Saturday, December 16, 2006


The Axioms Of Investment Probability

Measuring the chances of successful real estate investing.

Whether you are an experienced investor or a Buyer who is beginning now to explore the ever-evolving world of real estate, or even if you are merely a cyberspace vagrant who stumbled across this Post by pure coincidence, chances are high that you will agree with my statement that eating chocolate cake every night for dinner does not go a long way towards meeting the generally accepted objective of health and nutrition. If you agree with this statement, however, by implication you also agree on the fact that eating chocolate cake every night for dinner does go some way towards meeting the generally accepted objective of health and nutrition - albeit minimally.

And this is the whole point: some people live to 100 years while smoking, drinking and eating chocolate cake every night throughout their entire lives. Likewise, some lazy people with no education whatsoever get rich, and they do not even have to win the lottery. But those are the exceptions that prove the rule. There are times when one can win by fighting the odds rather than playing with them, but the chances of success are greatly reduced - albeit they still exist. Hence, to maximize returns, there are probabilities that most investors need to put in their favour.

Here is a pleasant surprise. Unlike many of life's other challenges, putting investment odds in one's favour requires very little incremental effort. One doesn't necessarily have to study harder, work harder or eat better. In fact, the less you do, the better off you will be.

But there is also a catch. In real estate investing our natural psychology can sometimes pull us away from doing the right thing. The unique challenge of successful investing is that many real estate investors do not quite really understand how investment probabilities work, so they are not able to put them to use. Furthermore, many investors are unaware of how their own psychology leads them away from basic investment principles. Successful real estate investing is in direct function of putting the Axioms of Investment Probability in one's favour. These Axioms are:

[ ] In the short-term, real estate markets move randomly and are, therefore, unpredictable.

[ ] In the long-term, real estate markets are predictable and invariably tend to move upwards.

[ ] Risk is largely absorbed by holding many fractional smaller investments instead of a large single investment.

Let's now examine these Axioms closely, beginning with the first. Why are real estate markets unpredictable in the short-run?

In real estate, of course, no value is more important than market value - and no other factor is of a more ephemeral nature. This is so because real estate is an imperfect market. Although commonly and somewhat misleadingly referred to or otherwise thought of as one market, real estate consists of several, smaller markets, each one of which is constantly subjected to and shaped in accordance to external influences and in direct function of economic variables. Externalities the likes of demographic variations, income fluctuations, trends and social preferences, technological progress and government policies - all have a bearing on the desirability of a certain real product and all are proximate factors affecting demand and, conversely, supply at any given time. As such, the numerical determination of market value is also shifting in the short run to follow and reflect the impact of externalities.

This leads us to the second Axiom, that is in the long run real estate markets are more predictable in that many of the above-mentioned externalities have settled already into and have become part of what we, in real estate, refer to as ‘established markets'. Sure, it is tempting to invest into newly-developed neighbourhoods, or even into sprawling new towns, but fact of the matter is that real capital assets hold their values better in established neighbourhoods in the long run. New subdivisions and developments are invariably more exposed to the conditions of the moment, whether the developer is lowering prices because he is pressured by his own financial commitments, or merely because the market turns ‘soft'. In hindsight what may look as a ‘good deal' today may not be a good deal at all tomorrow.

By contrast, values in established neighbourhoods tend to be more stable, since housing supply is produced using land, labour, and various inputs such as electricity and building materials. And, clearly, in older neighbourhoods the value of land typically skyrockets, since supply of land is exhausted. As real estate is a fixed and durable commodity and the land underneath is practically indestructible, in Economics 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.

And why is it the prices of real capital assets invariably tend to increase in the long-term? The production of real estate output requires a constant supply of a labour force which can conserve and add value to inputs and capital assets, and thus create a higher value. The rationale behind this is that labour 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 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. This is specifically the reason why many economic analysts keep their eyes on interest rates and levels of employment, when it comes to forecasting and anticipating the future performance of real estate markets.

As to the third Axiom of Investment Probability, it is a recognized concept in modern economic investment theory that the risk of investing in several real capital assets is not equal to the sum of the risk of each asset but that, rather, it is lower than the sum of all risks. The reason is that the risk of each real capital investment is offset, to a certain extent, by the risk of other real capital investments. The lure of a single high-yield investment is tempting and capturing but, all other variables being constant, many fractional smaller investments add up to the same yield over the same capital investment with a much lower degree of risk.

Luigi Frascati

Real Estate Chronicle


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