Tuesday, October 17, 2006
The Philosophy Of The Long-Term Achievers
Detailing the process of wealth accumulation in any real estate market.
Historical data relating to the appreciation of real estate property values throughout the years has always been very comforting. In fact, housing has appreciated consistently an average of 7.5 percent per year over the past 30 years in Canada [source: Canadian real Estate Association], and an average of 7 percent per year in the United States over the same span of time [source: National Association of Realtors]. Which goes a long way to prove how sound real estate is as a wealth-generating vehicle, notwithstanding the several ups and downs the industry has gone through in both countries.
The economic explanation of this brilliant and consistent track record is relatively simple. Housing supply is produced using land, labor, and various inputs such as electricity and building materials, with the quantity of new supply determined by the cost of these inputs, the price of the existing stock of houses, and the technology of production. As real estate is a fixed and durable commodity and the land underneath is practically indestructible, real estate markets are modeled as a stock-over-flow market. About 98 percent of supply consists of the stock of existing houses, while about 2 percent consists of the flow of new development.
What drives the accumulation of wealth in real estate 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. This is by no means unique only to real estate, as stock markets spin around the same principle as well. The difference, however, consists in the fact that real estate markets employ one economic variable that is entirely missing from stock markets: labor.
Real estate requires a constant supply of labor force, which can conserve and add value to inputs and capital assets, and thus create a higher value. The rationale behind this is that labor adds value by satisfying demand through production, since when people acquire income they tend to invest it, and the more people that acquire income the more people that tend to invest it. Therefore, there is a correlation between capital and employment in real estate or, if you will, between income and labor. An increase in levels of consumption sets forth an increase in prices caused by a corresponding increase in demand, in itself generated by a commensurate increase in the income-employment factor.
It follows, therefore, that real estate growth and appreciation of real capital assets are derived by the equilibrium of capital and investment with labor and employment, which is a characteristic unique to real estate. Which, then, explains the consistent track record of real estate as a wealth-generating venue. And which, moreover, further explains why ‘bubbles' are to be found only in the heads of the ‘bubbleologists' - that is all those who spend countless nights thinking about the next economic Apocalypse - but certainly not in real estate.
With all this in mind, one of the oft-touted clichés of real estate investing is that greed is the driving force that causes investors to jump into the market during times of real capital appreciation and expansion, and that fear is what drives the same investors to jump overboard during times of price deflation and decline. Personally I have never quite subscribed to this line of thought.
To be sure, when we experienced the recent 15 percent per year capital assets appreciation, I invariably stumbled across someone who wished the appreciation was 20 percent. So I guess that can be called ‘greediness'. And conversely, there is no question about the fact that the greatest fear of real estate market participants is to lose money, so there is a huge temptation to abandon the market when there is trouble ahead. But I believe that over time we have all become more sophisticated than this, and that investors have moved beyond the foregoing relatively simple explanation of greed and fear.
Market dips do not cause the panic that once did, not even among all those first-time Buyers or investors who have never experienced a market downturn. In fact, more and more people see periods of price decline as times of opportunity. And conversely, when the feeling is that real estate markets are very close to peak out or that are otherwise dangerously high, investors increasingly display the tendency to temper their expectations and prepare themselves psychologically for the eventual market pullback.
Therefore instead of greed and fear I believe it would be more proper to talk about hope and regret. As our expectations of good rates of return increase as the market increases, so do our hopes that capital appreciation will be even better than anticipated. When real estate begins to lose steam, as it is the case today in many areas, it is regret the feeling we experience when we lose money, even if it is money that we lose only ‘on paper' since we do not intend to sell. Econometric research, in fact, has long established that consumers put the value of a dollar ‘lost' at least twice as high as the value of a dollar ‘gained'. Put differently, any investor would have to earn two dollars to compensate for the psychological drawback of each dollar lost.
To experience regret is not the same as being disappointed. The difference stands in the degree of quantity of the loss perceived by investors. For instance, if a Buyer hoped to make a 15 percent return out of the sale of a real capital asset and only makes 10 percent, he will be disappointed but not regretful. If, on the other hand, the same Buyer will only make 5 percent - or no return at all - he will be regretful.
What separates long-term achievers from the rest of the crowd is the psychological capability to not let market cycles dictate their investment decisions. More particularly, in the ebb and flow of real estate, those who are most successful maintain their strategy throughout market cycles. This is, in ultimate analysis, what distinguishes investors from speculators.
The role of speculators in a free market economy is to absorb risk and add very little liquidity to the market place. In fact, more often than not, speculators will reduce market liquidity by inflating prices - the principal effect of speculation. Investors, on the other hand, play an entirely different role. In theoretical Economics the term ‘investment' refers to the purchase and holding of capital goods, which are not instantaneously consumed - i.e. sold for profit - but, rather, used at a later date. In short-term speculation, the measured risk of the acquisition is considerably higher and, in ultimate analysis, no better option than the leveraged capital appreciation through investment holding.
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