patrick.net

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")

DinOR,

I'm from Chicago too. Used to live in 60657. Lots of my old friends have rental RE, both residential and commercial. The minority that have done quite well by it have remained small; small enough to do a bulk of the maintenance themselves or manage the maintenance directly. And, their returns probably not enough higher than the market to justify the sleepless nights and hassel. The smart ones sold their addresses when the going was good, and early retired to low-cost of living areas like Montana.

@DinOR,

I saw the “The United States of Real Estate” article and totally agree. The problem is, thrift, value-based investing, and old-fashioned work ethic has long been out of fashion for a long time in this country --at least since the whole LBO/junk bonds thing got started in the 80s. People don't want to hear about how building wealth might actually require hard work, careful planning and some sacrifice on their part. They'd much rather chase the next big thing and magically grow rich.

Sort of reminds me of voters that want tax cuts along with *zero* reductions in cherished entitlement programs, sacred-cow industry subsidies, etc. Call it the Free Lunch America.

I don’t believe that we have seen the death of inflation

Have to concur for two reasons:

1. The vast majority of the Federal government's future underfunded entitlement obligations (mostly in the form of Social Security & Medicare) are indexed directly to the CPI or a CPI-derivative (CPI-W). As has been said here many times, it's quite obvious that the BLS has been gaming the CPI numbers for some time (hedonics, substitution, excluding "volatile" food, energy, food, non-rental housing, etc.). This allows the Feds to spend less on those programs in real terms as inflation slowly erodes the purchasing power of dollars paid out to entitlement program receipients. Allowing a broad-based deflation to take hold would increase money's real value, and by extension, increase the size of those obligations --unless Congress acts to cut SS/Medicare payments.
This could make an already bad situation much, much worse.

2. Broad-based deflation would also greatly increase the real size of the current National Debt, as well as the real costs of servicing the Debt (Treasuy yields), much of which is flowing overseas. This would increase the Debt's share of the federal budget and force painful (and politically unpopular) cutbacks in other programs. This effect would be only be magnified if wages and employment were to fall along with consumer prices (likely), which would reduce federal tax revenues.

Of course, as Peter P likes to say, "inflation is not a single variable". It's quite possible that sky-high RE prices can still decline in nominal terms, even as other consumer prices rise. The more broad-based inflation there is in other sectors, of course, the smaller that nominal drop will be.

Is the 60657 zip by the old Aragon Ball Room?

I lived right around the corner from the Vic Theater. Used to hang out at the Caberet Metro because I was one of those annoying "dressed in black" kind of kids.

H.Z.

You are talking about the "embedded option" in US-style mortgages if I understand you correctly. Could you explain more about how the refi option portion works with/against the prepayment option? And how is this affected when the average homebuyer turns over every 7-10 years?

@NO_BUBBLE_AFTER_ALL

I believe you are in the wrong thread. Please post your comments under "No Bubble, My Bad :-(".

Cheerio,
HARM

Thanks for the clarification H.Z. I understand the YTM proposition you're talking about now. This still is very different from the "risk aversion" phenomenon that Zephyr was crediting with the leverage advantage.

Some real estate bears will show non-logarithmic charts and then use that as evidence as to real estate’s unrealistic growth over the last 5 years.

The past 5 years of RE asset inflation are out of line even assuming geometric growth. Further, RE is subject to exponential decay every bit as much as exponential growth. Expect the correction to be just as astounding as the run-up.

@NO_BUBBLE_AFTER_ALL

I look all time, house only go up, then me watch Tarzan movie, like movie, tantor unk, me think like you huse only goes up. I buys now, you shoulds buys now also, bees sure to buys lots of spoons so you can eat my fucking ass.

Dick.

This Jack is not The Jack.

I did respond before reading his previous articles though; it seems his point is that the economy grew at 1% a couple hundred years ago, though I do wonder how that was measured?

Historical Finance is a big academic field. They use historical records and archeological techniques to estimate things like the GDP of Ancient Rome. It's a quite serious field of study, if a bit entertaining.

Looks like one of my favorite commentators has something to say on our little blog topic:

Contrarian Chronicles - Bernanke is no inflation fighter
The new Fed boss is most scared about deflation, not inflation. And when the markets figure that out, precious metals prices will scream.

By Bill Fleckenstein

H.Z. Says:

"And if one is not convinced of risk subsidy on home loans, just look at the rates that builders have to pay. Now what makes home builders so much more risky than home owners? Esp. if one takes into account of the proportion of the value that is the land instead of the structure. "

There are two reasons that construction loans are a lot more risky than typical home loans:

1. If the construction is not complete the lender just has land and a pile of wood to sell after they forclose (with a typical home loan they just evict the former owners in forclosure and have a complete home to sell).

2. The other reason is that with a construction loan the developer will not usually have the cash flow to service the debt after the construction loan debt service reserve runs out (while with a typical home loan an owner should be able to service the debt until maturity as long as they keep working).

The new Fed boss is most scared about deflation, not inflation. And when the markets figure that out, precious metals prices will scream.

Alternative theory: Ben was giving the "helicopter speech" just to get attention, in a period of deflation scare. People, especially public figures, are rarely what they appear to be.

Heli Ben is first and foremost a boomer, this means all his actions will be delivered with arrogance, the desire to get high and have sex, and having little or no culpability. He will bankrupt the country while enriching his cronies, every single one of his actions will be delivered with outright lies and data manipulation. His only desire is to make himself and the other boomer hogs on wall st. rich. Watch out, boomer in charge, turn up the Zep and lube up. Remember everything they do is better than you, every action is for them not you and everything they say is for the most part lies.

DinOr,

You made some interesting comments about institutional investors. I know many institutional investors and venture capitalists. I have had their money before, but I have no interest in that anymore.

You mentioned selling. There are times when selling is easy and times when it is difficult. In the last few years it was very easy to sell. Buyers were falling over each other to outbid each other. You are correct to observe that when the music stops it will be very difficult for me to sell - at least at a favorable price.

However, why would I want to sell during the down part of the cycle? That would be foolish. I buy during the lower points in the cycle. If I choose to sell, I will not do it when the market is weak - I would sell at the top. But selling is not in my plans. I have been accumulating these income producing assets for nearly 30 years. I intend to retire and live off the net income. To some extent I see rental properties as the ultimate inflation-indexed bond. Not only does the income grow with inflation, but the principal grows as well.

Of course, the cycle is important. Although selling is not a basic part of my strategy, I did sell some property at the peak in 1989 – but only because I was so convinced that the 1990s were going to be a bloodbath. I do expect prices to decline in the next few years, and I will wait for the bottom before buying again. If you don’t have to buy now you shouldn’t.

Not only does the income grow with inflation, but the principal grows as well.

Isn't this true even for TIPS? On the other hand, I do see that the principle growth for RE is tax-deferred.

Of course, the cycle is important. Although selling is not a basic part of my strategy, I did sell some property at the peak in 1989 – but only because I was so convinced that the 1990s were going to be a bloodbath. I do expect prices to decline in the next few years, and I will wait for the bottom before buying again. If you don’t have to buy now you shouldn’t.

But are you more convinced in 1989 than now?

Randy H,

You seem to be very focused on theory, and you make a lot of interesting points. I applaud your studiousness and awareness of theory. And I find your comments to be interesting, even on the points where we disagree.

You seem to be saying that those theories suggest that RE essentially cannot be a good investment. You mention zero sustainable growth. The problem with these theory-based assertions is that reality contradicts them. Theory is a great place to start. However, at some point the textbooks just don’t explain it all, and empirical data needs to be evaluated. The limitations of the condition-setting assumptions must also be understood. The real world rarely matches those assumptions in full. It often requires hands-on experience to see how it really works in the real world. I am sure you found this to be the case when you ran your software company. BTW, what ultimately happened with that company?

Trying to explain reality away with theories is not a good formula for success (unless you are a college professor, in which case reality might not interest you). I think it is more productive to start with reality and find the theory that fits. As I have aged I have become increasingly pragmatic. I no longer worry much about what reality should be (as I once did). Instead, I focus my energy on understanding what actually does exist, does happen or is likely to happen. Utopia is fun to contemplate, but it doesn’t really exist.

You seem to be very focused on theory, and you make a lot of interesting points. I applaud your studiousness and awareness of theory. And I find your comments to be interesting, even on the points where we disagree.

Zephyr, at least Randy agrees that the market is not completely efficient. :)

You seem to be saying that those theories suggest that RE essentially cannot be a good investment.

It really depends on the definition of RE as an investment. Is plain villa homeownership a form of investment? Is land development a type of RE investment? How about building? In each case, what is creating value? Is the particular value creation exactly RE investment, or is it just related?

I was more convinced of the danger then. The damage was already bad long before the peak last time. We had savings banks, builders and developers in bankruptcy several years before the peak last time. Their were so many bankrupt Savings and Loans that the S&L insurance corporation was insolvent well before the cycle peak.

As exuberant as the buyers have been, that level of pain has not happened yet. And I believe we are past the price peak, and already in corrective decline. No signs of systemic financial collapse. No Resolution Trust Corp. needed this time.

No signs of systemic financial collapse. No Resolution Trust Corp. needed this time.

Let's hope so.

But prices will fall significantly where the markets have been the hottest. Many novice investors will bleed their way into default. But this will take a few years because each of them have differing levels of resources and differing degrees to which they are overextended.

Those who can hold out the longest will sell at the lowest price (at or after the bottom). I will buy from them - the last to fold.

Zephyr,

I ultimately sold my business to SBC, retained the valuable software IP to preserve royalty revenue, and decided to go back to school for a while to figure out why I kept getting screwed by VCs, IBs and such. (I sold when the "nuclear winter" of telecom was just starting). I managed to get myself into a top B-School; thus my theoretical bias. What I came away with is that theory doesn't explain reality, but it's very tough to bet against it and win consistently.

Like you said, it's all in the market timing. And market timing is ultimately an intuitive endeavor. This is my argument against the notion that "common folks" should be following such a strategy. Timing any market is hazardous and difficult even for those steeped in theory and experience, let alone the workaday man.

btw, I've since started two more companies. I'm convinced, like you, that onwership of FCFs is the only way to accumulate wealth over time. I just don't have that "gut feel" to trust my ability to succeed in RE, being that I respect RE is a tough game.