying more interest than inflation shrinks the value of your payments. Which means you’re losing EV via interest.

So I haven’t really tripled my money. I’ve made anywhere from 20-70% in EV based on how big my loan was.
Wow, what a letdown. I could have made more money just buying 25k worth of gold and hiding it under my bed.
And I GOT LUCKY. If the house was in America, I would have lost a boatload of EV.

So what’s the good news? Well, it’s twofold.

How many assets do you know that would have even kept up with inflation over the last 12 years (50%)? Stocks? Nope. Bonds? Sorry. And did you have 25k just laying around 12 years ago to buy gold with?

Here’s the beauty of home-ownership. It doesn’t have to keep up with inflation. It has function above and beyond that of an investment, unlike gold.

We all need a roof over our heads. Our physical bodies, at least in a financial sense, are liabilities. We have to pay money each month to keep them going. If you didn’t own a house, you’d have to pay rent. That money is going out the door regardless. And let’s say you bought a house 12 years ago, saw it appreciate 3% a year (which works out to a 50% increase… a 50k house would be worth 75k twelve years later), but then lost it all in the housing correction in 2008. Sure, you lost value, because your house is worth the same money as 12 years ago, and a dollar is worth only 2/3 as much as 12 years ago, but you would have had to pay that much EV in rent anyways. It was actually a breakeven situation, not a loss!

But if you were counting on a gain to balance out bad spending habits…. you are effectively floating up Shit Creek.  Paddle sold seperately.  Basically, buying a house is not really an investment. It is ideally a way to turn a liability (needing a place to live) into less of a liability, or hopefully breakeven or even make a little bit of EV over time if you’re lucky.  But if you’re buying a house assuming it’s going to make you money down the road, make no mistake… you are not investing, you are gambling.

Not only that, but if you’re counting on making money on your house, you are almost certainly going to buy more house than you need, (or can afford) and thus unwittingly be taking risk on par with that of derivative traders.

And you ain’t getting no bailout.

How long will it take for the American housing market to rebound?

Personally, I think you’ll be waiting a long time. There are many factors that contributed to the housing bubble in the United States in the first place, and most of those were temporary factors.

For example, interest rates are currently as low as they will go. The Federal Reserve has been on record as stating that they intend to keep these superlow interest rates around for at least a couple of years. But, even with the availability of all of this super cheap money, the housing market has failed to work its way back to where it was. At some point, interest rates are going to have to start to climb again. At which point, money will become more expensive to borrow.

Another factor in this equation is simple supply and demand. Back in the day when even a simple job like a customer service rep paid enough money to buy a house, there were many more people in the market. Demand was high. But now, most low-level information service, manufacturing, and most unskilled labor jobs that don’t require the work be done in the same country have been shipped overseas, where the price of labor is drastically lower.

Put yourself in the position of a business owner, but would you rather do? Would you rather pay 10 people in America $10 an hour plus benefits plus payroll tax to do a job that can be done in India by 13 people for one dollar an hour? So until America’s unskilled labor rates become competitive with the rest of the world, or transport costs skyrocket so much that it becomes more cost effective to hire locally, those jobs are never coming back. Realistically, can you envision a reality where Americans back a politician that wants to do away with the minimum wage that makes our unskilled labor market so uncompetitive?

On the other side, there may be a growing demand for housing away from oceans, as cities like New York and New Orleans find themselves in increasing danger of becoming Venice or even Atlantis down the road, and people start to move away from cities on faultlines like San Francisco, but we realistically have no idea when those issues will come to a head. On the time scale of 100 years down the road, real estate further inland will have a major driving force pushing up its prices as people move away from the coasts as water levels rise across the world.

But call me shortsighted, I don’t have a 100 year outlook on my investing.