patrick.net

Quoted, one last word on why Debt Financing does not matter except for government-subsidized tax deductibility of interest

How Can Financing Matter?
Capital structure can matter in real world if and
only if the conservation of cash flow fails.

Perhaps I am wrong about such theory, but I think that M&Ms Theorem is based on assumptions that do not reflect the real world. Useful for the old pure thought exercise - but then one must adjust for the reality that markets are imperfect, transaction costs do exist, taxes generally must be paid, etc.

In a theoretically perfect world the theories are perfect.

Here is an article from Yahoo finance which proves there is no bubble.

Someone at Yahoo must be a FB.

If you really think you're right, then forget the landlord business and go start a Hedge Fund to arbitrage the hell out of this "risk aversion" discrepancy you claim. Why make mere millions when you can have risk-free billions?

Are markets efficient? At least they're efficient enough to account for a simple difference in discount rates.

Leverage is not a magic word. Over time you will do no better with leverage than without, short of the tax advantage that leverage offers. This is because what you lever up, you also lever down. Unless you always bet right (in which case you should forget RE and play the lotto), it all tends to even out over time.

I have to disagree. You do not have to "always bet right". You just need to have a positive and significant expectancy.

Let's not turn this into an efficient market debate.

Thanks for the reading suggestions. I am a little behind on my reading of theory. In fact, it has been a few decades since I spent the majority of my time reading economics textbooks and writings.

But I do read a wide range of material related to the economy and financial markets including the writings of economists and investors. And I have been busy in those markets for about 30 years, so my actual experience might be blinding me a bit from fully exploring the theoretical assumptions of how things should be.

Are markets efficient? At least they’re efficient enough to account for a simple difference in discount rates.

Well, I doubt risks are priced efficiently. Risk-free arbs are extremely rare, but beating the market on a risk-adjusted basis does not require "statistical certainty" (is there such a thing? :-) ).

Peter P,

I agree that the market is not efficient, but it is by-and-large efficient, at least enough to eliminate simple transactional and tax-shield cash flow differences. Your statement is true only assuming asymetric information severe and persistent enough to cause cash flow conservation to not hold. He was trying to argue that his renters do not take on debt to finance [rental income] businesses, instead funding him doing the same, which is actually a non-sequitur position anyway since the debate started about leverage pertaining to home-buyers (which would be a different risk profile and discount rate altogether).

I agree that the market is not efficient, but it is by-and-large efficient, at least enough to eliminate simple transactional and tax-shield cash flow differences.

This I agree.

Your statement is true only assuming asymetric information severe and persistent enough to cause cash flow conservation to not hold.

I guess you are right.

The information need not be asymetric. People bring their own bias and interpretation to the same information. Thus, the same info can cause different actions by different participants.

If the markets were efficient there would be less fluctuation than we have. And I suppose there would be no bubbles. In addition, it would be so unlikely for me to have beat the markets by so much for so many years. The luck required for me to have had such a run in an efficient market is astronomical.

People bring their own bias and interpretation to the same information.

I guess we can consider such "bias and interpretation" as a form of asymmetry.

Thus, the same info can cause different actions by different participants.

Exactly. Hence I maintain that the market is 100% driven by psychology.

Psychology is a big factor. Although, it might be a little less than 100%.

If the markets were efficient there would be less fluctuation than we have. And I suppose there would be no bubbles. In addition, it would be so unlikely for me to have beat the markets by so much for so many years. The luck required for me to have had such a run in an efficient market is astronomical.

Quiet! People who come here are intelligent. Teaching market inefficiency to them may actually improve market efficiency and reduce your trading profits. Such concept should be preached only in late night infomercials for suckers who will go broke and contribute more to the inefficiency. On the other hand, market efficiency should remain the unquestionable sacred law at business schools. :twisted: bwahahahahaha

Psychology is a big factor. Although, it might be a little less than 100%.

Ok, 99.875%. The remaining 0.125% is driven by data-entry errors. :)

Zephyr,

Your statements possess a degree of cogency, but surely there must be a better forum for repetitious boasts of your wild, market defying success.

Randy, I suspect that your suggestion quoted below was meant in the same spirit as your suggestion to read an introductory text on finance:

"If you really think you’re right, then forget the landlord business and go start a Hedge Fund to arbitrage the hell out of this “risk aversion” discrepancy you claim. Why make mere millions when you can have risk-free billions?"

FYI, real estate is not my employment occupation – just the chosen asset for about half of my personal investment equity. For employment I run a firm that provides capital support to other companies by removing financial assets and liabilities from their balance sheet to accomplish a reduction of leverage for them. I approve every deal and we take on over $300 million of new commitments each year. We currently have about $1 billion of such prior commitments still outstanding. I can assure you that it is not risk free.

"Are markets efficient? At least they’re efficient enough to account for a simple difference in discount rates."

While the markets are not perfect, some sectors are more efficient than others. I think the treasury bond market is one of the more efficient, while the stock market is relatively less efficient. I think that consumer dominated markets are very inefficient – which is why beating the market is easier in residential real estate. So many fools… so little time…

While the markets are not perfect, some sectors are more efficient than others. I think the treasury bond market is one of the more efficient, while the stock market is relatively less efficient. I think that consumer dominated markets are very inefficient – which is why beating the market is easier in residential real estate. So many fools… so little time…

Very true indeed. Too bad it is too difficult (if not impossible) to arb efficiency. :)

Unalloyed,

My returns were mentioned in the context of the claim that owning has been less favorable than renting during the last 30 years. The fact that I made strong profits as a landlord contradicts that claim with apples-to-apples comparisons – actual rents on the same properties owned. Of course, that is the past, and the future could be very different.

I am unwilling to buy real estate in the current market and will wait for the next market bottom before investing further. Why buy now when prices will be lower later.

Zephyr,

Fair enough. I guess there's a bit of mean-spiritedness in me. If your successes are for real, congrats and my hat's off to you.

Why did the Realtorâ„¢ cross the road?

Ans. To put up another Reduced Price sign, of course.

They are real.

I sometimes have to pinch myself...

I started my adult life working nights to support myself while attending college as an economics student. I did not have enough monety to eat full meals in those days. My typical dinner was half a package of Kraft macaroni and cheese with two hot dogs. My good meals would be dinner at my girl friend's house or at my parents' house. Each once per week.

I married the girl friend. She still feeds me.

Zephyr,

Did you ever read The Millionaire Next Door? I found it very interesting, particularly regarding the emphasis on frugality. When I was a teenager, I worked for a paper/printing supply wholesaler in the Bay Area. It was a shock to me to see the low profile some of the most successful printing business owners kept. Plaid shirt, older van or station wagon. Then my boss would share with me "that guy owns 5 print shops" etc. The young guy driving the Corvette or Jaguar was working out of a garage and sometimes not able to pay his paper/ink bills. What is your spin on the relationship between frugality and success?

My returns were mentioned in the context of the claim that owning has been less favorable than renting during the last 30 years. The fact that I made strong profits as a landlord contradicts that claim with apples-to-apples comparisons

Zephyr, My only fundamental disagreement is that this is *NOT* an apples-to-apples comparison unless you are suggesting that these people should also become landlords. Just because they choose to buy your "product" doesn't mean that they cannot pursue other, even more lucrative returns with the capital saved versus buying a home.

Now that you've described your financial experience, you well know that the risk profile for a renter and a business owner are very different; probably by at least 15% discount rate assuming the renter has no debt (which is a stretch).

Peter P,

Do you have a safe email address where I might send you a couple of not-yet-published finance academic research articles which are right up your alley? For example [...]In this paper we show that price momentum need not be thought of as irrational or a sign of market inefficiency.

Or you can email me your address at randolfe_@hotmail.com

Zephyr Says:

"In the long run you will do better with leverage. Clearly, leverage will amplify both profits and losses as respect equity. On the surface this would seem to give no long term advantage. However, there is a very fundamental reason why leverage is biased toward helping returns – the cost of debt is normally cheap compared to the average returns that can be earned by employing that same capital."

Then as others point out investing with significant leverage will cause most people to fail over the long term since "average returns" don't matter when you have a period of low cash flow and still need to make a high DS payment each month. I invested over $200K in San Diego apartments in 1993 (and like others thought we had hit bottom after almost three years of falling rents and values) and in 1994 I signed quitclaim deeds to my partners since there was no light at the end of the tunnel and I could not afford to write a check for thousands of dollars per month any longer. Leverage is fine on a small scale if you can cover the payments for a time when the investment is not covering the DS. If high leverage on a large scale was such a great idea REITs would have all 80% loans (or even mezz debt taking them to 95% LTV) not the

Randy H Says (commenting on the the automatic millioniare idiot's new book):

"* Renting is more expensive than PITI. I don’t even need to refute this it is so inane of a proposition, especially today post upside bubble appreciation. "

A few weeks ago a friend that is renting a one bedroom apartment on Pacific in Pacific Heights showed me a flyer for a one bedroom condo a block away from his building. The monthly taxes and HOA fees (that included insurance) were more than his rent!!

A personal example of how one can come out ahead by not buying a home:

I deferred buying a home for about 10 years after graduating college. I chose instead to "pay other's mortgages" and live frugally. I took the difference and invested it into starting my own company: a telecom software company, in the early 90s. By the mid 90s this business was returning over 250% ROE. By the late 90s I had accumulated 7x-9x the returns that I could have made in RE as a landlord, so buying my first house was reduced to a lifestyle and savings decision.

There was never a compelling quantitative reason for me to buy a home. Having a home was purely a qualitative choice. The landlords who rented to me weren't exploiting me, and I wasn't risk averse. I simply chose to invest in a business which I understood better than income RE an deferred my savings in order to build real equity. When I did move to CA and buy a home, I was able to benefit from rising values far more efficiently than if I had instead leveraged my way into a home back when I was 22.

Randy H,

I agree that most renters are not in a position to buy at any given time. However, who owns the property and who rents it does not change the fundamental relative economics of the asset.

Most renters fall into one of two categories - those who choose to rent and those who have no choice. Of those who choose to rent, most are on their way to later success. Most of these people will buy eventually. Some will choose to never buy for various reasons, some very sound and some shortsighted. Most renters lack the financial resources to accumulate wealth. Many of those who could accumulate wealth lack the discipline to save the required starting capital. They would rather have that new car now. Many others choose to rent because it suits their lifestyle, and many of them do accumulate wealth in other assets. Most people who attain any significant affluence ultimately choose to “be their own landlord” and buy a home.

Randy H, Your example pointsout the basic choice of resource allocation that must be made. You had the expectation that your capital/ resources would be more productively committed to your business than to owning a home. I often forego sure thing stock purchases that I expect will do really well. I skip them if I expect my existing holdings to do better. I am already fully invested and sinply unwilling to leverage myself further at this time in the cycle.

Market timing is very important and avoiding or minimizing downturn impact is important.

Timing the markets is difficult and tricky – even for market experts. Researching the fundamentals is also a lot of work, and most people are not willing to do so. But they want to beat the market – so what do they do?

Most people make their investments and other plans based on the expectation that what happened recently will continue forever - or at least for as long as matters. They are momentum investors. Most of the time this pattern works well - as they jump in on the winners to ride the tide. Of course this adds to the price rise, temporarily contributing to a self-fulfilling prophesy, but pushing the price above the sustainable level.

Unfortunately for them, once all of them have jumped in the market turns down and they are caught unprepared. Many who had been foolish optimists become foolish pessimists. So they refuse to buy when the prices are lowest, and wait for the markets to prove themselves by rising strongly. Over the cycle they go on switching from pessimist to optimist and back, always reacting too late and frequently getting burned in the end. Most people would be better served if they stuck to a steady long-term plan.

FormerAptBroker,

Unfortunately your market timing was bad. In 1993 the market was still in decline. Never try to catch a falling knife.

I always wait for the bottom to be fully established. With real estate the recoveries start slowly, so there is no advantage to trying to guess when the upturn will start (except to get prepared for it). I wait until a full year of broad market price increases have occurred before buying in again.

With stock the recoveries are often like a bounce from the bottom. Here you must be nimble.

GTG, I look forward to reading your comments later.

Peter P,

Do you have a safe email address where I might send you a couple of not-yet-published finance academic research articles which are right up your alley? For example […]In this paper we show that price momentum need not be thought of as irrational or a sign of market inefficiency.

Randy, I sent you a message to your gmail address.

Zephyr Says:

And I have been busy in those markets for about 30 years, so my actual experience might be blinding me a bit from fully exploring the theoretical assumptions of how things should be.

Is it my imagination, or has Zephyr recently transmogrified from a relatively reasonable bull into a smug, arrogant, cheat-beater?

Only *I* had the foresight and brilliance to make a killing on RE investment. Only *my* Efficient Markets/Monetarist/Friedman-acolyte view of the way risk and leverage work is correct. There can be *no other* explanation for my good fortune (plain old luck or fortunate birth, for instance).

I may have to reconsider the "reasonable" part of "reasonable bull".

spelling errro: cheat-beater

meant CHEST-beater

God bless them, every one. I love their willingness to finace me soooooo cheaply. --Zephyr

It isn't you HARM; something is afoot. Someone who's an active Partner Level in PE would know the intrinsic contradiction in the above statement. I know 7th graders who can tell the difference between systems of 2 unknowns and 3 unknowns; or are these miserable proletariat supposed to live in the park while they become landlord magnates like him?

DinOR,

On this we agree. Even more broadly, when Zephyr goes to sell his concern, whether it is private or public, it will be valued purely on its ability to produce stable FCFs at a sustainable growth rate (which will be very close to 0). For rental RE, FCFs are not very attractive (even when they are positive) because of the heavy depreciation and maintenance expenses involved. Of course a landlord can be frugal (something called a slumlord), but even that converges upon 0 real growth over time. This is why there is such a disturbingly high tax-related failure rate for RE rental firms once they reach any significant scale of operation.

Re: David Bach and his book

I went to B-School with a guy like this. He'll go unnamed, but he has written some fairly popular books on how you too can quickly make a mint starting your own business.

Of course, he omitts the following facts:

* It took him 18 years and 3-4 devestating failures to finally build a business with value which was well timed for acquisition by a major public conglomerate.

* His failures cost him his life savings (including a sizable inheritance) 2x over, his house, and [probably] his marriage.

* He had to take on over 100K of additional debt to get an Ivy MBA just so he could get in the door to pitch his biz.

* Even given all that, he had to wait until the winds of luck favored him.

It finally paid off big time, and now he's a millionaire...

...But, now you too can do the same thing in a year or less, and without all the hard work, education, and risk he himself undertook.

This kind of shit really irks me, being someone who has lived the "it's valuable because it's hard; it's hard because it's valuable" truism. (Corollary: "if it were that easy, everyone would be doing it")