Thursday, March 17, 2011

Why We Buy Property

Good news! I dislocated my shoulder which means I can't draw for a while and shall have to return to my lazy love of writing.

I have plans, big plans of writing a letter to my university that will change the very nature of education, and so today I thought I'd write about one section of it as sort of a first draft. There's so many concepts I don't know how they will all fit together yet.

My university like many others has adopted a practical bent, the focus of it's course structure, subjects, assesment etc is all geared towards preparing us for work. 'This is something you can use.' one will often hear of an assignment, a formula, blah blah blah.

I have graduated and worked once, my experience is that the soft skills (communication, reason, curiosity, feedback, time management etc.) are what gave me the biggest practical advantage, the hard skills (multiple linear regression, integrated marketing communication, gap theory of customer service, om's retail gravity law etc.) range between useless to a graduate or easy to learn on the job if they are necessary.

Whilst many institutions competing in a global education market have stressed practice over theory (at least in their marketing materials) I think (and this may be contentious) that having a strong theoretical or philosophical underpinning is actually the most practical thing a student can graduate with.

In simpler language, universities are now emphasising the HOW at the expense of the WHY. For some reason in my first degree many lecturers would seemingly boast that 60% of marketing graduates couldn't supply a definition of 'brand equity' one of the centermost concepts of the marketing field.

I feel in economics and finance, many graduates could not furnish you with a definition of 'investment' nor could many differentiate it from 'speculation', almost none would understand 'rationalization' and few after having sat through the subjects Investment and Risk Management would be able to define risk in non statistical terms.

These four terms alone though depending on a graduates understanding of them would powerfully transform the way they practice. I personally feel that it would be worth spending a semester hammering these four terms into students heads if not integrating them into the governments educational reform to teach financial literacy to children.

To illustrate the effects of such an underlying philosophy of investment I thought I'd look at one of my favorite pet peeves - property.

Straight up is property an investment? Well that depends on what your definition of investment is, if it is something you can spend money on then yes. But that is a broad and sufficiently meaningless definition of investment, by the same definition a sandwich is an investment.

What is an investment? Well an investment is an asset you can buy that will generate some kind of income stream. Thus an investment can be a factory that produces pies, that can be sold and if profitable that 'investment' will eventually pay for itself. It can also be a share in such a factory, these investments are referred to broadly as 'equity' and your share in the business will pay you some dividend from the profits. Or it can be an assett that pays interest or some other fixed income like a bond or debenture. And yes, it can also be property that has an income stream of rent.

So it probably isn't a shocking revelation that property is in fact an investment class. This is uncontroversial, what is controversial is the suggestion that property is only an investment because it generates rent.

There is a broader definition of investment that is fuzzy, that is it is hard to differentiate between a painting as an investment and a sandwich as an investment. It is to say that something can be an investment if you expect a capital gain.

A painting has no income stream. (As opposed to a museum) but may be expected to appreciate in value. These are referred to as 'greater fool' investments, because by purchasing an 'asset' that doesn't generate any income, you are a fool. Your only hope to profit from the purchase is to sell it to a fool who is willing to pay more money for it than you foolishly did. Hence 'greater fool'.

Certainly capital appreciation exists, particularly in property, but when is it as a result of sound investment and when is it a result of greater fool investment?

Enter pricing, enter - Business Finance. Here you learn to price all manner of assets through discounting. For example you can price a bond by discounting it's income streams to net present value. You simply take the Face Value, the coupon rates, the present interest rates (or yield) throw them in a formula and determine the net present value of all future cash flows.

You can do the same (albeit more fuzzily) with Shares. The net present value of a share (the price you should pay) is the discounted value of all future income streams. You can use some constant growth dividend formula to estimate a price for a share.

NOW for some reason with shares we assume rationality amongst purchasers, that is we don't factor in 'Capital Gains' into the constant growth dividend model because we say the price of the share is always determined by the future value of all dividends. That is a share can't appreciate in price without it being a direct reflection of expected growth in future dividends.

This does not however apply to property. I don't know whether to scratch my head at the Finance fields bounded rationality or applaud them for observing what happens in practice - but if you were treating property as an investment then you could determine a price for it based on the discounted value of future income streams - rent.

So you have a property that earns 10,000 rent per year, the interest rate on government bonds gives you the current yeild, you can calculate a fair price to pay for a house based on constant growth in rental income and prevailing interest rates. You can also use a simpler method of price/earnings ratio. That is you take the price of the property and divide it by it's projected (or historical) earnings and you will come up with a ratio that will tell you how long it will take to pay for itself. That is how good an investment it is.

No examples in my, or I suspect any course have ever applied these models to property. Why not?

Enter the importance of understanding speculation. One may assume you could fail constantly in the course by saying things that earn a rebuff from the professor 'that's not investment that's speculation.' Speculation rarely if ever has been mentioned in my course and sadly usually by students.

Being generous speculation is a type of investment, but is not really investment. It's a bad type, highly risky and profoundly irrational. It has more akin to gambling than investing. It is basically disregarding the underlying investment and focusing solely on changes in price.

In the case of property it is expecting prices to increase because they have increased. Most people would know speculation as 'investing for capital gain.' You are just betting on price changes. One can speculate on stocks of course, the internet bubble was an example, people were willing to purchase companies that had Price/Earnings ratios of 600 (this means for every dollar you 'invested' you could expect to be repaid via dividends in 600 years). Phenomenally over priced. People were buying these shares not because they had 600 years to wait for pay dirt or anticipating explosive growth in the companies earnings (though they may have told themselves so) but because they thought that tomorrow somebody would come along and buy that share back off them at 700 times earnings.

Property currently works like this as an investment, that is it is heavily speculative. Few people that own property cannot furnish a reason (that is a rational reason) why their property should appreciate in capital growth. Investing is intrinsically rational. It may not always be correct, and there are certainly good and bad investments because the world is unpredictable. But it is rational, speculation is not. Speculation is blind.

If my lecturers were to start to price property, what would they do? They would probably look at the rents, but they know that this would be a purely theoretical exercise. How could they look at capital gains. They would have to say 'Okay we expect the capital gains to be 10% per year...' WHY? We of course observe this happening 'out there' all the time, which I assume is why my educators have steared clear of touching property with any of our rational, reasonable pricing models.

Certainly 'investors' 'invest' for capital growth when it comes to property. What we want to understand is why would I pay a higher price for your investment than you did? Go on, just fucking try it.

I'm going to try it rationally. That is treat it like an actual investment, so let's look at the rental income. Even if you occupy your own property, there is still rent in the form of savings. The simplest thing to do is look at the rental income stream, typically a regular cash flow that comes in on a monthly basis. Now Net Present Value is the value of ALL future cashflows, so you have to estimate basically an infinite amount of rental income.

This may sound like no price is too high for property, but you are also discounting these infinite cash flows by an infinite number of time periods making such future earnings almost worthless. The time frame compresses, but basically I would need to make some assumptions about the future growth of rent income to put a price on the property.

Now rationally, I know that if I increase rents faster than household income, I am simply going to price myself out of tenants. Just as long term a companies 'constant' dividend growth can't be larger than projected global GDP growth because then we would be anticipating the company to grow larger than the worlds economy - which is by definition impossible.

So logically rents should follow wages. We can be greedy/optimistic and assume that rent will always be some fixed percentage of household wages (eg. 30%) or we can be conservative and assume that household income will grow faster than rents. (Which is reasonable because if rents grow faster, everyone will prefer to buy their own home than rent, a landlord has to provide some value to attract customers).

So all this is so we can price our property, thus logically the price will grow in line with growth in rental income, which will grow in line or follow growth in household incomes.

Who thinks (rationally) like this? Fucking no-one that's who.

We know in practice that over the past 16 or so years, property prices have grown faster than rental income, which in turn has grown faster than household income. The only way this sequence could be rational would be if it were reasonable to anticipate some massively transformative restructuring of the Australian economy resulting in widespread sudden appreciation in household incomes and subsequent rents.

Instead we have negative gearing, that is, you buy a house. You borrow money to do so, you get some tennants. They pay you $170 per week in rent (the prevailing market rate) and you in turn pay $200 to the bank to pay off your mortgage. Which is to say in purely rational terms, some joe is giving you $170 of their wages per week to live in your house. For the priveledge of having them live there you take an additional $30 per week out of your own wages and then take all their rent and pay it to the bank.

I would not be surprised if almost all rents in Australia wound up being paid to the bank. Certainly there are cash flow positive properties (where it pays more to own the property than it costs) and these are indeed 'investment properties' But if there were no hope of somebody paying to take that property off your hands, having a negatively geared property would simply drive you bankrupt.

The equivalent would be owning a business where you had to work a second job just to keep that business afloat. Few people who owned a milk bar would keep it if they had to pay $200 a week just to stay in business. You would sell it off and get out in a heartbeat. But people do the equivalent all the time with properties.

Similarly, even if you are quite wealthy and buy a house outright for say $3 million dollars. And that property earns $24,000 per year in rent ($166 per week for a 3 bedroom home) you have a price earnings ratio of 125. That property will pay for itself in 125 years! By contrast you can buy shares in Google at 21.35 times earnings. (as at today).

As per Peter Schiff said 'you don't invest to break even, Government (US) bonds are yeilding 3-4%, if you can't earn 6-7% on rent then why bother investing.' Few people make more income from rent than they would on an online savings account. Many more through borrowing lose money.

So why do people buy property? For the capital gain. But there is no rational reason for property prices to appreciate. That is the prices don't reflect the actual income generated by the property, just an anticipation of further price rises.

Few people would have the stones to admit that they expect property prices to go up because they have gone up. That is pure irrational momentum, but that is what they do.

Enter rationalization - According to the DSM-IV, rationalization occurs "when the individual deals with emotional conflict or internal or external stressors by concealing the true motivations for his or her own thoughts, actions, or feelings through the elaboration of reassuring or self serving but incorrect explanations."

That is you observe a phenomena - property prices increasing, you then furnish this phenomena with an explanation. The correct one in my belief was that banks loaned more money and people foolishly bid up the price of houses. The prevailing explanation is that Australia's population is growing faster than its supply of housing.

According to the 2006 Census data on the ABS Melbourne had 119,624 dwellings that were unoccupied. This represents 8.1% of the total housing supply of 1,471,154 dwellings. In 2001 Melbourne had 101,251 dwellings unoccupied representing 7.53% of the total housing supply of 1,344,624 dwellings. That means that between 2001 and 2006 (boom years globally) the surplus of housing actually increased. There are more empty houses now than there were before.

By contrast in the same time period the population only grew by 254 thousand people or 7% the supply of dwellings grew by 8%.

Thus the excuse/explanation/rationalization that has been popular for the past 5 years has no empirical justification. It is factually false. Australia has plenty of housing, population growth is not driving the prices, it is not a supply demand situation.

The importance of 'rationalization' to any prospective investor is crucial, in two regards. One the underpinning of almost all economic theory is in people's rational behaviour, rationalization is a topsy turvy kind of rational behaviour that is consistent but incorrect. Reason occurs when you observe an ice cube turn into a puddle, rationalization is observing a puddle and assuming an ice cube is there.

What is crucial is understanding how powerful rationalization is. The Census is the most statistically complete and reliable data available to Australians. It is available to the public for free, including journalists, business commentators, your parents, finincial advisors and government officials and yet its findings are emphatically ignored.

I observe academics that spend full time hours reading journal after journal to keep up to date on their thesis topics spout the same rationalisation of population growing faster than housing supply. I have only looked at Melbourne, but it is an Australia wide trend

How can so many people be so wrong? People who are supposed to be experts on this very subject? The short answer is I don't really know. The longer answer is because rationalization is all pervasive and very powerful.

Every bubble requires a 'new era story' that is an explanation of why things are different 'this time' - these were arguably more credible in the internet boom of the 1990's. The prospect of conducting business electronically, where products traded where software, where you didn't have the need for warehouses anymore and some kid in his garage could concievably take on Microsoft where plausible if improbable. It is hard to disprove something purely hypothetical, particularly with the speed of technological advances in the 1990s. E-business had literally never been seen before.

Property bubbles are harder to explain, they occur almost routinely. Neo-classical economic theory, and every model of investment cant explain why somebody would buy a property with a price earnings ratio of 250 and then supplement that income with their own to pay back a bank instead of just buying a bunch of shares in Google and reinvesting the dividends.

What it really really cant do is explain that even though assuming such irrational purchases occur in the first place, why people are rewarded with capital gains, or why somebody would come and pay an even higher price to lose even more money on the same investment whilst bailing out the last fool.

Furthermore, nobody can explain that while you can shove the raw data down somebody's throat or have it so readily accessible it is routinely ignored and the converse is accepted as fact, as gospel.

How can you have the school of Economics, Finance and Marketing and have Marketers sitting across the hall who believe that 'you can't tell somebody what "everyone knows is false"' without that rubbing off on Economists that believe that people are 'rational profit maximisers.' How do they coexist?

People buy property for a number of reasons, most of them emotional and very few rational. Property is simple, physical, you can go and touch it, walk through it, inspect the carpets and survey the ceilings. The numbers, the monies are abstract, people only observe the buy price and the sale price. They don't look at the returns of the rent, the maintenance costs, the depreciation of the physical premisis, the council fees, the taxation, the mortgage repayments, the risk of vacancy. They don't notice that unlike a portfolio of shares, you sell the whole house or keep the whole house, you can't liquidate part of it.

Property is for most people a terrible investment, the best that can be said of it is that it is a forced savings account. Your actual returns will if lucky probably track inflation, some make money by timing the market right, but in the end you will probably sell it for the present day equivalent of what you bought it for just like depositing cash and withdrawing it.

But many feel it is their paths to riches, and that is where the heavily statistically laden theories of 'risk' let us students down. Risk is much broader, comprises of both chance and consequences and is somewhat more than historically observed volatility and correalation. It is even contentious as to whether statistical theory is valid at all.

But in property again to illustrate, you have prices going up, how far will they go? If the market is characterised by speculation, there's no way to tell. Put simply, if there is no reasonable explanation as to why people are paying the prices they are now, then we can have no reason to expect somebody to pay a higher price tomorrow. Rationalization steps in and seemingly fills that gap. But it is just a story nothing more. The 'causes' of the phenomena are not actually occuring. Which means you cant turn to them to make predictions about the market, what I am saying is: if Australia's population actually started shrinking tomorrow - experts wouldn't bat an eyelid and still predict growth, because they haven't been looking at the population anyway.

The prevalence of stories to explain irrational market behaviour makes property risky enough for me simply not to touch it. I don't know how long the boom will continue, because there was no reason for it to get this high in the first place. Similarly, I have no idea when it will end - because there was never any reason for it to start, why should it need a reason to finish.

But consider this: If you saw a basket dangling in mid air and you couldn't see what held it up, Would you put your baby in it? Many parents are doing exactly this when they urge their children to buy a house right now.

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