A quick Q&A regarding my last post.

“Jake the truth” mentions that my thinking might be representative of a contrarian indicator.

I prefer not to bother myself with who is saying what, why and when, until and unless I’ve reviewed the data first. In this respect I have a number of factors I detail below that I look at before forming any opinion. Trying to judge whether something is undervalued, fairly-valued or ball-breaking expensive is impossible unless we understand the drivers causing such valuations. Mark and I have made a living out of funding businesses, and or buying assets, when they are substantially undervalued, and are less interested in whether or not those decisions are considered contrarian or not. We care only that they are profitable, everything else is just noise.

“Oil Derek” says: #1… EVERYONE, renter or owner, is paying a mortgage. Even as a TENANT you are STILL PAYING A MORTGAGE. It is just that as a Tenant you are paying someone else’s mortgage.

Yes everyone pays for accommodation. In the western (indebted) world it usually involves a mortgage but in some countries I like, this is not typical. This doesn’t change the cash flow argument. Don’t confuse ownership and renting. Where a mortgage is involved everyone is simply renting from the bank anyway.

#2… Real Estate is an ASSET and OVER TIME Real Estate has ALWAYS GONE UP and PLEASE don’t say “This time is different.”

What, like in the great depression when prices in the US collapsed by 90% between 1929 and 1946, and then took 30 years to get back to breakeven?

#3… You are correct in your above disclaimer that you have not made an allowance for rents going up. What you have ALSO NOT done is make adjustments for the value of the house going up AND the mortgage payments GOING DOWN.

I haven’t made adjustments for the value of a home going UP or DOWN. I also made the point that the loan is interest only. Thus the loan would go neither down nor up. This is why I made the statement that, “You’d better be damn certain of capital appreciation.” If we change the loan to a principal and interest loan then the divergence in cash flows will be more, not less dramatic.

#4… And the final and most important aspect is – leverage. Put down 10% on a place you have to live in anyway and when the value increases by 10% you’ve DOUBLED your money.

Leverage works both ways. 10% down requires only a 10% decline in value to COMPLETELY WIPE OUT YOUR ENTIRE CAPITAL. Furthermore, using my example, a 1% interest rate increase translates into a 16.7% increase in mortgage payments.

Australian and NZ RE markets

It is popularly touted that both Australia and New Zealand are experiencing a shortage of housing. This strikes me as deceivingly amusing. I’ve see bankers, property developers and real estate agents seize upon this statement like sword sellers descending on a “fresh” tourist on a Bali beach. They extrapolate that demand for housing will necessarily mean a rise in values.

Ha! Tell that to the thousands of Zimbabweans who have a “shortage of housing.” The fact is most of the world experiences a “shortage” of housing. Does this mean values will rise? No. The average Zimbabwean, Bangladeshi, or Burmese lives in a tin shack (massive housing shortage no?) because that is what their incomes dictate. Incomes drive values not a shortage of housing. I would go further and say that incomes, combined with functioning credit markets, drive values.

Which brings me to the current setup. When credit markets unravel (when, not if), refinancing existing debt will become problematic, and sourcing new credit will be even more problematic. Remember the central banks of Australia and NZ are not in the position that their counterparts in the EU and US are, where they can print up new bills without an immediate rout in the bond market. Doing so would lead to substantially higher interest rates which in themselves would kill any price appreciation dead in its tracks and likely cause distressed selling.

There are 4 major things that I look at when valuing a property market:

1. Yield
2. Replacement cost
3. Closely related to point one is credit markets, not interest rates but the overall state of credit markets. They’re not the same thing.
4. Income levels

In most developed and developing markets around the world market participants don’t look at the cost of a property as a direct one-off cost, like buying a toaster, but rather they amortize it over the lifespan of a loan. As such the entire real estate market has gotten to the point of being principally credit driven. Given the inflationary pressures being exerted on household incomes, this is why we find the extraordinary monetary acrobatics being performed by central banks all over the planet.

Consider that Australians pay 6.1 times annual income for a home, while their Kiwi brothers cough up between 5 and 6 times annual incomes depending on what survey you look at. Some independent economists say that the figures are closer to 7 times annual income. Viewed from an historical perspective the average median income to asset value sits around roughly 3 times annual income, we’re clearly on the wrong end of the curve. Combine this with the fact that disposable incomes are drying up due to rising inflation (the cost of feeding a family in Australia has risen by over 40% since 2000, the fastest of any major developed nation) and here in New Zealand where I spend time we enjoy some of the most expensive living, per capita, in the world.

New Zealand is especially vulnerable to rising interest rates due to its large net foreign liabilities. At time of writing both NZ and their Ozzie cousins continue to enjoy capital inflows, with both being commodity driven economies, and in an environment of inflationary monetary policies worldwide it’s reasonable to expect capital to move towards hard assets. At the same time however, for the reasons mentioned above, real estate in both countries makes little sense to me.

I like to buy RE when prices are a fraction of replacement costs and preferably where credit is either no longer part of the equation or minimal. There are a few countries which I like in this regard which I’ll discuss next week. They’re probably not where you think they are.

Even though I know of no direct way to short these markets I think it way to risky to do so anyway. Some factors that could play out include a faltering world economy would cause central banks to revert to their very limited playbook. This would involve providing liquidity via lowering interest rates. The problem with this is that it involves borrowing. Borrowing when debt is 127% of GDP in a tiny economy (NZ) and 95% of GDP for Bruce and Sheila has its limits. On top of the lowering of interest rates which is in itself inherently inflationary they will hike taxes, further quashing business and individuals. The problem with much of the western world is that they store most of their “wealth” in their own home and these homes they cannot actually afford. It would be better if they treated them like toasters.

The average yield on a standard middle class residential home in both countries ranges between 2 and 4%. Buying here is like snatching pennies in front of a steamroller.

I haven’t discussed the very real problem of aging here either. An ageing population may not be problematic for the supply and demand of real estate but it is a Sword of Damocles hanging over tax revenues which in “Oops we spent it all” socialist democracies, poses a threat to government accounts, and in turn pose a threat to the borrowing power of the state, sending us full circle back to the old interest rate argument mentioned above.

Either we see a slow deleveraging of personal balance sheets, with inflation eating away at personal debt levels (this is what central bankers are trying to engineer), or we see things go all screwy and out of control. Either way I don’t care. I’m not buying anything at these levels in either of these countries.

Later this week I’ll share with you one country you might not have thought of and why I like it.

– Chris

 “Judge a man by his questions rather than by his answers.” – Voltaire