Sunday, July 30, 2006
Real Estate Bubble – The End
In light of the recent stream of statistical and economic data coming from the Feds, it can be safely asserted that, rather than popping up with a loud burst, the real estate bubble has now sunken. Just like I forecasted in December, 2005. [Note: article first published on Ezine Articles on May 2, 2006]
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All those illustrious ‘bubbleologists’ out there are not going to like this one bit: not all real estate bubbles burst. Some of them actually sink – just like The Titanic.
Only a few weeks ago the real estate bubble captured the attention of a great many bloggers, authors, even news commentators all of which had in common a very dire prediction, which can be encapsulated into what has become known as the ninth note of the musical diatonic scale, right after Do-Re-Mi-Fa-Sol-La-Ti-Do: ‘Pop’, with all the consequences that such novel high-octave implied, including a cataclysmic price crash, Armageddon and, possibly, the end of life on Earth (save and except, perhaps, for a handful of protozoa).
At the root of the Theory of The Bubble, it will be recalled, were the notions that U.S. consumers have too much already and want more, that they do not save enough, that the trade deficit is too large and bound to become even larger and that the American economy is far too dependent on housing. Absent from the minds of the bubbleologists, however, was the fact that much of this debt is anchored on the built-in equity of real property assets, which thus far has been growing steadily. So therefore, to make the monthly debt burden onerous enough to cause a bubble to burst - that is a cascade of mortgage defaults with a flood of foreclosures on the market, which in turn would bring prices down - one would have to look not to higher interest rates but, rather, for a big drop in family income. As monthly debt payments remain the same, a drop in income would quickly dry up the cash reserves of many consumers, so that the predicted avalanche of mortgage defaults would start rolling down.
Unfortunately for the doomsayers, however, not only nothing of the kind has happened but, furthermore, data released by the Federal Reserve System and the U.S Department of Commerce indicate that consumers are far, far away from suffering a catastrophic drop in family income for a very long time to come. As a matter of fact, the US economy has created 211,000 new jobs in March, according to the Labor Department, which have contributed to an overall drop in the unemployment rate to 4.7 percent, annualized. This level of activity, furthermore, has caused consumer spending to rise by 0.6 percent, up from the 0.2 percent growth seen in February. Which rise in spending, the bubbleologists should be made aware, was aided by an increase in family income, up 0.8 percent in March compared to the 0.3 percent jump in February.
This past week, in fact, Ben Shalom Bernanke, the new Feds’ boss has announced that the economy grew at an annualized rate of 4.2 percent in the January-to-March quarter, the highest level in these past two and a half years. This marks a vast improvement from the anemic 1.7 percent growth rate in the final quarter of 2005. And on April 19, 2006 the US Department of Commerce has released data showing that the benchmark median housing price has increased at an annualized rate of 3.2 percent for the First Quarter of 2006 ending on March 31.
The Bureau of Labor Statistics, moreover, is pegging the Consumer Confidence Index at 109.6 in April, up from 107.5 in March and higher than the 103.8 of December, 2005, when I published the Article entitled “Breaking The Real Estate Bubble Myth”, which has earned me an interview on local TV and that has been praised by many for its thoroughness and, now, rightfulness. The Consumer Confidence Index is now at the highest level since March, 2002 {figures released by Statistics Canada, incidentally, are equally positive). Finally, in line with the inflation-targeting approach announced by Prof. Bernanke in February, the Feds has raised interest rates again by a quarter of a percentage point to 4.75 percent. Rates have increased from 1 percent over the past 20 months, and are now at the highest level since April, 2001. And, finally, the Greenback rose against most currencies on the prospect of higher borrowing costs, which tend to enhance its attractiveness to foreign investors. This signals a renewed influx of foreign capitals into the United States and, by reflection, Canada – both still the the most economically secure, politically stable, most trusted and better defended investment arenas of the entire world.
A note of caution was made by the Feds’ Chairman, to the extent that “while prices at the pump have yet to impact confidence, further increases (of gas prices) could dampen consumers' mood". Should that come true, however, and should cost of crude and prices at the pump hamper spending and reduce – or even halt growth, that would have nothing at all to do with a real estate bubble bursting, since the whole economy would be affected. In fact, all world economies would be affected.
So therefore, there is no valid reason to believe, under the circumstances, that consumer confidence applies to everything but real estate and that an economic bubble would affect only real estate markets and nothing else. It is furthermore evident now, in light of the foregoing deluge of statistical data, that all those bubbleologists, Sunday-afternoon crystal ball readers and part-time economists out there have been completely wrong. So much so, in fact, that merely to cite another example, in the Summer of 2004 the long-term bond treasury yield was 5 3/8 percent, whereas right now it is 5 1/8 percent. This is another clear indication that the US Treasury does not envision rates to climb much higher, contrary to what the bubbleologists have been prophesying all along.
It is, therefore, pretty difficult to foresee a collapse of the real estate market with interest rates which, in the long run, are actually dropping.
Perhaps some of those Hollywood big movie producers should ask Leonardo Di Caprio to star in “The Bubble”, a sequel to “The Titanic”, where one could enjoy watching another transatlantic ship sink right to the bottom of the ocean, with all those bubbleologists jumping overboard to meet their destiny into the frigid waters of their economic ignorance.
Luigi Frascati
Real Estate Chronicle
Thursday, July 27, 2006
Terror and Real Estate
To counter the negative effects of terrorism, Islamic Governments such as those of Saudi Arabia and Egypt have tried to offset terror by putting tax revenues into the production of security. Facing a rising tide in terror, so was the idea, a government that acts optimally increases the proportion of output spent on defense. Thus, when terror peaks, given the scarcity of available economic resources, the long run equilibrium is of lower output and diminished welfare. Which, as many Muslim countries have discovered later on, results in a drop of aggregate demand and a general economic slow down as well.
European Union members, on the other hand, have and are experiencing the economic impact of terror in a different fashion. Here too, as the massacres in Madrid and London have demonstrated, terror, among other things, endangers civilians’ lives. Fears, bewilderment, and different types of uncertainties proximately created by terrorist activities have been responsible in Europe for altering and redirecting individuals’ economic choices. Insecurity manifests itself in the daily life by increasing uncertainty such that, as terror or even just the threat of terror increases, life itself becomes less certain. In reaction to the rise of insecurity levels, European Governments too have tried to offset the threat of terrorism by increasing defense spending. Thus, the total cost of terror has emerged from both the individuals and governments response to terror. Individuals have changed their consumption and investment decisions in response to the change in their perceived sense of security. Governments have responded by increasing defense expenditures. And in many member States, counter-terrorism measures carry what economists call a “security tax” - higher costs associated with longer waiting times, additional shipping charges and other ways of making the economy less efficient.
By contrast, this is not what happened in North America. Whereas, in fact, defense spending in Europe has been kept down to minimal levels for decades, even during the times of the Cold War, defense spending has taken invariably a substantial portion of the American budget. As a result, therefore, European countries had to allocate resources ex novo to guarantee the security of their citizens and safety of their institutions, while instead all America simply had to do was to shift already existing and available resources for different purposes.
Surely enough, also in North America consumers had to redirect their economic decision-making processes, but to a far lesser extent. Besides the debate of a few years ago involving restrictions of civil liberties, a closer scrutiny on who is coming in and going out of the country, the plan announced by the Bush Administration of eavesdropping on people’s private telephone calls and the ‘infamous’ ban on carrying nail-clippers into aircraft, North American consumers cannot say they have been subjected to much else.
Since safety does not come for free, governments must use real resources to ‘produce’ security and, unless they run the risk of magnifying their defense budgets specifically to address security concerns, governments must take those real resources from the private sector. Therefore, the decision of governments about how much to spend on defense is based on comparing the social costs of resources, i.e the costs of forgone consumption and of forgone future consumption (investment), which are used to provide security, with the benefit that emerges from making life safer, that is the benefit of reducing terror. This decision, however, is much less drastic when the private sector already has plenty of resources that can be allocated for security purposes.
And, in fact, the privatization of security, always under government’s supervision, serves as a catalyst to domestic economic activity and growth. It is an undisputed fact that market economies, in Capitalism, are moved by the supply and demand for goods and services. Specifically as it relates to capital markets such as real estate, furthermore, the production of output depends essentially on the accumulation of capital. This is so because the propensity to invest in production (construction of new inventories) depends a lot on expectations of future profitability and on the present perceptions of market risk.
Growth is derived by the equilibrium of capital and investment with labor and employment. And since production is in direct function of consumer spending, which increases as unemployment falls, it follows that capital accumulation increases as employment rises and capital accumulation decreases as employment falls. The development of and privatization of security, therefore, has worked in North America as a stimulus to growth by increasing employment levels and subsequent consumer spending, as proven by the levels of the Index of Consumer Confidence reported by the Feds in recent years, which levels remain very high. Since Capitalism is commonly understood to mean an economic system in which the means of production are predominantly privately owned and operated for profit, and whose primary objective is to promote capital growth, North America’s response to growing terrorist threats has had a beneficial effect on capital markets, including real estate.
Luigi Frascati
Sunday, July 23, 2006
There Is More At Stake Than Just Another Kibbutz
Come discover the secret arsenal of Mahmoud Ahmadinejad.
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The Re-engagement War, as the Israelis are so fond of calling it, has more serious reverberations for the West, both of an economic and political nature, than just saving another bunch of kibbutzes. By that I do not mean to imply that going about saving kibbutzes is unimportant - it is, especially if one so happens to live in the one that is being saved. But in the general order of things, saving Israeli kibbutzes would be no sufficient reason for the West to start worrying so much about the Israel - Lebanon - Hizbollah confrontation of these past few days, especially in July - a time of the year we decadent Westerners typically dedicate for such mundane tasks as ... vacationing.
Likewise, although thousands of dislodged Lebanese civilians are a very good reason to be worried as Kofi Annan, the Secretary-General of the United Nations, has pointed out on the Larry King Live Show, there is a big question mark as to whether Westerners should now start talking so much about Armageddon, the beginning of World War III and the end of the world. Especially since nobody remembers having seen - much less heard - the Secretary-General crying out loud with equal impetus for the destiny of thousands and thousands of Sudanese victims caused by the ‘ethnic cleansing' at the hands of the Janjaweed, the armed Muslim Arab militia. Not to mention the fate of counteless Somalis at the hands of the Supreme Islamic Courts Council of Mogadishu, on the excesses of which the Secretary-General has not pronounced himself - neither on the Larry King Live Show nor on any other show - Westerner or Easterner.
Some bad mouth out there (not me) might even argue that the Secretary-General seems to be intent at showing us his tonsils only when Israel is involved - but I digress.
But then, going back to the eternal Arab-Israeli confrontation, what's the big fuss about it from the viewpoint of the West? In one word: Zelzal-2.
Zelzal-2 is a very large Iranian-made rocket that can loft a 1,300-lb (650-kg) warhead as much as 125 miles (200 km), bringing even cities in central Israel within range of rocket attacks from Lebanon. Additionally, Zelzal-2 is said to come in three versions - the economy model, the deluxe model and the super-dooper-ultra-gosh-my-gosh-deluxe model, so to speak. The economy model is basically a rocket, that is it has no form of guidance system. Once fired, no one knows where it is going to land. In this respect this is the reason why it is called a ‘dumb' weapon. The Zelzal-2 deluxe model instead is not a rocket but a missile, with the difference consisting in the fact that it sports a guidance system connected to a ‘solid propulsion motor'. With this model one can actually aim at a target and guide the missile to its final destination. Fortunately enough, Iranian guidance mechanisms are not the best in the world, but this does not make the Zelzal-2 deluxe any less dangerous.
The Zelzal-2 super-dooper-ultra-gosh-my-gosh-deluxe model is not finalized yet, apparently. This missile, complete with guidance system and all the umpah-pah is said to have a range of - get ahold of this - 400 miles (550 Km), which would then locate it well into the group of missiles categorized as ‘tactical weapons'.
In light of the foregoing, one can see all the interest that this latest conflict has suddenly generated. In essence, by handing a quasi-tactical weapon to a terrorist organization the likes of Hizbollah, Iran is positioning itself as a major local player in the Middle East, well ahead of traditional Arab states such as Egypt and Saudi Arabia. Iran has the military might of Egypt combined with the oil reserves of Saudi Arabia. Additionally, and unlike Egypt and Saudi Arabia, Iran has a leader - Mahmoud Ahmadinejad - who is a confirmed believer in the coming Apocalypse.
Like Judaism and Christianity, Shiite Islam has its own version of the messianic return - the reappearance of the Twelfth Imam. And as in some versions of fundamentalist Christianity, the second coming will be accompanied by the usual trials and tribulations, death and destruction. The Iranian press, in fact, has quoted Ahmadinejad as saying in official meetings that the Imam will reappear in two years. Exactly two years. The Iranian President has made this declaration six months ago - and the clock is ticking.
Couple this with his intention to press ahead with Iran's nuclear program, the staunch anti-Israel rhetoric, and his repeated calls for Israel "to be wiped off the map", and it becomes clear why Mahmoud Ahmadinejad is the real reason for the West to be all up the wall, and for Israel to be all up in arms.
Think the Israelis will send in ground troops to neutralize Hizbollah and their missiles? You bet. And we better hope the Israelis win, lest it will be our turn to go in - in which case we can really kiss goodbye to our vacations.
In the meanwhile, can someone please fire Kofi Annan?
Luigi Frascati
Real Estate Chronicle
Thursday, July 20, 2006
Does It Pay To Wait?
Does it pay to procrastinate the acquisition of a real estate asset during times of prices deflation? Find out...
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If you ask your Realtor whether it is a good idea to delay your real estate purchase when prices are falling, the answer you will probably get is that, no, it is not a good policy to wait out the market because sometimes, somewhere, somehow – in an unspecified region of the planet – prices will go up again, so that you will miss out on the opportunity of a lifetime. Conversely, if you ask me the same question during regular business hours, my standard reply will likely be: “No, don’t do it. I want my commission now” (I have been known to render this type of responses, on occasion).
But seriously, does it actually pay to delay the acquisition of a real capital asset in times of deflation?
Deflation, by definition, is a sustained fall in prices, so sustained, in fact, as to affect the velocity of money, that is how often money is spent by consumers in any given month. Because of its effect on profits, deflation causes a slow-down in business activity and a consequent escape of investment capitals. In its extreme forms, deflation affects employment and wages, thus spreading the drop in income and higher unemployment rate to other sectors of the economy, and seriously hampering growth. Hence, deflation is caused by a collapse in demand and is associated with recession and, more rarely, long-term economic depression.
Since deflation discourages investment and spending, because there is no reason to risk on future profits when the expectation of profits may be negative and the expectation of future prices is lower, it generally leads to, or is associated with a collapse in aggregate demand. Without the "hidden risk of inflation", it may become more prudent just to hold onto money, and not to spend or invest it. Therefore, deflation is a tax on borrowers and on holders of illiquid assets such as real estate, which tax accrues to the benefit of savers and of holders of liquid assets and currency. Because of this, therefore, prospective real estate buyers may decide to hold on to their purchases, since future expectations of realized profits as well as prices are lower than the present.
So, therefore, are the proponents of the ‘waiting game’ correct? Is it better to wait for prices to drop further as opposed to making the purchase now?
Central Banks have a special monetarist tool to combat deflation. By tightening the Feds’ control over money supply as well as short-term interest on treasury bills, the end result is a more valued domestic currency and higher interest rates. In these times of economic globalization, such a move results in an influx of foreign capitals to offset the shortage of domestic investment. Just because price expectations may not be attractive to domestic consumers does not mean that they may not be attractive to foreigners.
Additionally, Real Estate is possibly the quintessential economically inefficient market because different participants typically have varying amounts, degree and quality of market knowledge and interest to actively participate in it. The reason of an investor to purchase a rental property is very different from the reason of a first-time buyer to purchase an apartment or a house. Therefore, the first time buyer, or the married couple wanting to upgrade to a single-family detached unit will go ahead with their purchase even during times of falling prices, since they expect to live in their newly-acquired property for years to come. And even investors, in fact, may want to buy and hold properties, and not to resell them right away. Just like builders, for instance, who do not have to build and sell, but may very well build and move in.
And, finally, price deflation increases the purchasing power of money as opposed to inflation, which decreases it. Therefore, a continued fall in prices leads to the point where the very equilibrium between price and worth is altered. The ratio of the perceived value of a capital asset vis-a-vis its intrinsic risk of acquisition is termed ‘worth’. Clearly the lower the risk, the higher the worth. It follows, therefore, that the perceived value – or simply ‘value’ - of a real capital asset is the total monetary worth obtained by reducing exposure to risk and liability. Put in elementary terms, ‘value’ is the total net benefit a buyer expects to receive from a purchase, measured in currency. The measure of the ‘value in exchange’ of the real estate transaction is the sales price.
When average prices drop below a certain level, just about everything becomes a bargain, and expectations of future returns go in second position. For instance, say that a five-bedroom home on a large lot overlooking a golf course was worth $600,000 last year, and that because of the shift in prices this home has progressively lost ground and is now worth $500,000, and that it continues to lose ground. When will a buyer decide to purchase it? When its price is down to $450,000, or $400,000 or even $350,000? It will get to a point where, in the eyes and mind of a purchaser, this house will be a bargain, no matter the future expectations of profitability. Therefore, the rule of thumb is that in any market the velocity of money will pick up again, and that the relation between supply and demand will be tilted in favor of demand once again, thus spurring a renewed capital influx through investments, and growth. This is what it is known as 'market consolidation'.
Which then, in ultimately analysis, means that your Realtor was correct. It is not a good policy to delay a purchase simply because prices are falling.
Luigi Frascati
Real Estate Chronicle
Sunday, July 16, 2006
It's The Crude, Dude!
Public confidence, the main governing variable of real estate and financial markets in North America, stems out from and finds its roots right in the center of Jerusalem.
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QUESTION: what do North-American real property owners have to do with the Middle East conflict? ANSWER: everything and anything they can possibly imagine.
Fluctuations in the world economy are largely driven by confidence. A changing level of public confidence is the ultimate driver behind much of the variation in individual and national incomes, in employment rates, in corporate earnings, in interest rates and in many other measures of the world economy. All the more so when nations, and indeed entire continents, are as economically intertwined as nowadays. In these times of globalization, the political-economic policies of the European Union, for good or bad, are exported to North America. Unrest in China or a terrorist attack in Mumbai are reflected in the public confidence of financial and investment markets. A more and more despotic and dictatorial Putin has the effect of altering the commodities markets by undermining investors' confidence worldwide.
But there is nothing, nothing at all short of another September 11 disaster that works so much as an impediment to financial and real estate markets in North America than a conflict in the Middle East. And this week's attack of Lebanon on Israel is yet another proof of it. Just take a look at the dive of the Dow Jones of these past few days. Just take a look at the spike of the price of crude. To be sure, it is not so much the Lebanese or Hizbollah per se that kill investors' confidence in North America. Afterall the Lebanese or Hizbollah are, taken all and by themselves, nothing more than a bunch of ignorant, fanatical boors. But it is what's behind them that worries Capitalism.
It's the crude, dude!
There is a very specialized field of Economics, known as ‘Behavioral Finance', which applies scientific research on human and social cognitive and emotional biases to better understand economic decisions and how they affect market prices, returns and the allocation of resources. Behavioral Finance is the heart of Capitalism, the pump that moves money worldwide. To better realize how important is Behavioral Finance, one must understand that one of the tenets of Capitalism is that democracy has significant indirect effects which contribute to growth. Democracy is associated with higher capital accumulation, lower inflation, less political instability, and greater economic freedom. Anytime democracy is threatened either by war, terrorism or unwarranted attacks to free and sovereign countries, even in places as far away as the Middle East, Capitalism grinds to a halt. Capitalism abhors the uncertainty created by political instability.
This particular concept is very clear to the ‘Masters of Capitalism' - all the American Administrations since the end of WWII. And of all places on the planet, no one is as important to Capitalism as the oil fields of Islam. This is the reason for American direct political involvement in the Middle East since mid-1947, following the departure of Britain from Palestine and the creation of the State of Israel. This is also one of the key reasons behind Washington's intervention in Iraq - to take control of that country's massive oil resources. Controlling the region in order to ensure US access to its ample oil resources has been one of the key features of American foreign policy for decades, dictated in large part by Arab flimsiness and unreliability. And in light of this policy, a strong, powerful and nuclear Israel has been and is the best sentry America can have in the region. Thus the USD 4 billion plus that America shells out to Israel annually in loans, grants, financial aids and military armaments, as well as the political support at the United Nations (another unreliable organization in large part financed by America).
Oil is essential to the economies of the industrialized world, at least for now. Yet it is a finite resource, and there is less of it in the Earth's crust than the general public probably wants to realize. We have at least enough to last for another few decades - although that is not a huge amount of time, considering how central oil is to our lives. Furthermore, while we are not about to run out of oil, we may soon run out of cheap oil. That is, oil which can be pumped out of the ground without great difficulty, and that therefore can be brought to markets at the sort of prices we have become accustomed to in recent years. In the coming decades, we can expect an intensified international competition, even military rivalry, over the increasingly valuable remaining reserves of cheap oil, most of which are located in the volatile Middle East.
In light of this geopolitical and economic context, naturally one might expect a relation between oil and house prices, since high oil prices tend to damage the economy and hence people's ability to pay for their homes. They also raise the cost of heating a home. There ought to be at least some relation, since an oil price boom can create a recession, and recessions tend to be bad for housing markets.
An examination of oil price behavior in recent decades indicates, in general lines, that oil prices rose abruptly between 1973 and 1974, during the first oil crisis thanks to the supply squeeze by OPEC, the oil-producers' cartel. Oil increased again between 1979 and 1980, during the second oil crisis, due to the Iranian revolution and the Iran-Iraq War. Overall, oil has remained an expensive commodity since 1974. Starting in 1998, with a brief interruption in 2002, oil prices have increased four-fold. Many have attributed this to demand from fast-growing developing markets like China and India. Moreover, there are fears that, as this growth continues, China and India will make even more extraordinary demands on natural resources like oil. These fears have pushed prices even higher.
Unlike stock prices, which change randomly, house prices are governed by ‘momentum' and sentiment. Therefore, given the recent rises in real estate values and assets appreciation, one might expect further increases later on, even though at present many real estate markets have fizzled out. However, the oil price boom could threaten the world economy, thus bringing with it the end of the housing boom. The ascent of oil price, due especially to the voracious energy appetite of India and China and coupled by the instability in the Middle East, is generating a resurgence of public fears about the oil markets. The sudden public recognition that there could be binding resource constraints as emerging countries develop, may very well encourage potential oil suppliers to hold off on development so that they can sell at higher prices later on. This fact in itself has the potentiality of creating higher prices today, sparking a prolonged speculative oil bubble that can spell real trouble for the stock and housing markets.
Indeed, the risk of such an oil bubble can be the biggest threat to the world economy - if not now, in the coming years. There is even a danger that, instead of looking at ways of reducing consumption or for alternative sources, we will become transfixed by the risks of high oil prices to an increasingly competitive world economy.
It is clear now, therefore, how relevant is the stability in the Middle East to real estate markets in North America. As I said before ... It's the crude, dude.
Luigi Frascati
Real Estate Chronicle
Thursday, July 13, 2006
The Hidden Cost of Real Estate Investing
Any real estate transaction involves a hidden cost that only shrewd investors factor into their offers. If they didn’t, they wouldn’t be shrewd investors.
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Investment is a term that refers to the money used to buy capital assets, including real capital assets such as land, houses and buildings. Real capital assets are a special type of consumer goods, in that they are not consumed instantaneously but, rather, they are used for accumulating future wealth. In fact, since this type of assets are non-productive by nature, their sole purpose to exist serves the accumulation of capital.
Clearly, without investment the accumulation of capital would be at a standstill, since one’s personal capital stock would gradually wear out. This is, in fact, one of the axioms of economics, since for economic growth to occur, new investment must be sufficient not only to add to the capital stock, but also to replace what amount of capital stock is wearing out. Hence, for investment to generate growth, the rate of capital accumulation must be always over and above the current rate of inflation, to make economic sense. Furthermore, the more money that is saved, i.e. that is not spent on consumption, the more money is available for investment.
Investment operates as a function – and as a direct and proximate cause and effect - of the equilibrium between income and interest rates. An increase in income will encourage higher investment, whereas a higher interest rate will discourage investment as it becomes costlier to borrow money. Even if an investor does not need financing and chooses to use his own funds, the interest rate represents one measure of the opportunity cost associated with the choice of investing those funds rather than putting them out to different uses.
Cost of opportunity is best described as the benefit or benefits forgone by investing capital stock in a certain way as opposed to the best alternative way. Given the innate scarcity of resources of investors, that is the limitation of capital available to them, investors will invariably try to maximize growth by, among other things, reducing costs. Suppose that an investor is willing to increase his investment so as to increase the accumulation of wealth. The investor will have to divert resources away from other purposes, to acquire a real or other capital asset. Therefore, the opportunity cost that the investor must bear is the loss of the gain(s) he would have received by investing the money elsewhere in the most valuable alternative.
Opportunity cost need not be assessed in monetary terms but, rather, it can be assessed in terms of anything that is of value to the person or persons doing the investing. The consideration of opportunity cost is one of the key differences between the concepts of economic cost and those of accounting cost. Assessing opportunity cost over a scale of values to investors is fundamental to assessing the true cost of any course of action. In the case where there is no explicit accounting or monetary cost (price) attached to a course of action, ignoring opportunity cost may produce the illusion that the benefits derived out of a certain course of action cost nothing at all. The unseen opportunity cost then becomes the hidden cost of that course of action.
It is important to note that opportunity cost is not the sum of all available alternatives, but it is instead the benefit that could have been derived by opting only for the best alternative. Thus, the opportunity cost to a real estate investor might be the benefit he forwent by not investing his capital into stocks, or in a different property, or not at all (as in the case of an investment resulting in a capital loss, for example). Although opportunity cost needs not to be expressed in monetary terms, the following practical example perhaps best describes the cost of opportunity to be borne by a typical real estate market participant.
Let’s assume that an investor is given the choice to buy one of three rental properties offered for sale. Property A costs $600,000 and yields a net annual rate of return of 7 percent. Property B is priced at $700,000 and has a net yield of 7.5 percent per annum. Property C is offered at $650,000 with a yearly capitalization rate of 7.75 percent. Our investor has $200,000 of his own for the down-payment, and qualifies to purchase any one of the foregoing three properties. Whatever he buys, his best option is to finance the deal with a 3-year term closed mortgage. The $200,000 are invested in a term deposit bearing interest paid semi-annually at the rate of 4 percent per year and accruing to the benefit of the investor . The investor decides to put in an offer to purchase Property C.
The factor in the determination of the hidden cost of opportunity in the foregoing example is that had the investor opted not to purchase any rental property and, in fact, had he decided not to do anything at all with his money, the term deposit would have yielded 12 percent in three years – the length of the term of the mortgage he is about to take on. By electing to go ahead with the purchase, he is now going to invest his $200,000 at the new net rate of return of 7.75 percent per year, equivalent to 23.25 percent in three years. Since $200,000 amounts to 30.77 percent approximately of the purchase price, the net yield attributable to the down-payment is going to be (23.25 x 30.77%) = 7.15 percent, so that his cost of opportunity spread out over three years will be 12 – 7.15 = 4.85 percent.
Hence, our clever investor will target a purchase price of a maximum of $618,475, say $618,000, to recover $31,525 over and above the standard negotiating discount, which is equivalent to the 4.85 percent opportunity cost on the purchase price of the acquisition (in this example assumed to be $650,000 - the asking price, for the sake of simplicity) spread out over three years.
Luigi Frascati
Real Estate Chronicle
Monday, July 10, 2006
'Mes Amis,' I've Got To Hand It To You!
Soccer is not only a wonderful game that unites millions of fans around the world, it is also a modern symbol of solidarity on account of its diversity - irrespective of faith, colour of skin, political commitments and affiliations. People are carried away by this beautiful and exciting spectacle. And it is in this spirit that I am writing these few lines, still fresh of the tumultous emotion and fatigue of having watched Italy playing a formidable adversary such as France - and win.
France does not have my devotion - that stays with Italy. But Les Bleus have my profound respect, and that of countless Italian fans. I do not know if that is worth the Cup, but it's got to be worth something. France played superbly well, both in the first and the second half. Italy played superbly well only for the first forty-five minutes and then, of course, at the penalty kicks. But in the second half you really put us in disarray. How we won is probably a question that should be asked of whomever spins the wheel of destiny in this world. Certainly no human can answer that question.
But we won.
Which highlights a fact of life - and of soccer, of course - that is, being better and winning do not go necessarily hand in hand. I am not trying to put down the Italians here. How could I? Ultimately they did equalize and they scored a perfect five at the penalty kicks, whereas the French did not. I am talking, however, about the quality of the game played. Strategy, swiftness, attack and team balance ... those are the qualities that distinguished Les Bleus and of which the Azzurri seemed to be somewhat in short supply. Certainly France could have had a more precise aim in their shots, and Buffon - our goal keeper - is better than Bastien, by far. But to watch Henry, Zizou, Makelele and Ribery come after us every two minutes was no fun - trust me!
If there is one thing that France forgot or otherwise underestimated, however, is the fact that the Azzurri have seven lives, just like cats. They never die. Which, in ultimate analysis, may be the sole explanation as to why they have prevailed.
And what can be said about Zidane, the famous Zidane, who has chosen to head-butt Materazzi? Well, I can certainly state here and now for the record that I would not want to meet Zizou in a back lane at night, that's for sure. This is what happens when there are two billion eyes belonging to one billion viewers all over the world scrutinizing each and every move you make. I am not talking by direct experience here - I do not believe that two people (the equivalent of four eyes, so to speak) have ever cared about what I do at any given time, let alone one billion. But I am saying that pressure manifests itself in different ways for different people.
Zizou flipped. And he directed his anger at the man who had equalized: Materazzi. Afterall it was Zidane's last game, the culmination of a career that puts him at the same level, height and majesty of Pele'. Victory was within reach and Materazzi was the man that had taken it away from him. A human reaction, certainly not a plausible or justifiable one, but human. Considering also that it is unlikely that Zidane would have changed the score during the play. He had tried twice and failed, and was running out of steam. An act of desperation in the heat of the battle, something that the man should not be put on the cross for.
Bottom line, and this is my own personal message to all my French counterparts ... France should be proud of their team. Chirac is right: you should celebrate Les Bleus when they come back to Paris, as they have earned not only the respect of the French, but also of the Italians. Best French player? For me Henry, even better than Zidane.
The Cup stays in Italy, fair enough. But the glory is with you.
Vive la France. Viva l' Italia.
Luigi Frascati
Wednesday, July 05, 2006
Blue Chip Real Estate
Small professional office buildings are sought after by a variety of professionals, especially in the medical industry, for the amenities they offer, which enhance their practice and professional images. For instance, many of these buildings are built with ancillary storage or utility space that can be used for a variety of reasons, provide rooftop or basement HVAC systems, or even nicely appointed consultation rooms in which clients and audiences will be more relaxed and potentially more receptive to presenters.
What makes small professional office buildings so particularly prized by investors is the fact that there is a shortage of them. As they offer more and better facilities, construction is typically more expensive than normal. The plus side of things is that market values of free-standing professional office buildings never fall, because there are not that many and they are always in high demand – specifically because tenants almost never leave.
In addition to generate highly reliable rental income, landlords usually take advantage of other important benefits, all of which are paid for by tenants.
Property Taxes and Utilities
Property taxes are typically higher than the norm but, as in all commercial tenancies, they are apportioned to and paid for by the individual tenants. Care must be exercised to be accurate in the measurements of common areas and passageways, so that a proper apportionment of property taxes can be made among tenants. In some instances, landlords are entitled to estimate the taxes payable for the subsequent calendar year, and to require tenants to pay the estimate in advance, provided that when the actual amount of taxes is known, tenants shall be invoiced by the Landlord.
Operating Costs
Operating Costs refer to the total of all expenses, costs and outlays of every nature incurred in the maintenance, repair, operation, insuring and management of the building all calculated in accordance with generally accepted accounting principles. Operating Costs include cleaning and janitorial, all utilities in the interior and exterior of the building, security, window cleaning, insurance required to be carried by the Landlord, repairs and replacements to the building, heating, cooling, ventilation and air conditioning if provided, outdoor maintenance including landscaping and snow removal, replacement of light bulbs and fixtures, telephone and other utilities, service contracts with independent contractors, supplies, legal or management fees and disbursements, federal sales tax on rent or similar taxes such as the Goods and Services Tax (in Canada), and all other expenses paid or payable in connection with the operation of the Premises and maintenance of the building.
Insurance
In addition to be responsible for payment of the pro-rata share of the landlord’s insurance, tenants must carry their own comprehensive general public liability insurance (including bodily injury, death and property damage) on an occurrence basis, with respect to the business carried out in or from the premises and the tenant’s use and occupancy thereof. Such insurance must contain a waiver by the insurer of subrogation against the landlord or shall include the landlord as a named insured, and shall protect the landlord in respect of claims by the tenants.
Furthermore, the tenant must carry insurance in respect of fire and other such perils covering the tenant’s trade fixtures, furniture and the equipment, all leasehold improvements of the tenant and plate glass, and which insurance shall contain a waiver by the insurer of subrogation against the landlord or shall include the landlord as a named insured, and shall provide that any proceeds recoverable in the event of loss to leasehold improvements shall be payable to the landlord.
Leasehold Improvements
Unless stipulated otherwise, tenants bear all costs of alterations and improvements to the premises, and any and all such alterations and improvements, once completed, will become property of the landlord. Whereas free rent or free leasehold improvements are frequent in the leasing of average commercial, retail or industrial space, when it comes to small professional office buildings any such incentives or inducements to lease are unheard of.
The average size of this type of holdings is in the 10,000 to 15,000 square foot range, two or three stories in elevation and private, gated parking. As practically all expenses are paid for by tenants, capitalization rates are typically very high. The capitalization rate is the return an investor requires for investing in a property, so as to receive the annual flow of net operating income. Small free-standing professional office building have price tags ranging from CAD $1.5 million to CAD $2.5 million depending on the area, and cap rates as high as 20 percent per annum. Real property annual appreciation has been a steady 8 to 10 percent per annum over the past ten years. This means that a property that sells today for CAD $2 million would have sold for approximately CAD $750,000 in 1996.
Saturday, July 01, 2006
North America's Real Estate Markets Are Still The Safest Havens For Investors
The recent French riots in particular underscore the increasingly untenable system of job security at the expense of entrepreneurship, and that the grounds are set for a collision between expectations and economic reality. And whereas certain niches can certainly be found for international real estate investors, especially in countries like Bulgaria, the implied economic risks that must be assumed far outweigh, for the time being, the profits that can be reaped.
In China the economic achievements are huge, but so are the problems. President Clinton, in one of his last speeches, said that 200 million people in China were lifted from absolute poverty from 1978 to about 1999. That's equivalent to about two-thirds of the entire population of the United States in twenty years. But, at the same time, the factors of economic instability are many and worry the leadership. These factors include a financial and banking system that is basically bankrupt, with bad loans-out greater than the real net reserves of the entire banking system.
But, perhaps even more importantly, there is a great imbalance of wealth between the thirty-five percent of the population that lives in the cities and the sixty-five percent inhabiting the countryside. If one is lucky enough to be born in a city - and registered as a city dweller - it is easier to get into university. In the city, one can work at all the large companies and government agencies. Conversely, those who are registered as rural persons are subjected to very severe restrictions on where they can live and work. And this is actually the biggest human rights problem in China today. There is a majority of this population of 1.3 billion people that are, by law, second-class citizens. And unless the Chinese leadership comes to terms with this reality, this social injustice is a ticking time-bomb that one day will explode, also in the faces of those foreign venturers that invest in China.
Since capitalism is, by definition, a system in which the means of production are predominantly privately owned and operated for profit, and which operates in the absence of government coercion or constraint on the production, distribution, or consumption of goods and services, the whole of Islam, most of Africa and all South America – with the notable exception of Chile – are entirely cut out. This includes wealthy countries like the United Arab Emirates and especially Dubai, where the real estate boom of recent years has been plagued by slavery, stories of construction workers not being paid for months on end, and excessive working hours all of which have led to the rioting early in the year, as upset workers damaged cars, buildings, and construction equipment. Again, investment niches can be found anywhere, but risk far outweighs profitability.
Everything taken into account, therefore, real estate markets in the United States and Canada are still the two safest havens for secure investments. The production of real estate output depends essentially on the accumulation of capital. This is so because the propensity to invest depends on expectations of future profitability and on the present perceptions of market risk. If the present perception of market risk increases sharply, capital will exit more and more from the sphere of real estate production. What drives the accumulation process, therefore, is the perpetual search for more surplus value - that is the amount of the increase in the value of capital upon investment, i.e. the yield regardless of source or form.
North America’s real estate markets offer this surplus value, both in the short and long run, coupled by political security and financial stability, and thus position themselves as the destination of choice of all those who want to reap the profits of investment while, at the same time, minimizing the socio-economic risks of investing.
