Thursday, November 30, 2006

 

The Goal Of Successful Real Estate Investing

“Fortunately, we are not a bunch of computers walking around with limbs and big mouths. But if we were, we’d make far fewer investment mistakes” [Harry Max Markowitz, Nobel Prize 1990 in Economic Sciences and Professor Emeritus at City University of New York].
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The human mind is very dangerous.

I am not talking about the capacity, unique to the descendants of the Homo lineage, to wage war, inflict destruction on to one another, ruin Nature and the environment, run other species to extinction, deplete natural resources, forge the powers of the atom for evil purposes, alter the genome and, in general lines, destroy anything and everything that Whoever is out there, by pure folly, one day decided to hand over to us. No, I am not talking about any of the above.

I am talking about the myriad different ways the brain can work against our own best interests in everyday aspects of life.

The very same capability for generating complex thoughts that allows mankind to be infinitely creative and which gives our lives richness and meaning, also contributes to less, far less desirable behaviours. Specifically as it relates to the investments landscape, it leads us to make inappropriate decisions the end result of which is a detraction from our investment returns. The good news, however, is that Behavioural Finance has made significant progress in uncovering some of the mysteries of investing psychology. Behavioural Finance is a particular specialty of the Science of Economics that 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 distinguishes among three general psychological traits common to investors that have a bearing on investment mistakes. They are:

Unawareness

This is probably the most inoffensive of the three psychological traits. It basically consists of two elements: lack of knowledge and innumeracy. The first is self-explanatory. As it applies to real estate investing, many investors generate sub-par returns because they either do not know or do not understand some of the investment basics. Or they simply have not been educated in the fundamentals of how real estate markets work and how to use markets characteristics to their own advantage. Lack of knowledge applies equally to general investors as well as to all those with specialized expertise, such as realtors and lawyers.

Innumeracy is a form of unawareness that is insidious, in that it is less obvious to most people. This is so, because it has to do with how most of us struggle with the Theory of Probability. Behavioural Finance asserts and recognizes that probability, specifically conditional probability, plays a much more significant role in investing than most of us realize. In very simple terms, conditional probability is the likelihood that event A will occur, given the known occurrence of event B. The reason why most investors get it wrong is because they underestimate probability. We all tend to think of unusual events as unlikely to occur, because our innumeracy inclines us to underestimate random patterns. When unusual events do occur, we label them as coincidences. But probability explains that there is a frequency of randomness between events, that can be expressed in Cartesian Algebraic form (this is, incidentally, the same frequency of randomness that Stephen Hawkings cites in his bestseller "A Brief History Of Time", which postulates The Theory Of Chaos as the basis for the formation and development of the universe).

In fact, the probability of some unusual event occurring at any given time is generally high. It is the probability of a particular unusual event occurring at a particular time that is low.

Perceptions

Real estate, we all know, is mainly a matter of emotion. Unfortunately emotion leads to distorted thinking, defined as the faculty of rendering superficial, quick judgements about reality. Have you ever been interrupted and cut short while you were trying to make an important point? It happens to me all the time in the course of my real estate practice. I used to think that ‘people don't listen'. Oh, they listen alright, but they jump to conclusions. It is an emotional form of irrationality that affects the human brain to varying degrees, and which is entirely counterproductive in the context of real estate investing.

Specifically, Behavioural Finance recognizes that heuristics (from the Greek ‘heurisko', i.e.:"I found it") are mental shortcuts that the brain develops in order to organize and synthesize information quickly. Unfortunately, data tends to become lost and, because of this, the representation of reality in the mind lacks focus. A common form of heuristics that relates to money is known as ‘gambler's fallacy'. The specific example is that of a gambler who, after tossing three heads in a row, is absolutely sure that the forth toss will be a tail. This thinking stems from our use of the law of large numbers to represent a smaller sample.

We all know that a good prediction of the ratio of heads to tails is 50-50, so we generalize that if we get 75 percent heads, at least 25 percent must be a tail. This is exactly what happens when you hear all those ‘bubbleologists' out there - that is all those intent at predicting real estate bubbles of all colors, shapes and forms - saying that real estate markets are bound to crash because we have had already a few ‘up years' in a row.

Now you not only know that the brains of all those ‘bubbleologists' are mush (as I have always stated) - you have scientific proof of it!

Mental Accounting

This is one of the most amusing examples of distorted thinking. Once in a while we all tend to reward ourselves with a nice night out, perhaps to a lavish restaurant - and an expensive one too. But on the way to the restaurant we circle around the block a few times in search of a free parking spot, so we do not have to tip the valet.

Mental accounting describes the irrational ways our brains use to put different expenses into different accounts in our heads. We do not mind debiting the ‘restaurant account' of a conspicuous sum, but we are much more stingy with the ‘parking account'. This demonstrates our ability to categorize money in many different ways, which is all and by itself a distortion of reality.

In light of the foregoing, one can appreciate how correct Professor Markowitz really is. Harry Max Markowitz is the Nobel Prize 1990 in Economic Sciences and Professor Emeritus at City University of New York. He declared "Fortunately, we are not a bunch of computers walking around with limbs and big mouths. But if we were, we'd make far fewer investment mistakes". We are disadvantaged vis-à-vis computers, in that we act illogically, irrationally and emotionally. None of us can be the Mr. Spock of Star Trek all the time. On top of that, we are largely oblivious to these weaknesses and this factor alone has the greatest impact on our investment returns.

Therefore, the goal of successful real estate investing is, first and foremost, to understand and master how our psychology affects investment decisions. Ignore emotion at your own peril. But understand how it works, and you will be better equipped to stay the course of profitability and above average returns.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

RealEstate Chronicle

Monday, November 27, 2006

 

Is Condo Life For You?

As a real estate professional and apartment dweller myself, people ask me this question quite often.

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Condominiums have been in the news in recent years, sometimes for the wrong reasons.

In British Columbia, thousands of people have lost millions of dollars in equity because they bought condos that turned out to be leaky. The situation became so serious that the Provincial Government launched an inquiry, which ultimately came up with a compensation package for distraught property owners. And those property owners were really in distress. The members of the Barrett Commission, in charge of the Government inquiry, stated that they had never encountered anything like the passion and rage of people who felt their homes had been violated and their finances shattered - by water. It turned out that the construction techniques, which work well in California and Arizona, do not work equally well in the soggy weather of Canada's West Coast, no matter how nice all those wooden exteriors look.

On the other hand in Toronto, in the post-September 11 real estate boom, condos were again big news as they came to dominate new home sales in the built-up urban areas. According to the Greater Toronto Home Builders Association, fully 80 percent of all sales in the 416 area code were condos, while the numbers were reversed in the 905 suburban area, where 80 percent of all sales were non-strata freeholds. This is of great interest, since condos have accounted traditionally for just under 30 percent of the market, with one notable exception: before the real estate collapse of 1989.

To be precise, a non-strata freehold interest in land is one in which the titleholder owns ‘everything' - from lot line to lot line, whether it is a detached house, side-by-side duplex or even townhome. He owns the grass, driveway, bricks, shingles, windows and walkway. Not so with the condo, where what it is own goes from the inner one-half of a wall to the inner one-half of the opposite wall, and floor to ceiling as well. The condo owner, furthermore, shares in the ownership of everything else in the development with all the other owners, including outer structure, parking garage, elevators, landscaping, windows and roof.

Condos can also come in different varieties, not just as apartment buildings. There are condo lofts, condo townhouses, condo commercial units and rural communities with acres of common grounds. Typically some of the common features that everybody owns are set aside for the exclusive use of individual owners, such as balconies or backyards, lockers and parking spaces. Condos are bought, sold and mortgaged just like regular non-strata freehold interests, but the owner only insures the contents of the unit, while the strata corporation carries insurance on the physical structure itself. Condo owners pay a regular monthly fee for common expenses such as outside maintenance, ongoing repairs, landscaping and utilities for common areas, as well as a contribution to a reserve fund to be used in emergency situations.

Like homes, condos come in all price ranges and can be a great way for first-time purchasers to get into real estate, moving from rental tenancy to ownership in a small apartment unit. At the other hand of the scale, aging Baby Boomers are selling off their mansions, which require lots of care and attention, and move into luxury condominiums which offer a more liberating lifestyle as well as added security.

Indeed, there are distinctive advantages to purchasing a condominium. For example, there is no outside maintenance to worry about - no grass to mow, snow to shovel, roof to patch or driveway to seal. All this work is arranged and contracted out by the strata corporation. This means, one can have an exceptionally carefree lifestyle, knowing that someone else is looking after the chores.

Also appealing is the stable nature of the ongoing costs of ownership. With a single-family detached house one just simply never knows when the furnace is going to quit or, worse, the hot water tank is going to give up and flood the basement. With the condo, the predetermined monthly fee takes care of everything. Furthermore, speaking of money, it costs far less to find a nice condo residence in a demand neighbourhood than a single detached house in the same location.

Another big plus for people who like big swimming pools, exercise rooms, libraries or even art galleries is that condo developments often come with such amenities built right in. When everyone contributes through their monthly fees, some impressive things can be achieved.

So therefore, is condo life ideal for everyone? Definitely not.

Some people absolutely despise the loss of personal freedom that condominium lifestyle invariably brings about. Because one does not fully own the unit he lives in, one cannot control or even change it without collective agreement. This means making no exterior improvements or even internal renovations in some cases. There can be a great deal of rules and bylaws, and they can change at the whim of the majority of the property owners, who may not share the same vision or who may collectively decide that major renovations or improvements are required. The owners may decide that additional money may be collected on top of the monthly fees, and the strata corporation can place a lien on a unit if the owner refuses to pay up.

There have been instances in deluxe developments where prospective purchasers have had to be sponsored by existing condo owners, and then had their own personal finances and habits examined to be eligible for admission!

Less dramatic, but equally important, are the possible restrictions that can be imposed on ownership of a dog or cat. Also privacy is drastically reduced, compared with a single-family house. Then there is the value of the unit itself to consider, entirely dependent on how much a similar unit has sold, even on a different floor.

So therefore, condo ownership is an entirely different ballgame, which does not suit everyone. A careful scrutiny of the development in which the condo is being purchased always help, but in ultimate analysis what counts is the capability of the purchaser to adapt to an entirely different lifestyle.

Luigi Frascati

luigi@dccnet.com

www.luigifrascati.com

Real Estate Chronicle

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Wednesday, November 22, 2006

 

The Price To Pay For Real Estate Growth

Nothing is free.
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Canada and the United States both rely heavily on international trade and foreign investment for economic growth, and are both major producers of commodities. Because of the fact that they share these attributes, they also share a keen interest in the health of the global economy. So it is extremely important for both countries to focus on how events in the international arena unfold.

Over the past few years, there has been a strong expansion of the global economy. Indeed, the rate of expansion has exceeded the growth rate of global potential output. This strong growth has led to higher prices for many of the primary commodities that North America produces. In turn, this has meant an improvement in terms of trade and rising national incomes in both countries.

This global growth has been rooted primarily in the economic strength of the United States and, by reflection, of Canada. Specifically with regard to the U.S. economy, growth has come from strong household demand, while net national savings have been negative. By comparison, in emerging Asia household demand has been weak, while net national savings have been very high. These forces have contributed to the global current account imbalances that have now become an important macroeconomic concern.

These global imbalances are caused by the large and persistent U.S. current account deficit, which is mirrored by current account surpluses in Asia and in many oil-exporting countries. And these imbalances have grown to the point where the United States needs to attract 70 percent of the world's capital flows to finance its current account deficit - clearly an unsustainable situation.

Additionally, following events such as the Asian and Russian financial crises of the late 1990s and the bursting of the tech bubble earlier this decade, Central Banks around the world have injected a lot of liquidity into the global economy. Clearly, this liquidity has helped to encourage the strong growth in North America of recent years. But now, Central Banks are in the process of removing some of it. The interest rate increases seen to date, and the prospects for more increases to come, have been associated with the slowdown in real estate and a somewhat increased volatility in financial markets, as investors adjust their expectations about future growth. Moreover, the recent revamp of that very old Middle East conflict and the expectations of many analysts of further, substantial increases in the price of crude certainly do not help.

This withdrawal of liquidity is completely appropriate, given that the global economy is now likely not too far away from the limits of its capacity. Thus, it seems very likely that global growth will slow to a more sustainable pace. Ideally, this would take place in a relatively smooth way. But there are a number of risks surrounding this scenario, and there is a possibility that global growth will slow more sharply than desired, to the detriment of the economies in North America. The most important risk has to do with the way global imbalances are ultimately resolved.

There are a couple of concerns here. First, in order to reduce its current account deficit to sustainable levels, the U.S. economy needs to reduce its domestic demand. But as U.S. demand and American consumerism have been a key support for the global economy, it is crucial that other major players boost their domestic demand to pick up the slack. Specifically, it is important that China and the economies of emerging Asia take steps to reduce their savings by strengthening household demand. It is also important that demand in Europe and Japan continue to strengthen, to help global economic growth smoothly 'rotate' away from the United States without global demand slowing too much or too quickly.

Second, it is crucial that real estate and investment markets remain confident that policy-makers are serious about putting the right policies in place to allow for an orderly resolution of imbalances. As long as they have this confidence, markets are likely to continue to function smoothly. The alternative is an increased risk of investment and financial instability in North America, and such instability could then spill over into trade in goods and services, leading to a dramatic decline in global growth.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

Saturday, November 18, 2006

 

How To Become Rich And Get Dumped

A very good reason to buy the worst house on the best street for your loved half.
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No kidding! It shows that I'm a bachelor.

Most people buy residential real estate based purely on emotion, without ever really thinking rationally about why they are doing what they are doing. For example, I have a friend who lives in a suburban community distant three hours by car from Downtown Vancouver, where I live. As my pal also works in Downtown, he has to travel six hours each and every day of the working week - that's 30 hours per week just to come here to earn a living and go back home. That's an awful lot of driving. When I asked why he bought his home so far away, his answer was simple: that's where his mother-in-law lives, and the wife wanted to be close to her.

The trouble is, in that location the home is a tough sell and will appreciate in value slowly, if at all. Heck, I'm not even sure it's Canada .... Meanwhile, six hours a day on the road is enough to eat up a normal car every three years and run up a mountain of gas and maintenance bills. That real estate decision may make the wife happy, but it is hardly logical. The point is that when you are dealing with the single most expensive asset of your life (your house, that is ... not your wife), representing the bulk of most people's net worth, then emotion has to be relegated to the back seat.

The most valuable feature of real estate, by far, is where it is located. The old adage of ‘location, location, location' as being the three cardinal rules of housing is true today as it has ever been. Real estate is, afterall, an unmovable commodity and it is worth what it is worth mainly because of where it is at. Therefore, location is the very first thing to take note of, not the condition of the structure that sits on that apron of land. In ultimate analysis, whatever may be wrong with the house can always be fixed, rebuilt, repaired, restored or replaced. However, a bad or questionable location can never be changed - unless one buys the entire subsection of the city.

This is the reason why one should buy the worst house on the best street, and not the other way around.

In every city and town there are invariably neighbourhoods or areas that are ‘in demand', and they are in demand for a reason - either they sit on a lake or river frontage, command views of the city skyline, of a ravine or the ocean, or have peaceful, leafy streets. Some areas are close to schools or public transportation routes, or are unique in terms of topography, history or population variety. So the savvy Buyer will try to get into these areas whenever he can, and then will sleep well knowing that he has taken care already of the resale value of the home he has just finished purchasing.

When shopping for a home, it is always best to avoid houses that sit near major traffic thoroughfares because of reduced privacy and more traffic; or houses sited next to schools or retail stores, as they will always sell at a discount compared with the ones in the middle of a quiet residential block. And forget about buying anything that is near a police, ambulance or fire station, or a hospital or factory. Furthermore, it pays to avoid neighbourhoods that are in transition, since tree-filled areas will always and invariably be worth more than new, suburban streets with twigs planted along the boulevards.

But since what one buys will always reflect what one spends at any given time, to buy the worst house on the best street is the sure way to maximize capital gains at the time of resale, simply by fixing it up a little. It sure pays to live where everybody wants to live and make a little money in the process. And if you get dumped by your loved one in the meanwhile, look at it on the bright side - you can also enjoy your new neighbourhood in peace and tranquility.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

Thursday, November 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 and its never-ending conflicts? 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 the attack of Lebanon on Israel of this past Summer is yet another proof of it. Just take a look at the dive the Dow Jones took during those days of war. 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, this time for good. 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, has generated a resurgence of public fears about the oil markets in the past, and there is no doubt that it will do so again in the future. 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

luigi@dccnet.com

www.luigifrascati.com

Real Estate Chronicle


Monday, November 13, 2006

 

Real Estate Outlook 2007: The Great American Iced Lemonade!

What do California sunshine, the citrus industry, an excess surplus of ice cubes and Nancy Pelosi all add up to? Find out ...
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Did anyone out there ever coined the phrase ‘The New Era Of American Socialism' yet?

Well alright, that is unfair. After all Real Estate was sliding downwards even before the Democrats took over the House and Senate, and Nancy Pelosi became the Speaker to be. However, it can be safely stated that the recent mid-term elections have not exactly shed a ray of hope on the already faltering housing prices. So now, in light of the entirely new and revolutionary political landscape in Capitol Hill, what are mundane folks like you and I supposed to do?

Sure, the social agenda of the Democratic Party in general, and the personal ‘socialist' agenda of Congresswoman and Speaker of the House Nancy Pelosi (D-Cal.) in particular take somehow the breeze out of the investment world, both as it relates to Real Estate and the Stock Market. But when it comes to Real Estate, however, there are some positive notes worth mentioning.

Housing supply is produced using land, labour, and various inputs such as electricity and building materials. The quantity of new supply is determined by the cost of these inputs, the price of the existing stock of houses, and the technology of production. Essentially, the production of real estate output depends on the accumulation of capital, which requires a constant supply of labour force that can conserve and add value to inputs and capital assets, thus creating a higher value.

The rationale behind this is that labour adds value by satisfying demand through production, since when people work and acquire income they tend to invest it, and the more people that work and 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 labour. 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 growth is derived by the equilibrium of capital and investment with labour and employment. And since, furthermore, 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.

Therefore, seen from this perspective, the Democratic agenda of both increasing minimum wages and put people at work through more direct governmental intervention than the Republicans otherwise would like to see, finds in fact its long-term benefits in Real Estate. It is a statement of fact that, in retrospective, many workers in North America have missed out and are missing out on the rewards of globalization, so trumpeted about by both the present Chairman of the Federal Reserve System, Prof. Bernanke, as well as the former Chairman, ‘Maestro' Alan Greenspan.

Rich countries have democratic governments, so continued support for the globalization process will depend in large part on how prosperous the average worker feels. Yet in the United States real wages have been flat or even falling these past few years while, at the same time, capitalists and large corporations have never had it so good. In America specifically, profits as a share of GDP are at an all-time high of about 15.5 percent, and Corporate America has increased its share of national income from seven percent in 2001 to thirteen percent this year.

In fact the primary culprit and cause of the slowdown in Real Estate is the ratio between wages and real estate market values. This ratio is entirely skewed to values. Whereas market values in metropolitan areas have appreciated an average of fifteen percent per year through 2005 inclusive - or a total of seventy-five percent since 2000 - salaries have increased an average four percent per annum - or twenty percent total. There is, therefore, a fifty-five percent gap, which accounts for the problem buyers are facing today when it comes to go to the bank and qualifying for a loan. In this sense, therefore, a redistribution of income from capital to labour is now due.

The flip side of the Democratic agenda, however, is that it is going to take a long time for government economic intervention to get a foothold in the economy, in order to make workers earn income sufficient enough so that they can go to the bank, get a loan and go shopping for real estate. Thus, it is going to take equally long for demand to jump and prices to increase as well. This is so because demand is in direct function of underlying personal income. An increase in personal income will encourage investment to a higher degree, which, in turn, will spur demand causing a proximate levitation of prices and subsequent economic expansion.

A second but equally important flip side is how foreign investors and debt-holding nations are going to view this sudden shift to the left of the American behemoth, and whether emerging economies such as India and China will continue to finance America's spending habits. Confidence in the U.S. Treasury is out of the question, but how convenient is it going to be for foreigners to continue investing in an America tilted definitely to the left?

Many economists have long been expecting America's widening current account deficit to cause a financial meltdown in the Dollar, and the main reason as to why this has not happened yet is that emerging economies have been happy to finance the deficit. In 2005 India, China, South Korea and Japan (not an emerging economy but a very important debt-holder nonetheless) ran a combined current account surplus of about USD 2 trillions, a large chunk of which was reinvested in American Treasury securities. It is all to be seen, however, whether the Asian Tigers will continue to find the convenience in investing their foreign cash reserves in American securities or if instead they are going to withdraw their support of the American capitalistic system, especially if such system will be perceived increasingly as shifting much too much to the left.

By purchasing Dollar assets the Asian economies and Japan are subsidizing American consumers, encouraging too little saving on our part and too much spending. But should they decide not to buy anymore and in fact to cash in, the American economy is likely to suffer a real hard landing. This is the reason why it is important to monitor and understand how developments in the world economies affect the balance between domestic demand and supply. Exchange rate movements tell something about economic developments that may be having a direct impact on aggregate demand.

By monitoring the fluctuations of the Dollar in the forthcoming months it will be possible, therefore, to anticipate whether the Central Bank will ease or tighten monetary policy by stimulating the economy through lower interest rates or by reducing the stimulus through higher interest rates. And, therefore, it will be possible to predict the impact that anticipated shifts in interest rates will have on demand for domestic real capital assets. Clearly, in the eventuality that demand for U.S. Treasury bonds will abate, the Federal Reserve will have no other choice under the present circumstances but to raise interest rates, so as to continue to attract foreign capitals and thus contributing to a further slowdown in the domestic housing markets.

Should a forced rate increase actually take place in 2007 to maintain the momentum with foreign debt-holders, that would really fly in the face of all those analysts and commentators who have assumed that a vote for the Democrats would contribute to a rate settling.

Certainly we are entering into a period of financial uncertainty, all the more remarked by what promises to be an economic - if not political - stalemate between a conservative White House and a liberal Congress. And should this stalemate translate into higher interest rates, the soft landing that Chairman Bernanke was mentioning only this past July may very well become in 2007 a distant, wishful dream.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

Friday, November 10, 2006

 

The Future Of Housing Values

Back in the '80's real estate and stock markets took a dive together, with disastrous economic consequences. Is history repeating itself now? Find out ...
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Some people are under the impression that real estate and stock markets move in different ways and for different reasons, with no real connection between them. But to think in this way is a mistake. There is a synergy between them, an interaction of economic elements which, when combined, produces a total effect that is greater than the sum of the individual elements.

The last and greatest example of this synergy goes all the way back to the 1980's, when real estate and stock markets took a dive together. The equity markets died on ‘Black Monday', October 19, 1987 when the Dow Jones Industrial Index collapsed 22 percent in value in a single day. The 1987 plunge, as it turned out, was also the beginning of the end of a massive bull market in real estate, which had marked that entire decade. By 1989, sales activity in most major North American markets was petering out just as the average home price was hitting its zenith. Within eighteen months the economy was in full recession and real estate values, especially for condos, sunk dramatically. Twelve years later, at the beginning of the bull housing market of 2001, the average home price still sit below that of 1989.

So what does all this tell us about the future of housing prices? What is the connection between real estate and stock markets?

To be sure, there is a fundamental difference between the two fields of investment. At its core the housing market, like the stock market, is all about supply and demand. But the difference is that investors base their decisions to buy into stocks on future potential whereas investors base their decisions to buy into housing on inherent value. However, specifically because both real estate and stock markets move in accordance with the shifts of equilibrium between supply and demand, they are both subjected to the fluctuations of the individual components of supply and demand as well.

This explains why housing prices soared in the late 1980's, as Baby Boomers swamped the markets; why they tanked in the early 1990's as unemployment rate jumped higher; and why they boomed again beginning in the new millennium, as stock woes, terrorism and accounting scandals drove millions of investors to look for safe alternatives to stocks and equities.

With stocks, supply and demand is dictated by corporate earnings, economic conditions, risk, greed and fear. On the other hand, externalities as varied as immigration, internal migration trends, marriage trends and cultural precepts as well as generation gaps affect real estate markets, but the greatest element is affordability. And affordability, in turn, is governed by the interaction between prices and interest rates.

In the 1980's the real estate boom ended for one single reason: the average house became too expensive for the average family to buy. More specifically, house prices rose sharply during the boom, then interest rates also rose sharply thus making homes far less affordable. Suddenly people saw real estate markets in exactly the same way they saw stock markets - as not giving good value. Conversely, in the post-September 11 boom of 2001 investors were intensely motivated by the combination of relatively low prices and the cheapest mortgage rates in forty years. This was coupled by the fact that all the major banks began to offer below-prime packages in an attempt to get an ever larger share of what was going to become the quintessential cut-throat business: lending.

Affordability in 2001 was the best it had been in more than a generation, just as stock markets started to sputter and move towards a collapse. So long as investors, including foreign investors, saw value in real estate and not in stocks, money continued to flow in. As a direct and proximate result of the new real estate mania, home prices rose by ten times the annual inflation rate. New housing starts repeatedly hit new records and in May, 2002 for the first time in the history of American real estate, sales of new homes passed the one million mark in a single month.

By comparison, today's markets are not nearly as brisk as they were only a few months ago. The combination of higher mortgage payments and steeper house prices has meant an erosion in affordability. The primary culprit and cause of this slowdown is the ratio between wages and real estate market values. This ratio is entirely skewed to values, so that wages have not kept up with appreciation, particularly of residential real properties. Price dropping has been a steady staple these past few months. And all this has come precisely at the moment when a retreating stock market means that stock values and mutual funds are once again shrinking fast.

Many economists do not envision the real estate slowdown as a market downturn, much less the onset of the real estate bubble believers in the Apocalypse have been prognosticating all along. And because of the savvy monetary policies enacted by the Fed, economists forecast that a slower appreciation of real property values will allow salaries and wages to catch up and thus to regenerate the pool of buyers, especially first-time Buyers, entitled to take their first steps into the world of real estate.

There are many reasons to become a homeowner, with the most important of which perhaps being that one has to live somewhere. Additionally one can build up equity and borrow against it, as well as enjoy tax-free capital gains. Because of this, therefore, and since stock markets do not offer investors a reliable alternative, real estate will continue to remain a viable investment venue, though no longer the gold mine it has been in the past.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

Tuesday, November 07, 2006

 

Energy And The Rise And Fall Of Civilizations

Energy as the catalyst to progress in the context of human societies.

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David Attenborough, the famous naturalist and paleontologist, has stated that "The history of human civilizations - including their rise and fall - can't be properly understood unless we appreciate the importance of ‘power subsidies'".

In the evolution of societies and cultures, energy has played invariably a pivotal role, beginning with the energy that we, as living humans, must store in our own bodies to survive. Because of this, the destiny of our ancestors in the Homo lineage was that of wandering the plains of Africa in search of food that could be assimilated and stored as reserve energy. Which was, by the way, the destiny of all other members of the Animal Kingdom - except that Homo excelled at it. By acting collectively and cooperatively with the environment, Homo (by now become sapiens) was able to increase the critical mass of the brain and to use the added intelligence to secure what he needed to sustain small communities - the embryo of civilization.

Later on, as the quest for improved life progressed, Homo sapiens continued to hone his above-average intellectual capabilities to make the transition between nomadic life to that of more stable nuclei, which based their sustenance on agriculture. By domesticating animals and plants, furthermore, Homo sapiens secured a continuous and reliable supply and surplus of readily available energy and, by so doing, further increased the quantity of energy that could flow through his communities - and his body. Plant cultivation, moreover, aided by irrigation systems, greatly increased the yield per unit of human energy - labor. Agricultural surpluses, later on, freed people from attending the land on a daily basis. Thus various Homo sapiens could differentiate tasks and this differentiation spawned new, more complex institutional and hierarchical arrangements within their primitive societies.

As a direct and proximate result of all this, Homo sapiens abandoned pre-history and walked triumphantly into history, and this very passage helped to facilitate an even greater energy flow-through. It was 10,000 years ago.

From the onset, the relationship between energy and cultural development has been very strong. The tie and junction point between energy and culture is also the thread behind the concepts of ‘allocation of scarce resources' in Neoclassical Economics. Lionel Charles Robbins (1898-1984) defined ‘resource scarcity' as the difference between what people desire and the demand for goods. Thus a good is said to be scarce if, at any given price level (including price level zero - i.e. for free), people would consume more of it than the available supply. But the impact on demand - and thus the desire for a certain type of good, continued Robbins, has its roots in the culture of any given society, whereas the availability of that given type of good is in direct function of its cost, that is of the total combination of raw materials, labor and energy involved in its production.

No better example of this can be found in the variety of foods and cuisines all over the world. Foods that are consumed in North America, like hamburgers for example, are certainly not as nearly appreciated in India, where cows are sacred and untouchable. Likewise the production of ham and other cured pork meats for which Italy is worldwide famous is absolute anathema in Israel and the Muslim world for religious reasons.

Robbins stated that there are three critical factors in assessing the ‘progress' of any culture: first, "the amount of energy harnessed per capita per year". Second, "the efficiency of the technological means with which energy is harnessed and put to work". And finally "the magnitude of human need-serving goods and services produced". By combining these three factors together, societies evolved as the amount of energy harnessed per capita per year increased or, alternatively, as the efficiency of the technological means of putting the energy to work increased. Either way, energy is both the catalyst and the ruling factor in the development of cultural systems.

The human experience as an evolutionary journey is in direct function of the increased use of available energy. The degree of civilization of any people, or group of people, is measured in fact by the ability to utilize energy for human advancement. More specifically, whether a culture is low or high on the scale of human progress is directly correlated to the amount of energy produced and consumed per capita. A fact this, substantiated by econometrics studies. In fact, going back to David Attenborough, "the very function of culture is to gather and control energy so that it may be used for man's wants and needs".

Human beings throughout the world and in any epoch have accomplished the development of their societies by inventing tools to capture and transform energy to manage the creation and maintenance of social institutions. So therefore, what we call ‘progress' is merely the use of tools in combination to capture, store and use more and more energy and, by so doing, to extend our power and increase our wellbeing. All of which brings us to the present time.

Energy is so essential in today's technologically advanced world, that no one can envision a society without it. So much so, in fact, that no one and nothing can function without energy either. Going through a blackout, even of modest proportions, underscores this point. Classical capitalist theory embeds the concept that the creation and transformation of energy is vital to the proper functioning of the capitalistic system. David Ricardo (1772-1823), the English economist, in his work entitled Principles Of Political Economy And Taxation examines not only the importance of energy within the (new at that time) concept of free trade in Capitalism, but also sheds light on the reason - the sole reason, in fact - as to why civilizations ultimately collapse and disappear.

Collapse sets in when a mature civilization reaches the point at which it is forced to spend more and more of its energy reserves merely to maintain its complex social arrangements, while experiencing diminishing returns in the energy enjoyed per capita. In the early stages of civilization, the creation of infrastructures such as roads, irrigation systems and conquest of new lands and territories are determinant to a net increase of energy returns over energy expenditures. In the late stages, states spend most of the energy just to maintain existing infrastructures, as well as to sustain the ever-expensive lifestyles of political elites or other "non-productive members of society".

Furthermore, a large population whose number grew during times of economic expansion suddenly enjoys less energy per capita, even as people are working harder and longer. At the same time, states impose more and more taxes on people to make ends meet, thus hastening the downwards spiral. Often times, at the very end of the civilization cycle, in a final effort to protect themselves from the anger of the population, states order whatever energy is left in the form of surplus food, money, outputs and economic resources to be allocated first for use and equipment of the military, thus further angering the public. The population begins to disaggregate and fend for itself, setting off the process of disintegration. Unless a new source of energy is found, either by discovery or conquest, collapse is all but inevitable.

Naturally, if anyone reads in the conclusions brought forth by David Ricardo some two-hundred years ago an ominous parallelism with what is happening in our societies today, and with the plight for oil, gas and the control natural resources in the political arenas of the world, any such similarity must be nothing but purely coincidental ...

Luigi Frascati

luigi@dccnet.com

www.luigifrascati.com

Real Estate Chronicle


Thursday, November 02, 2006

 

Real Estate Investing: The Value Of Compromise

Capital growth, income, liquidity, borrowing, yield, debt-management and risk in real estate investing, and their economic interactions.
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Investing in real estate, in general lines, involves compromise and is often more a matter of what an investor is willing to give up than what he actually wants.

If I were to ask "What is your investment objective?" how would investors respond? Most likely the answers would range from "I want to retire at 55", to "I want to start my own business within the next five years", or perhaps to "I want to have enough money set aside for my children education". We all have many different ways of expressing what we are trying to accomplish when we set investment objectives. When all is said and done, however, there are really only three fundamental goals we really intend to achieve. All goal-setting boils down to growth, income and liquidity.

We want our real capital assets to grow in value, that is to be worth more at some point in the future than they are today. Then, while we are in the process of accumulating whatever amount of wealth we can, we need to generate income out of those assets to minimize costs of owning such as property taxes and maintenance and, possibly, to increase our own salaries or wages. And, finally, we want to be able to quickly convert those assets into cold cash, should the need ever arise to get through some unexpected crisis, or if a better investment opportunity suddenly comes in sight.

That's quite a lot that we want from our real estate investments. The truth is that only few of all investors will have situations so straightforward as to be able to accomplish all three goals in equal proportions. For the vast majority of us, it will be a matter of seeking compromise so as to incorporate in our investments only some elements of growth, income and liquidity, and not in perfect equilibrium. This is due not only to the nature and type of the real estate investment we decide to make at any given time, whether residential, commercial, multi-family rental or a combination of any of the above, or to the situation of the market at the time we make our investment, but also for a quintessential human trait common to all investors.

We spend money on things we need, and we save money for things we want. Which is great, until such time as we decide to reclassify what is that we need and what is that we want. Human nature being what it is, when we see something that we suddenly decide we ‘need' and the money is readily available, our best intentions can wilt and disappear instantaneously. If the cash is not in the savings account already, we can pay an unexpected visit to our friendly neighbourhood banker who will be more than thrilled to advance the money secured by our real capital assets, or to refinance our existing real estate loans. This is, in ultimate analysis, how consumerism works.

There is no doubt that the judicious use and management of debt can accelerate the accumulation of wealth. In Finance, this is called ‘leveraging': the use of borrowed money to meet investment objectives, particularly growth and income. However, financial leverage is a double-edged sword: using other people money to invest also increases the risk associated with the investment. It is bad enough to lose one's own money if a real estate investment sours. It is much worse, however, to lose the banker's money - one may quickly discover how unfriendly, all of a sudden, the friendly neighbourhood banker may become.

Historically, leverage strategies work best and are more popular during times of low interest rates and high appreciation of property values. If, for example, an investor borrows money at 5 percent to purchase an investment that appreciates at the rate of 10 percent a year, obviously the investor will come out ahead. Additionally, in certain circumstances the interest expense is tax deductible, thus making the net return even higher. Unfortunately, however, during times of downward fluctuations leveraging may be a risky proposition, as the cost of borrowing may exceed the investment yield even after deducting interest expense.

So, therefore, when is leverage appropriate? In Finance, the rule of thumb is that every dollar borrowed increases the risk of investing by 50 percent. This means that if an investor has $100,000 of his own money and decides to borrow an additional $100,000, he increases the risk by 50 percent. If he borrows $200,000, he doubles the risk. If he goes as far as borrowing $300,000, he increases the risk by 150 percent. Therefore, if the real capital asset chosen by our investor would normally yield, say, 10 percent, he should expect a return of somewhere in the area of around 10 + 5 = 15 percent to account for the extra risk, if he pays $200,000 for the real property he is acquiring, $100,000 of which are financed by a lender.

This ratio holds true for leveraged investments of higher or lower proportions too. For instance, if the investor matches each dollar of his own money with 50 cents from the bank, his expected return should be at least 25 percent higher than if he only used his own money, or 10 + 2.5 = 12.5 percent. Likewise, in the case of $200,000 financing the expected yield should be 20 percent. And then, of course, there is the real big one: the 100 percent leverage, also known as the zero-down option (the one they show on TV at midnight), with the investor using none of his own funds (because he doesn't have any, since he just landed straight out of the Mongolian desert - like the chap on TV). On a purchase price of $200,000, the yield should hover to on or about 10 + 5 + 5 = 20 percent. On a purchase price of $300,000 it should be in the range of 10 + 5 + 5 + 5 = 25 percent and so on.

Luigi Frascati

luigi@dccnet.com
www.luigifrascati.com

Real Estate Chronicle

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