With an obvious homage to Whitesnake, I do certainly feel that I was meant to walk alone. Only this time I dare prognosticate a financial twister: the next real estate bubble.
Recently I have been reading several articles on the "inter webs" about how great a time it is to invest in real estate. Especially, the rental market. One pundit after another has been extolling the upsides to investing for renting.
Exhibit A: http://finance.yahoo.com/news/first-person-why-invest-rental-properties-now-151500067--finance.html
Here is my rebuttal of all the reasons mentioned in the article
Lowered Asking Prices
"The way real estate works it's either a buyer's market or a seller's market. Right now most of the U.S. is definitely in a buyer's market."
That is unless you actually step out to purchase a house. Then you realize that it is a market for everyone else other than the individual buyers and sellers. There are frictional and intermediary and hidden and unexpected costs all over the place. There's a buyer's agent, a sellers agent, an escrow company, an appraiser, an under writer, insurance agent, the home owner's association, just to name a few (I'm sure I'm missing several such as lawyers to draft your purchase / sale agreements, tax consultants etc.). If you are not paying outright cash, then there is of course the lender, a loan officer and a small army of nearly robotic paper pushers. OH and then there's the government city, county, state and federal, who all want a piece of the tax pie. ALL of these hardworking people and their families must be supported by the actual two parties transacting: the buyer AND the seller. This MUST mean that, for all these middle entities to get paid, on average, the buyer must bear the burden of a higher selling price than the "natural price", while the seller must suffer the depletion of wealth as the shylocks secure their pound of flesh.
What this means is it is typically a "buyers' market" for the seller, and a "sellers' market" for the buyer. In reality it is a feast for the parasitic elements in the transaction.
Never, in any investment, should a "lower price" be the motivation to buy. I'll elaborate my thoughts on this a little further down since it hits at all the points mentioned in the offending article.
More Renters
"More foreclosures means more renters. When homeowner's lose their homes, they often turn to renting from private landlords, so you'll have a large customer base."
Grant Programs
"If you're willing to fix up and rent a blighted property, you can receive grant money. The amount you'll get varies by program, but it will help cover the cost of purchasing and repairing a rental home."
Higher Rent
"Another advantage to having more renters is an increase in demand. Real estate works much like any commodity. When there is a higher demand than there is a supply, prices increase. As a future landlord, that is great news for you."
Let's get this straight: the author is saying that people who just lost their houses are going to be forced into the renters market, and because of this, the demand shall increase leading to lofty rental rates. Consequently, in expectance of large future cash-flows (rents), it is a smart move to purchase properties to let, even at increasing prices, so that some of this rental money may come your way.
Do you see the fallacy in her argument? Yes, demand and supply do influence prices. HOWEVER, the range of conditions where the relationship is predictable is fairly narrow. The author is talking about a market full of people who probably lost all their savings during the foreclosure of their property. This population then has very little means to pay lofty rents, even if they are forced to sign agreements: they are in the market because they violated the covenants of their mortgage agreement!
Expecting a steady monetary supply from a bankrupt leasee is tantamount to foolishness. Since the underlying conditions of the market are changing, the corresponding price equilibrium price points must change too.
Furthermore, such a population would also be in no position to be high value consumers. Since economies, and particularly the US and developed economies, are largely consumer driven, a financially hurting population implies shrinking markets, which would in general, imply large scale layoffs.
The only folks who benefit from a frenzied buying of properties to rent to population too bankrupt to support a roof over their heads are the mortgage lenders and the parasitic middle men.
Currently, the large banks and lenders hold several trillion dollars of "under water" illiquid foreclosed assets on their balance sheets. These would ideally take at least a few years to clear, even at the peak bubble rates of 2005.
(Sidebar: Note that "value" is different from "price". "Price" is what fetches in the market, while "value" is what something is truly worth. If Price is below value, then the buyer got a bargain. When price is above value, then the buyer got a raw deal. It is the exact opposite for the seller.
Truth be told, the true worth of anything is subjective. Think "beauty is in the eyes of the beholder". In normal circumstances, market prices typically track or approximate the average notion of worth exhibited by all market participants. In Adam Smith's parlance, the "intrinsic value" or "true worth" of some good - at a given time and place- is how much "manual effort" the commodity can command in that moment and at that location.
For the following discussion, it is taken as an axiom that the "value" of property remains fairly constant over long periods of time (assuming underlying fundamentals remain the same), and that an estimate of this "value" may be derived through a long term average of its market price)
Also, the Fed MUST at some point raise the rates OR cause inflation by pumping in more money into the system. If they raise interest rates, house prices MUST correspondingly fall: Since if values are to remain relatively constant, the total value of principal and interest that an investor can pay must remain constant. So if the rates increase, the increase in interest payments must be offset by a corresponding diminishing of the down payment. Typically down payments settle to a fixed proportion of the home price, implying the market price of real estate must fall.
The alternative is more inflation via "quantitative easing". This would essentially mean that the interest payments would be worth less. E.g. If $3 today buys a bottle of beer at a restaurant, in a period of double inflation, the same $3 would either buy half a bottle of the same beer, or equivalently, the full bottle would cost $6. This means in real terms, the value of each interest payment would be less, so the down payment needed would be higher, meaning the property price must tend to increase so that the value remains constant.
While the inflation scenario seems to be profitable, it isn't. In some ways it is a gradual wealth erosion. Here's how: suppose the buyer had $100k in their bank prior to inflation, to be used as the down payment on a $300k house. If double inflation kicks in prior to the down payment being paid, the home price will tend to rise to $600k, which means to achieve the same level of down payment 30%), the buyer would now have to pay $180k. Consequently, the home price increase is no longer sustainable.
High inflation also means that potential renters' savings will dwindle and they will find it harder to make their rents, and will also impact consumption. This will lead to the same downward spiral as in the increasing interest rate scenario.
This all spells trouble for the fool hardy "investor" who plunks down premium prices in expectation of rosy rental returns because the "prices are lower."
I do NOT mean to say that The Savvy Investors cannot make money in this endeavor or this economy. They can, but only if they are savvy or know something that the rest of the market does not. A real estate investment is still a good choice for those wealthy folks who wish to diversify, provided their combined investment bears no more risk to reward ratio than can be achieved through other means or channels (e.g. Stocks, bonds, commodities, cash).
Do thy homework, and not listen to any prognosticator (yours truly included!), lest ye fall prey to the taxicab indicator.
Recently I have been reading several articles on the "inter webs" about how great a time it is to invest in real estate. Especially, the rental market. One pundit after another has been extolling the upsides to investing for renting.
image source: house_for_sale_sign_hg_clr.gif via On the Edge by Kristi Gustafson Barlette
Exhibit A: http://finance.yahoo.com/news/first-person-why-invest-rental-properties-now-151500067--finance.html
Here is my rebuttal of all the reasons mentioned in the article
Lowered Asking Prices
"The way real estate works it's either a buyer's market or a seller's market. Right now most of the U.S. is definitely in a buyer's market."
That is unless you actually step out to purchase a house. Then you realize that it is a market for everyone else other than the individual buyers and sellers. There are frictional and intermediary and hidden and unexpected costs all over the place. There's a buyer's agent, a sellers agent, an escrow company, an appraiser, an under writer, insurance agent, the home owner's association, just to name a few (I'm sure I'm missing several such as lawyers to draft your purchase / sale agreements, tax consultants etc.). If you are not paying outright cash, then there is of course the lender, a loan officer and a small army of nearly robotic paper pushers. OH and then there's the government city, county, state and federal, who all want a piece of the tax pie. ALL of these hardworking people and their families must be supported by the actual two parties transacting: the buyer AND the seller. This MUST mean that, for all these middle entities to get paid, on average, the buyer must bear the burden of a higher selling price than the "natural price", while the seller must suffer the depletion of wealth as the shylocks secure their pound of flesh.
What this means is it is typically a "buyers' market" for the seller, and a "sellers' market" for the buyer. In reality it is a feast for the parasitic elements in the transaction.
Never, in any investment, should a "lower price" be the motivation to buy. I'll elaborate my thoughts on this a little further down since it hits at all the points mentioned in the offending article.
More Renters
"More foreclosures means more renters. When homeowner's lose their homes, they often turn to renting from private landlords, so you'll have a large customer base."
Grant Programs
"If you're willing to fix up and rent a blighted property, you can receive grant money. The amount you'll get varies by program, but it will help cover the cost of purchasing and repairing a rental home."
Higher Rent
"Another advantage to having more renters is an increase in demand. Real estate works much like any commodity. When there is a higher demand than there is a supply, prices increase. As a future landlord, that is great news for you."
Let's get this straight: the author is saying that people who just lost their houses are going to be forced into the renters market, and because of this, the demand shall increase leading to lofty rental rates. Consequently, in expectance of large future cash-flows (rents), it is a smart move to purchase properties to let, even at increasing prices, so that some of this rental money may come your way.
Do you see the fallacy in her argument? Yes, demand and supply do influence prices. HOWEVER, the range of conditions where the relationship is predictable is fairly narrow. The author is talking about a market full of people who probably lost all their savings during the foreclosure of their property. This population then has very little means to pay lofty rents, even if they are forced to sign agreements: they are in the market because they violated the covenants of their mortgage agreement!
Expecting a steady monetary supply from a bankrupt leasee is tantamount to foolishness. Since the underlying conditions of the market are changing, the corresponding price equilibrium price points must change too.
Furthermore, such a population would also be in no position to be high value consumers. Since economies, and particularly the US and developed economies, are largely consumer driven, a financially hurting population implies shrinking markets, which would in general, imply large scale layoffs.
The only folks who benefit from a frenzied buying of properties to rent to population too bankrupt to support a roof over their heads are the mortgage lenders and the parasitic middle men.
Currently, the large banks and lenders hold several trillion dollars of "under water" illiquid foreclosed assets on their balance sheets. These would ideally take at least a few years to clear, even at the peak bubble rates of 2005.
(Sidebar: Note that "value" is different from "price". "Price" is what fetches in the market, while "value" is what something is truly worth. If Price is below value, then the buyer got a bargain. When price is above value, then the buyer got a raw deal. It is the exact opposite for the seller.
Truth be told, the true worth of anything is subjective. Think "beauty is in the eyes of the beholder". In normal circumstances, market prices typically track or approximate the average notion of worth exhibited by all market participants. In Adam Smith's parlance, the "intrinsic value" or "true worth" of some good - at a given time and place- is how much "manual effort" the commodity can command in that moment and at that location.
For the following discussion, it is taken as an axiom that the "value" of property remains fairly constant over long periods of time (assuming underlying fundamentals remain the same), and that an estimate of this "value" may be derived through a long term average of its market price)
Also, the Fed MUST at some point raise the rates OR cause inflation by pumping in more money into the system. If they raise interest rates, house prices MUST correspondingly fall: Since if values are to remain relatively constant, the total value of principal and interest that an investor can pay must remain constant. So if the rates increase, the increase in interest payments must be offset by a corresponding diminishing of the down payment. Typically down payments settle to a fixed proportion of the home price, implying the market price of real estate must fall.
The alternative is more inflation via "quantitative easing". This would essentially mean that the interest payments would be worth less. E.g. If $3 today buys a bottle of beer at a restaurant, in a period of double inflation, the same $3 would either buy half a bottle of the same beer, or equivalently, the full bottle would cost $6. This means in real terms, the value of each interest payment would be less, so the down payment needed would be higher, meaning the property price must tend to increase so that the value remains constant.
While the inflation scenario seems to be profitable, it isn't. In some ways it is a gradual wealth erosion. Here's how: suppose the buyer had $100k in their bank prior to inflation, to be used as the down payment on a $300k house. If double inflation kicks in prior to the down payment being paid, the home price will tend to rise to $600k, which means to achieve the same level of down payment 30%), the buyer would now have to pay $180k. Consequently, the home price increase is no longer sustainable.
High inflation also means that potential renters' savings will dwindle and they will find it harder to make their rents, and will also impact consumption. This will lead to the same downward spiral as in the increasing interest rate scenario.
This all spells trouble for the fool hardy "investor" who plunks down premium prices in expectation of rosy rental returns because the "prices are lower."
I do NOT mean to say that The Savvy Investors cannot make money in this endeavor or this economy. They can, but only if they are savvy or know something that the rest of the market does not. A real estate investment is still a good choice for those wealthy folks who wish to diversify, provided their combined investment bears no more risk to reward ratio than can be achieved through other means or channels (e.g. Stocks, bonds, commodities, cash).
Do thy homework, and not listen to any prognosticator (yours truly included!), lest ye fall prey to the taxicab indicator.
