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Many people have a weird obsession with homeownership.
When it comes to buying a house, they are willing to overlook, or even completely throw out, a bunch of financial values and principles they claim to hold dear.
The unfortunate truth is, for many middle-class folks, buying a house is often a very silly financial decision, especially if they are young (in their 20s or early 30s), or have a low net worth.
A well diversified portfolio
The most mind-boggling thing I’ve come across is that most people who punt the importance and wisdom of home ownership, will also tell you they believe you should have a well diversified investment portfolio.
“Spread your investments over many asset classes.”
“Don’t put all your eggs in one basket.”
And so on.
Well, for the average middle-class-30-year-old Joe, buying a house is akin to gathering up all his eggs, borrowing another 9 times as many, and putting them all together into one basket.
Not only is the the average middle-class-30-year-old-home-owner Joe way over-invested in exactly one asset class (residential property), he is also completely undiversified within that asset class, since he owns exactly one property, in exactly one area, based in exactly one town, located in exactly one country.
In short, it’s just about the most undiversified investment portfolio a person could dream up and manage to get himself into.
Leverage basically comes down to borrowing money to invest in something.
If you invest R1,000,000 in something, but you borrow R900,000 and only use R100,000 of your own money, then you have an investment in which you are leveraged 10:1.
That 10:1 is called the leverage ratio of your investment. And it is 10:1, since the thing you’re investing in is worth 10 times as much as the cash you put in.
Leverage is great if the thing you invested in grows a lot in value over a short period of time, because it allows you to make a lot of money by investing only a small portion of your own cash!
Unfortunately, the reverse is also true.
If the thing you invested in loses value, then it is very easy for you to lose a lot of money – even more than the initial amount you put in!
While Warren Buffet’s ethics may be a stinker, I do agree with his views on employing leverage:
- If you’re smart, you don’t need leverage. If you’re dumb, you have no business using it.
- Warren Buffet
Even though, over the long-term, returns made on equities outperformed returns made on property, by far, almost no sane person will leverage themselves 10:1 to invest in equities (i.e. shares).
For most people, this is way too nerve wrecking to even consider. If you suggest such a thing, you might be labelled a gambler, or worse, a madman.
And yet, everyday, average middle-class-30-year-old Joes all around me are buying properties in which they are leveraged 10:1 (and even more), without a second thought.
After spending many months thinking about this phenomenon I can only put it down to the fact that the truth doesn’t matter.
It’s just another asset class
In case you think I have a deluded and deep seated mistrust of property that most likely stems from a childhood nightmare of being swallowed by a house, let me just make my position official:
I have zero issues with investing in residential property.
Residential property is just another asset class.
I don’t currently, but I have in the past allocated a portion of my investment portfolio to residential property (both locally and abroad), by buying shares in publicly listed companies whose business it is to buy and rent out houses and flats.
I just don’t view residential property as a magic-unicorn-galloping-over-a-rainbow-of-profits type of investment with which “you can never go wrong”.
I’ve spent a significant portion of my adult life looking for investments like those, but unfortunately I haven’t found one yet.
Liability and Liquidity
If you are still adamant that you want to invest in residential property, then I have a great suggestion for you:
Why don’t you just buy some shares in publicly listed companies whose business it is to buy and rent out residential properties?
If you do some research and choose a good one, chances are that they are better than you at spotting and buying well-priced properties and collecting rent, because that is what the people who work for those companies do for a living.
There are also some other advantages about investing in residential property by buying shares in publicly listed companies.
- You can have a more diversified investment portfolio: By only buying a few shares you are able to limit your exposure to residential property to a reasonable percentage of your net worth.
- You have limited liability: If the company goes bust, you will not be liable for any losses. Comparatively, if you buy a property using debt and, for whatever reason, become bankrupt and can’t afford to make the bond payments, then you most likely have quite a few years of hell to look forward to.
- Shares in publicly listed companies are liquid: If you ever need to do so in a hurry, it will only take you about 5 minutes and a few key-strokes to sell all the shares you hold in almost any publicly listed company. Selling a house, on the other hand, is a ludicrously expensive multi-month administrative nightmare.
Interest rates and timing your property purchase
Residential property is an asset class that is very directly influenced by the cost of borrowing money.
In our society, it is considered a perfectly normal and responsible thing for a person to finance the purchase of a house by getting a 20-year loan from a bank.
In fact, it is considered such a normal thing for the average middle-class-30-year-old Joe to be a debt slave for most of his life, that if you had to suggest to him that he should save up for a house and only purchase it once he had saved up enough money to buy it outright, using cash, he will probably think that you are crazy to even suggest such a thing.
But, I digress.
My point is, the vast majority of residential properties are paid for using borrowed money.
Because of this, when interest rates go up, so do monthly bond payments. When bond payments go up, some people can’t afford to make their bond payments and they are forced to sell their homes, or default on their bond. A few actually do default, resulting in a seizure and forced sale of their properties by the bank.
To summarize: When interest rates go up, property prices fall (or increase very slowly, usually at a rate lower than inflation), because the available supply of residential properties increases, while at the same time the demand for residential properties decreases. Conversely, when interest rates go down, residential property prices usually go up quickly, because more people can afford to take out bigger loans!
The first rule of business is: buy low, sell high.
This is such an obvious concept and yet, in practice, it is very difficult to do, because it usually means doing the exact opposite to what everyone around you is doing.
If you are going to buy a property, for whatever reason, then at least buy it at the best possible time.
And when would that be?
Well, of course, a few months after interest rates hit their peak after having risen quickly for two or three years in a row.
Take a look at the graph below, which shows the prime interest rate in South Africa over the last few decades.
2014 started with interest rates at record lows and just entering an upward cycle.
In my opinion, the present is just about the worst possible time for anyone to be invested in residential property.
You will know it is the right time to buy your dream home by looking for a few of these signs:
- Interest rates are starting to stabilize at a high rate, after rising steadily for two or three years in a row.
- Many people are trying to sell their properties, some in a real panic, because they are struggling to make their monthly bond payments.
- You hear many tales of properties being foreclosed on, also in neighbourhoods where people are considered to be wealthy.
- People around you are generally feeling quite negative about owning property.
When the blood is in the streets, my friends, that is the ideal time to buy your dream home.
Paying rent is simply throwing away money every month
I often hear people making this argument. I’m sorry, but that is just a silly thing to say.
Upon purchasing the average middle-class-suburbia home, you’re not only paying a massive amount of TAX to the government, you’re also forking over a significant amount in fees for bond registration, deeds and a bunch of other stupid banalities. Never mind the commission that goes to the estate agent.
Property tax, commission and other fees can easily add up to over 15% of the purchase price of a house. This makes residential property one of the most expensive asset classes to invest in, at least as far as up-front costs are concerned.
Then, once your bond is registered and you are the proud owner of your new home, you’ll be paying interest to a bank, every month, until your bond is paid off.
And don’t forget about maintenance! You know… paint starts peeling, roof start leaking, toilet stops flushing, that type of thing.
Lastly, you’ll also be forking out on a monthly basis for rates & taxes. Which,as property owners in Greece found out just recently, can easily go up by sevenfold in two years, if your government is anything like most governments are.
Safe-haven investment my ass.
Except for squatting on someone else’s land, there’s no such thing as living for free.
So are you saying no one should ever own a house?
No, of course not.
I’m saying people should save up for their family homes and buy them cash.
The saving part should be done by building a well diversified investment porfolio and the home buying part should be treated as an expense, rather than the purchase of an asset.
I know… in the world we live in I’m very much on my own in suggesting such a boring and outdated thing.
But I’ve looked at the facts, and even though I’m well aware that the truth doesn’t matter, I also know that nothing matters to anybody until it matters to everybody – and by then it’s too late.
If you disagree or find a flaw in my logic, please leave a comment below. I’d love to be proven wrong, and I’m willing and eager to consider any counter arguments.
|2010 Bank of England note signed by Andrew Bailey, former Chief Cashier of the Bank.|
A few years ago, Peter Stella and Åke Lönnberg conducted a study that classified national banknotes by the signatories on that note’s face. They found some interesting results. Of the world’s 177 banknotes with signatures (10 had no signature whatsoever), the majority (119) were signed by central bank officials only. Just four countries issue notes upon which the sole signature was that of an official in the finance ministry: Singapore, Bhutan, Samoa, and (drum roll) the United States.
Stella and Lönnberg hypothesize that the signature(s) on a banknote indicate the degree to which the issuing central bank’s is financially integrated with its government. The lack of a signature from a nation’s finance ministry might be a symbol of a more independent relationship between the two, the central bank’s balance sheet being somewhat hived off from the government’s balance sheet and vice versa. The presence of a finance minister’s signature would indicate the reverse, that both the treasury and central bank’s balance sheets might be best thought of as one amalgamated entity.
The nature of this arrangement is significant because if something disastrous were to happen to an independent central bank’s financial health, say its assets were destroyed and all hope of profits dashed for eternity, the central banker should not necessarily expect support from his/her government. Lacking in resources, monetary policy could go off the rails. (Why would it go off the rails? Here I go into more detail).
On the other hand, should it be established by law that a government is to backstop its central bank, that same disaster would pose a smaller threat to monetary policy since the nation’s finance minister, his John Hancock affixed to the nation’s notes, would presumably come to the central bank’s rescue.
These ideas are similar to Chris Sims’s classification of type F and type E central banks (alternative link). One of the features of type F banks (like the Fed) is that “there is no doubt that potential central bank balance sheet problems are nothing more than a type of fiscal liability for the treasury.” On the other hand, with type E banks (like the ECB) “it is not obvious that a treasury would automatically see central bank balance sheet problems as its own liability.”
So is it the case that the Federal Reserve is actually more fused with the U.S. Treasury than other central banks are? One reading of the Federal Reserve Act might indicate yes. Section 16.1 stipulates that Federal Reserve notes are ultimately obligations of the US government:
Federal reserve notes, to be issued at the discretion of the Board of Governors of the Federal Reserve System for the purpose of making advances to Federal reserve banks through the Federal reserve agents as hereinafter set forth and for no other purpose, are hereby authorized. The said notes shall be obligations of the United States and shall be receivable by all national and member banks and Federal reserve banks and for all taxes, customs, and other public dues.
The language in the above phrase would seem to indicate that should the Fed find itself incapable of exercising monetary policy (Stella and Lönnberg use the term policy insolvency), the US government is obliged to step in and make good on the Fed’s promises, however those promises might be construed. The fact that Treasury Secretary Jacob Lew’s signature appears on all paper notes, as does that of U.S. Treasurer Rosa Gumataotao Rios, can perhaps be taken as an indication of this guarantee.
Bank of Canada notes, on the other hand, are signed by the Governor of the BoC and his deputy. Finance Minister Flaherty’s signature is nowhere in sight. This jives well with a quick reading of the Bank of Canada Act, which stipulates that though notes are a first claim on the assets of the Bank of Canada, the government itself accepts no ultimate obligation to make good on banknotes. In theory, should the Bank of Canada cease to earn a profit from now to eternity, Canadian monetary policy could go haywire—American monetary policy, backstopped by the Treasury, less so.
Other central banks go even further in formalizing this separation. In Lithuania, for instance, the law states that: “The State of Lithuania shall not be liable for the obligations of the Bank of Lithuania, and the Bank of Lithuania shall not be liable for the obligations of the State of Lithuania.” Should Leituvos Bankas hit a rough patch, so will its monetary policy.
Stella and Lönnberg correlate the rise of independent central banking with a movement away from the printing of finance minister signatures on notes. For instance, the sole signature on Euro banknotes is that of the President of the ECB, Mario Draghi. Two of the currencies replaced by the Euro, the Irish punt and the Luxembourg franc, which had carried signatures of finance department officials, no longer exist, symbolic evidence of the Euro project’s dedication to central bank independence.
Sims uses the ECB as an exemplar of type E central banks because “the very fact that there is a host of fiscal authorities that would have to coordinate in order to provide backup were the ECB to develop balance sheet problems suggests that such backup is at least more uncertain than in the US.” For evidence, he points to the fact that the Fed carries just 1.9% of its balance sheet in capital and reserves while the ECB holds 6.7%.
Stella and Lönnberg hint at the prevalence of a “rather singular U.S. view of central bank and treasury relations.” My interpretation of this is that most conversations about central banking are inherently conversations about the the world’s dominant monetary superpower, the Federal Reserve. This is surely evident in the blogosphere, where we mostly talk as-if we were Bernanke, not Carney or Poloz or Ingves (Lars Christensen is a rare counter-example who is fluent in multiple “languages”). In the same way that all Americans only understand English while all foreigners are conversant in English and their native tongue, non-American commentators like me can’t talk solely in terms of our own central bank (in my case the Bank of Canada) lest we fall out of the conversation. The Fed becomes our focal point.
Yet among central banks, the Fed is an odd duck, since the wording in the Federal Reserve Act and the signature on its notes would indicate a more well-integrated financial relationship between central bank and treasury than most. The upshot is that popular conceptions of the central banking nexus will often be wrong as they will be couched in terms of the U.S.’s integrated viewpoint, whereas most of the world’s central banks are not structured in the same way as the U.S. A deterioration of the Fed’s balance sheet would likely be neutral with respect to monetary policy, but for many of the world’s nations this simply isn’t the case.
On a totally unrelated side note, I found it interesting that Bank of England notes stand out as being signed by the Chief cashier of the Bank, not the governor. When the BoE opened its doors for business in 1694, the banknotes it issued were written on blank sheets of paper, often for unusual quantities (standardized round numbers were not introduced till the 1700s). The bank’s directors and its governor, usually well-established bankers who simultaneously ran their family business, were not responsible for the BoE’s day-to-day operations, this being devolved to the bank’s cashiers who were given the repetitive task of signing each note by hand. Even when the ability to print signatures directly on to notes was developed in the 1800s, the practice of affixing the cashier’s signature continued, despite the fact that mechanical process would make it easy for the higher-ranked governor to get his name on each note.
So while Mark Carney’s route from the BoC to the BoE got him a higher salary, more prestige, and posher digs, in one respect his standing has deteriorated: there are no longer millions of bits of paper circulating with his name on them. Chief cashier Chris Salmon has that distinction.
It’s all a matter of perspective.
A classroom demo
The Stomp Monster Cometh
The sly trick of discounting Alternative
There’s no place like home
Corporations Have Record Cash: They Also Have Record-er Debt, As Net Leverage Soars 15% Above Its 2008 Peak | Zero Hedge
There is a reason why activism was the best performing hedge fund “strategy” of 2013: as we wrote and predicted back in November 2012 in “Where The Levered Corporate “Cash On The Sidelines” Is Truly Going“, US corporations – susceptible to soothing and not so soothing (ahem Icahn) suggestions by major shareholders – would lever to the hilt with cheap debt and use it all not for CapEx and growth, but for short-term shareholder gratification such as buybacks and dividends. A year later we found just how accurate this prediction would be when as we reported ten days ago US corporations invested a whopping half a trillion in buying back their stock, incidentally at all time high prices.
Putting aside the stupidity of this action for corporate IRRs, if not for activist hedge fund P&Ls, another finding has emerged, one that was also predicted back in 2012. Because in addition to still soaring mountains of cash, corporations have quietly amassed even greater mountains… of debt. In fact, as SocGen reveals, net debt, or total debt less cash, has risen to a new all time high, and is now 15% higher than it was at its prior peak just before the financial crisis!
US corporates do indeed hold lots of cash, which is currently at record levels, but they also hold record levels of debt. Net debt (so discounting those massive cash piles) is 15% above the levels seen in 2008/09. The idea that corporates are paying down debt is simply not seen in the numbers. What is true is that deleveraging has occurred through the usual mechanism of higher asset prices (no doubt an aim of central bank policy). This is the painless form of deleveraging. It is also the most temporary, for a simple pull-back in equities and rise in volatility will put the problem back on centre stage.
And while it would be excusable if this debt had gone to prefund future growth, it is a travesty that the only thing companies have to show for it is that it has simply made a few already rich hedge fund managers even richer.
By: Tom Chatham
Many people dream of the day when they are wealthy and can leave the workplace behind to enjoy life. But what are they really thinking about when they dream of wealth? What is their definition of wealth? How do they know when wealth has been achieved?
The modern definition that many people would use would be the accumulation of enough money to do what they want without working anymore. To that end, most people build up a savings account, pension account, stock portfolio or other type of retirement account. What do these things have in common? They all represent digits in some computer somewhere. If you had one million dollars in a bank account you might consider yourself moderately wealthy. But what would that mean? If the bank suddenly lost your account information would you still be wealthy? If you had one million dollars in cash and the money suddenly became worthless would you still be wealthy?
Money in the form of cash, computer digits and other types of paper are merely a means to store current excess production for later use. This type of storage carries a considerable amount of counterparty risk and is not necessarily the best means to save for the future.
This type of wealth is potential wealth. That means it does not become actual wealth until you actually use it. A dollar in your pocket or a dollar in the bank is nothing more than a claim on goods. Until you actually cash it in for something it does not matter how many dollars you have in storage. Once you cash it in you become wealthier. This is achieved by getting possession of physical goods. Something you can use for some purpose.
If your neighbor has a million dollars in the bank, a large home with a mortgage and a new Mercedes bought on credit, and he suddenly lost the million dollars for some reason, what would his net worth be? If you lived down the road and owned two acres of land with a clear title, a 35 foot travel trailer and an old pickup truck, and the banks closed or money suddenly became worthless, who would be in the better position?
You can be sure the bank has paperwork showing he does not own the home or the new car so what would they be worth to your neighbor?
True wealth is the possession of real goods. Some people buy more practical things but all physical goods represent your true wealth. Those that are practical will have goods that are not only useful but can actually earn more dollars which can be used to obtain more real wealth. These can be classified as capitol goods. Goods that are worth potentially more than the purchase price. Things that have production capability like an ax, a sewing machine, a set of tools, machining equipment, knowledge, farming equipment or livestock are things that have some capability to generate money.
Land that can be built on or farmed, an old truck, a rifle, a wood stove, quality furniture, art or antiques, gold and silver, a wood lot and even a pile of scrap metal all represent true wealth. They are physical things that you can hold and use and trade for other things at some future date. When the wealth that many people think they have suddenly disappears and the computer digits no longer exist, the only true wealth that will exist will be the things that people physically hold in their hand and own free and clear. If you want to know how wealthy you really are just look around you at the things you really own. In the end that is the only real wealth you may have if all of the potential wealth you entrust to others suddenly disappears into the make believe world from which it came.