Naive Investor Chapter 6: "Bricks & Mortar"

Before looking at Cash, the most common investment category for Naive investors we'll look at 'property' or 'the good ol' Bricks 'n Mortar [hok-sput!]' because this is the most common aspirational investment. By aspirational I mean, that almost by default the 'average' person, studies, works, saves and buys a 'house' then spends 40 years paying off the mortgage (present market conditions) or tries to get rich quick through property 'flipping' with or without first blowing money on renovations.
The eagerness generally, combined with social pressure (as Benjamin Graham said 'Much bad advice is offered freely'*) presses me to deal with property first, before looking at what you are more likely to have - cash sitting somewhere.

Earnings

How does property make money? The first (bad) piece of advice you will get from your parents at the kitchen table in Casa De Melton is: 'The house makes money from Capital Gains.' A view so prevelant that we have a highly dangerous and unpredictable financial bubble in the Australian domestic housing market. Forgive me if I go to pains to rectify this error - Capital Gains is a function of an appreciation in Price.

They are called 'Earnings' because they are EARNED.

Properties make money through RENT. Rent is the only way the business of accomodation makes money. It is the only actual income stream.

Properties make money through RENT. It is RENTED accomodation. RENT is the income of property. Properties only INCOME is RENT.

Think of them as a discount form of Hotel accomodation. They are very spacious, penthouse/villa-esque suites, maybe with Garden, crucially in some location. You generally rent the 'suite' for periods of a year, instead of by the day (or in a Japanese love hotel, hour). Because the customer is in principal 'bulk buying' their accomodation and paying off in installments, they get a discount. It may cost you a weeks 'rent' for a house to stay one night in a hotel that is not as spacious or comfortable.

They look different but this analogy will be useful when it comes to talking price. The other thing I will be at pains to point out is:

Even if YOU are planning to OCCUPY the residence YOURSELF, RENT is still the Earnings. You have to treat it as an opportunity cost though, weighing the 'ownership cost' (ie, mortgage repayments) against your next best option (renting a similar property off someone else).

Therefore, if you are an 'Owner Occupier' you must consider your SAVINGS in RENT as your income/earnings.

Price

Okay, just for you the investor - Price is what people are willing to pay for the property. But as an extra treat let's add an observable reality or 'rule of thumb' for the property market:

'A property is worth what a bank is willing to lend for it.' Which is to say that property is highly SPECULATIVE.

You may though have detected some condescention on my part in the introduction to this chapter. Namely ridiculing 'Bricks & Mortar' and also wrapping the word 'house' in quotation brackets. Here's why:

Unfortunately in Australia and most of the world, you don't buy a 'house' so much as a 'House & LAND' package. This is an important distinction, and why I actually prefer a seemingly vauger term like 'property' which I will use instead of 'house' from here on because they are not actually synonymous.

The 'bricks and mortar' are almost irrelevant to price and you need to understand that as an investor. Think of it logically, if you took your money and just bought a whole stack of bricks, what would you expect to happen to the price? The bricks would go down, in part to wear and tear and otherwise just inflation.

Bricks are a depreciating asset, just like a car, lumber, canned foods etc. When arranged into a house nothing changes, you just have to do more maintenance. The 'house' itself is actually a source of ongoing expense, just as a hotel room would need to be maintained cleaned and serviced every day - to some extent so too does a house.

The land determines the value and it is actually far more based on its relationship to the land around it (rather than itself). Namely infrastructure both man made and natural. If it is by the sea it is more useful, if it is near the city it is more useful, if it is near public transport, shops and hospitals it is more useful.

It is the LAND component to the 'House & Land' equation you pay through the nose for. The house will fall down, burn down or worse, be heritage listed, the Land will appreciate in value as the economy grows.

P/E Ratio

Now bear in mind you are an investor (albeit a fairly naive one, but an investor none the less) not a speculator. As such, we are concerned with determining Price as a function of value.

Hence the 'Price/Earnings' Ratio is important. So...

I grabbed a quote on a particular house we may wish to buy today (24-March-2010) in Essendon, its a 3 bedroom house to buy at $780,000.

A 3 bedroom house in the same suburb I obtained a quote for $420pw to rent. (Note I'm not being very thorough, I just wanted some figures to illustrate the example, there could be better prices, better rents, worse rents etc.)

So P/E ratio's are normally denominated in years or 'How many years it will take to earn back the investment/purchase price?' So $420*52= $21,820 pa.

$780,000/21,820 = approx. 35. Given BJG suggests 20 as an acceptable P/E multiplier, this investment is kind of risky, much of the earning value is already accounted for in the price.

Conversely assume a P/E ratio of 20, (Benjamin Graham uses this multiplier as acceptable) the price to buy the property at is $436,400 (it will pay itself off in 20 years, it is WORTH $436,400). But rents grow by a whopping 10% between now and this time next year. Then at the same P/E ratio the property would be WORTH $480,040. Even if rents increase by 10% it still wouldn't be WORTH $780,000 (to an investor). At an acceptable P/E ratio of say 25, rents would have to be $600 a week to pay the asking price, a whopping 40% increase. (I don't even believe that is legal to do in a 12 month period, so it would be IRRATIONAL to anticipate a 40% increase in rents).

Now, before moving on, I want to address the causal chain for a rational expectation that earnings (that is rents) would increase (or decrease).

Risk

Keeping it simple, lets look at the primary risk to an investor - that is we are primarily concerned about our earnings, they are what make the property valuable.

Thus the chief risk faced by a property 'investor' is a lack of tennants, a lack of tennants means no income. Without income your P/E ratio is infinitaly bad. There is a cost (at the very least opportunity cost) of having your money tied up in the property, when you can at least have it sitting in a bank account earning 1% interest.

For the investor a house with no tennants is the same as a company with no customers.

Now the investors emphasis on rents illuminates a causal chain effecting rational pricing decisions.

Tennants can only pay rents they can afford - therefore their wages have to be sufficient that they can sustain their daily needs (food, clothing, transport etc.) and have enough left over to pay rent. So rent will have a maximum, you cannot charge people more rent than they earn.

We have been gifted a nice rule of thumb in determining the rent people can afford called 'housing affordability' that is NO MORE than 30% of a persons take home pay can go to the cost of housing.

Therefore, to be confident of a rent increase you need to first observe a wage increase. The higher (affordable) rents the lower your risk, the higher a price for the same asset you can afford with confidence. Thus for house prices to increase you need to observe an increase in wages, which allows greater earnings via rent.

We generally don't observe this though, house prices have increased faster than rents which in turn have increased faster than income. This makes the speculative risk, quite risky...

Let me introduce what I tentatively call 'popular risk' if you are bitter and vindictive you may call it 'stupidity risk'. It is irrelevant to an investor but not the general public. It follows movements in price around.

Generally a minority of the public is financially literate. I suspect it is a small minority. Thus it is unreasonable to assume that people will act rationally to the system of finance simply because they do not understand the rules.

Furthermore your typical person is 'risk averse' that is they don't want to lose money they want 'easy money' or gains that require no effort or exposure to downside.

Most people learn through observing history. A naive forecasting method where you take what happened yesterday as indicitive of what will happen today.

Enter the problem of inductive knowledge. It is too lengthy to fully illustrate here. But I'll try to be brief:

Suppose you are a turkey. You observe the first day in your new coop that 'the farmer' comes and feeds you grain. You gather from this piece of evidence that the farmer has your best interests at heart. Next day same thing happens, another 'observation' confirming your theory the farmer is looking out for you. 1,000 days = 1,000 pieces of coroborating evidence that the farmer is looking out for you.

On day 1,001 the farmer comes wrings your neck and serves you up for lunch.

That's the problem of inductive knowledge. When you are at your most confident of your safety (1,000 pieces of corroborating evidence) you are actually in the most danger.

The housing market, in general works exactly the same. That is speculators who 'judge the underlying value of an asset by watching movements in price' watch the prices in the housing market. So if house prices increased by 10% last year, they treat this as evidence not that 'house prices have gone up' (which is true) but 'house prices will go up'.

Most people in other words are turkeys. They treat an increase in price as corroborating evidence that houses are valuable and will increase in price, not what should be immediately apparant to an investor that they are actually 'less attractive' because every price increase, increases the P/E ratio and erodes your margin of safety. (when looking to buy in).

Put simply the 'popular risk' is when prices and the market conform to popular (turkey) thinking. The forecast is this 'House prices will increase because they increased' the higher the price the more attractive. People want to buy in 'before it is too late' and we the investor become blind.

Mathematically the price has become a function of the price. It isn't based on anything except itself.

But there must be some limit? There is, people's ability to pay, which is a function of how much they can borrow (and then repay) when we are talking maximums. Hence 'A property is worth as much as Banks are willing to lend.'

Risk Part 2: Bank's Perspective

I feel that looking at property investment from the perspective of a bank is illustrative. Hence this special 'part 2' segment.

Most people buy properties through a type of loan called a 'mortgage' which means that the asset being bought serves as collatoral for the loan. This mitigates the lender (the banks) risk, because if you default on repayments they simply seize the asset and sell it.

Most people are turkeys, and most turkeys are ill served by something they are obsessed with: 'Negative Gearing' this means, they take a loss on the property purchase.

The mortgage repayments exceed the earnings (rent) from the property. They then deduct these losses from their assesable income reducing their tax. They then pat themselves on the back.

From the banks perspective, they earn interest on the loan. Their earnings are interest. If their customers were rational (if naive) investors then the rent repayments would cover the interest expenses. But they are turkeys so they pay ALL their earnings (income/rent) from the property to the bank, which the bank keeps. THEN they dip into their own pocket and pay the balance.

Your rent comes from the tennants productive income. The banks thus get paid part of the tennants income, then they are paid part of YOUR income.

From the perspective of 'earnings' the banks get premium earnings above what the property could attract on its own.

NOW, if you ask an economist (don't) they will be sorely tempted to explain interest rates in terms of 'supply & demand' that is at a high interest rate (say 10%) then banks will want to loan money out (to earn 10% interest) but, people won't want to borrow money (because it costs them 10% interest). If you lower the interest rate a bank will (supposedly) be upset because it isn't earning as much. People will be happy because the cost of borrowing funds is cheaper.

CRUCIALLY though this economic model works on the assumption that PRICES ARE FIXED.

Here is a more realistic model.

1. The interest rate is lowered from 10% to 5%.
2. People are happier to borrow money, demand for funds increases. (so far so good).
3. More people borrowing means more people bidding on property.
4. Demand for property increases. Supply is (relatively) fixed.
5. Property prices increase.
6. Banks lend MORE funds at LOWER interest.
7. The increased amount of funds (to cover the higher property prices) mitigates the lost interest (from lower interest rates) for the bank.
8. House prices HAVE increased thus (from turkey vision) they WILL increase.
9. Banks lend EVEN MORE funds.

And so on. Thus we hit on Peter Schiff's property paradox. To turkeys, 'High house prices make housing affordable'. That is when you expect property to increase 20% pa, you don't really care about taking on larger debt, (because you expect to profit from 'flipping the property').

Now to summarise the risks, for a bank there is 'no' risk they get an EARNINGS PREMIUM by lending more money to more people, and if the person defaults they retain the underlying asset which they can sit on forever. Their only risk comes from a catastrophic number of defaults, which means all their money is tied up in repossessed houses that they can't sell without increasing the supply of housing drastically (resulting in lower prices), but they may be forced to if depositors then try to withdraw their funds. (this is what triggered the GFC).

To you the investor, popular risk makes you blind. The moment prices depart from any rational basis in earnings, then you can't explain why the house price increased last year THUS you cannot explain why they will go on increasing.

You may be tempted emotionally and through social pressure by your turkey friends to buy in under the assumption that 'prices did go up, therefore they will go up.' but I urge you not to, because they will go up right up to the moment they start going down. Then the only bottom to prices is a rational one (where the P/E ratio makes it crazy not to buy).

Popular risk may be summarised by Keynes observation that 'People would rather be wrong in numbers than right alone.' (Benjamin Graham was a student of Keynes I believe).

Bubbles tend to burst at the pinnacle of confidence. But that pinnacle may only be recognisable as the pinnacle for a few moments.

Liquidity

Property is not very liquid, for a number of reasons.

Firstly it is indivisible. You sell the whole property or you sell none. Whereas you may sell some shares but not all, and with cash you can spend it a cent at a time.

Secondly, holding costs are so negligible that land banking is very attractive. The only ongoing expense for an empty block of land are the council rates. Most councils now use what is called 'CIV' rating or 'Capital Improved Valuation' which means if you build a very nice house on the property you will be charged more in council rates. If you let the house fall into disrepair such that nobody but a drug dealer would want to live there, you get a discount on the council rates. If the neighbourhood becomes a major drug trafficking zone then you get a further discount. If you bulldoze the property you get a discount. If somebody graffitis your property they are doing you a favor holding costs wise because you get a discount on your rates.
So you can bulldoze any useful structures on your property and effectively hold onto the property forever. People do do this, particularly developers who drip feed the market new land in order to maintain high prices (similarly to the diamond vaults that keep diamond prices high) but other individuals as well.
This means that the supply of land can be quite high, but the holders of unused land have no real incentive to sell because the longer they hold onto it the more desperate (and irrational) you will become. Thus property doesn't transact as frequently as it should.

The only way you can get more money out of your asset is to refinance it on an 'equity loan' the problem with this is that if you did invest in property (that is buy it at an appropriate P/E multiplier). Then the 'Capital Gains' that you are borrowing against is the equivalent of borrowing money to buy the property at a higher price from yourself. You become the irrational turkey.

Frequency of Payments

Rent is typically paid monthly and is a steady income stream. IF you have tennants. If not, you may be in the lurch. You can't rely on having tennants. This is the primary risk for an investor (who wouldn't buy in right now).

Opportunity Cost

The opportunity cost is two-fold.

If you are an owner-occupier the opportunity cost is the difference between the cost of owning (mortgage repayments) and the cost of renting the same property. Thus if it only costs you $500 to own, but $800 to rent, you are laughing. But if it costs you (more likely) $800 to own, but $500 to rent, you should be crying but are probably laughing because you are a turkey. Your opportunity cost is $300.

The second fold is to look at a relatively safe reliable investment option like a Treasury Bond. Here Peter Schiff puts it best 'How do you know if the price is good? You look at the rents, if the rents aren't getting you 5-7% above the mortgage repayments don't buy it. Nobody invests to break even... a government bond pays 4%'

I'm paraphrasing but in principle think of it like this. Assuming you don't have to borrow funds and your required rate of return is 0% (break even) then over 20 years every $1 in rent you spent $1 to own the property.

If however you borrowed the funds at 7% then for every $1 you get in rent suddenly you paid $1.07 to own it. Thus to overcome the opportunity cost of a treasury bond paying 4% over the same time period (you get $1.04 for every $1 inested) you need to get AT LEAST $1.11 for every $1.07 you paid.

Ethicality

I treat property ownership as fundamentally unethical.

The only exception I would make is in owning your own home/workplace, and that is to say that it is the lesser of two evils. You may as well monopolise the resource you are using rather than let somebody else do it for you.
Straight up and down though, let me be clear: Investment properties are unethical because you can contribute no actual value, yet tax another person for their productive efforts.
That's right rent is unethical. John Stuart Mill alludes to the argument 'private property is theft' and like proving the existence of god, it is much much harder to argue that it isn't than to argue that it is.
Start simply with the question 'what value does a landlord actually provide?' and it all falls apart from there. A landlord can provide value in some circumstances but these circumstances don't crop up with anywhere near the frequency of landlords themselves. I'm not going to go into it here, partly because it's an interesting meditation to have for yourself.

*I am aware that this is ironic, and will also point out I am still a few semesters ,away from being able to offer Financial Advice in any legal capacity, my advice is general in nature.

**Unless they are playing tax trickery.