Tuesday, 26 November 2013

Debt Levels Unsustainable: Asset Prices Unbelievable

Too much debt for overpriced assets.

This is the equation for the chaos that defines the global financial state and dictates economic recovery or lack thereof. In times past I have joked that suited-up kids fresh out of university have become qualified valuers without having any real life or business experience to give reliable asset valuations. The greed that has long been the cancer of world stock markets has crossed the border and invaded residential and commercial property markets. And it is a problem that will not easily or quickly resolve itself.

In western economies the long-held establishment that your principle place of residence - your home, always be excluded from the value of your investment portfolio, has been washed away. The greed of the Baby Boomer generation has, within the space of ten years, destroyed the hopes and dreams of generations to come. There is now a mentality that real estate is the new gold and that once you buy it, it always goes up in value and is always worth more than you paid for it. This dangerous and uneducated view has been accepted wholesale by financial institutions, who have been quick to exploit and perpetuate the stupidity further by lending heavily into this asset class.

Institutions such as Freddie Mac and Fanny Mae collapsed because of stupidity. In plain and simple terms, that is all it was. You can create as many financial derivatives as you like and spin whatever story you like: DEBT is still debt and equity is (these days), rare! Zeitgeist has us believe all money is debt and the GFC, sparked largely by debt burden in the housing markets is probably a good argument for this. But debt levels have accelerated away from equity levels and definitely outpaced revenue and profit growth worldwide.

The stark reality is that too many people became complacent. And overconfident in real estate holding its value. You can argue that a real estate asset is valued at what the market values it att all you like. The reality is that the bulk of the 'market' are not financially educated or financial experts. So what does this say about how the market 'values' real estate in the first place. We have real estate agents who will enthusiastically give an opinion. Their pay is based on commission on the sale of the real estate - WHAT DO YOU THINK THEY'RE GOING TO SAY? "Gee sir, it's a dilapidated piece of sh** and I think it's only worth half of what this dreamer wants for it." 

My own brother often brags about how he made close to $100,000 profit on the sale of his house when he sold it just 3 years after moving in. He now regularly complains about the fact his sons and daughter will not be able to afford to buy their own home. Ah...wakey, wakey! The sad fact is that people like him have created this dilemma and are now griping about it. Now that the economies of the western world have slowed and gone backwards, we are coming to the sad realization that assets in all classes have been overinflated in value. Everyone will be paying the price of this for years to come.

The impact is worsened in terms of economic recovery, because individuals, companies and Governments are forced to stop altogether and reassess their balance sheets. This 'halt' is caused by the fact that everyone is so deep in debt, they are physically unable to carry any more of it. So business activity has stagnated while everyone tries to get hold of their debts levels and get back on an even keel. This is a good thing, but it also means productivity stalls because no one can really borrow more money for acquisition or expansion.

The biggest problem with real estate is this: it was promoted as a quick way to make money. Instead of being a long-term investment, people were educated they could make money fast and so even private housing became a business! The underlying problem is that houses are NOT a business! They do not produce goods. They do NOT offer services. They do not offer productivity or genuine ongoing employment! My argument has always been that the economic value of a house is absorbed and consumed after the builders and carpenters have completed construction and walked away! The only economic benefit residential property offers thereafter is occasional work and maintenance for upkeep. In other words, employment for plumbers, gardeners, roof tilers and other home handymen.

Some might say that you can consider housing a business in that it offers a rate of return when a house is rented out. But would you go into business and pay hundreds of thousands of dollars for a four, five or six per cent return? Most likely not. And my argument still stands - there is no genuine economic benefit provided, even if the property is rented out! When you buy a legitimate business, you are paying for the cash flow it produces from the economic activity it engages in. You pay a multiple of the net cash flows and the reality is that you cannot expect a higher rate of return from something that simply does not produce anything!

But with dollar signs in our eyes, we have allowed the myth to perpetuate that real estate 'never goes down in value.' Right. Well, as with any other form of investment yes, real estate can go down in value. Too many people have learnt the hard way and paid the ultimate price: losing their home and in many instances, going bankrupt. With any luck, it will be a timely reminder that people need to reacquaint themselves with the lost art of negotiating price. This current economic climate could have been avoided and certainly should have been addressed well in advance of corporates like Freddie Mac and Fanny Mae going bottom-up.

My suggestion would not be popular with real estate agents or economists anywhere. But my argument would be for a system of zoned valuations. Picture in your mind a map of New York, but with red rings forming a Bulls Eye target over the top of that map. Any property within a 5 mile radius from the epicenter of the CBD in NYC would at maximum, have a set price no higher than one million dollars - $1,000,000. No higher; legislation would prevent it. Ten miles out - $800,000 maximum. Twenty miles out, $500,000 etc etc. Those values might differ city to city and suburb to suburb, but essentially the system would dictate the maximum amount a property can sell for. It would allow plenty of room to negotiate up and to that maximum value.

A system of zoned valuations for real estate would give the market transparency, based on each property's proximity to the center of the most important economic hub. Setting prices and importantly, setting them lower - would encourage a more fluid market with properties changing hands more often as businesses and individuals seek expansion, growth, downsizing, upsizing etc. It would also prevent individuals and businesses from being cut out of the real estate market, which invariably occurs as prices soar. Real estate agents who would otherwise complain about lower commissions would be rewarded with more sales. Not to mention more confidence amongst buyers and sellers who have a firm guideline on values.

The point has been proven that income, revenue and profits cannot keep pace with price and value rises. The million-dollar question of what something is worth is the same as the adage 'how long is a piece of string?' It is doubtful anything remarkable will come about through the haze of stupidity that has led to the GFC being cast upon us. With debt levels still at elevated levels and western jobs and employment heading east, there is still much concern to be addressed. We now have a new dilemma that there is a decreasing number of jobs and prospects for economic activity to service the existing debts. Let alone be capable of borrowing more in the future. Scary stuff.

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