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The Changing Housing Market - Part Two

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Something new is happening in property markets around the world. It's obvious in the UK and also in the USA. It will probably trickle down to other economies as well.

Before I explain what is happening, let me fill you in with a little background.

I quite deliberately did an article on the new interest rate mismanagement that is ongoing at the European Central Bank (ECB). On one level it is an indication that the economic mess that is the EU is much worse than was admitted. The situation is not even stagnating, it is spiralling further and further out of control. The trouble is, in attempting to do two specific things, the ECB is managing to do quite a few more. It is like those dreadful pills you take to alleviate something. If you read the contraindications, you find that maybe the pill cures one thing, but it sets off a whole raft of other unpleasantness.

The various central banks are trying to cope with spendthrift governments. They are also trying to lower the value of the currency under their control. With low interest rates governments can afford to keep borrowing. The moment interest rates rise significantly, government finances around the world will go into hysteria mode

The other problem is trying to revive the economies of the industrialised world. To make one country competitive, the value of that country's currency is kept low.

One of the usual ways to deal with both problems is to keep interest rates as low as possible. Since so many countries are adopting the low interest rate approach for the first problem, it does nothing to help the second problem, because all that is happening is that there is a race to the bottom for the major currencies of the world.

Those are the intended consequences of a low interest rate world. However, what this also does is to wreck savings, and destroy people's pensions, and takes away the old fashioned safe haven status of so many of the places where one traditionally put one's savings.

A hundred years ago you parked your funds in Consols. Then it was Gilts, and Treasury Bonds. But these instruments are providing savers with negative returns relative to inflation. Who wants to invest to lose money? This situation has caused not just a flight to investing value, but a complete change in attitude towards investment funds.

Some very strange situations begin to emerge in this new fiscal environment. Let me quote from someone I fellow for his investment insight, and his interesting take on life in general, Bill Bonner.

"Take IBM, for example. Its bonds, maturing in 2017, yield 1.78%. Officially, the CPI is about 2%. But when MIT measured inflation, without using adjustments and fudges, it came up with a rate of 3.91%. This makes IBM a NIRP borrower, actually earning more than 2% on every dollar it borrows.

So, say you have to borrow at twice the rate of IBM – let's say 4%. With a real inflation rate of 3.91%, you're getting money for essentially nothing. But you still have to make debt payments...

You borrow $1 billion. You have to pay $40 million in annual interest. But you take the $1 billion and use it to buy your products (whatever they are). Your company shows sales of $1 billion. You bring about 40% of that to the bottom line... giving you debt cover of 10 times. This makes you one of the best credit risks on the market. Then, if your shares sell for 20 times earnings (modest for a tech company), the capital value of your company will soar by 20 x $400,000,000 = $8 billion!

You see? You started with nothing. Through the magic of ZIRP and NIRP... along with some accounting chicanery... you now have a company worth $8 billion. Sound crazy? Yes. And that is almost exactly what the Fed is trying to encourage."

If you remember, I introduced ZIRP (zero interest rate policy) and NIRP (negative interest rate policy) in my blog a couple of weeks ago.

Do you invest your retirement savings into the company above? You might make a fortune, or go completely bust, but how would you know which to expect?

Those investors who dont like the uncertainty, or maybe assume the end result is likely to be bust in the above scenario, are doing something else. They are investing in real estate, but not in the old fashioned way.

Here's another quote:

"we are currently seeing something in residential real estate markets that has not occurred in our lifetimes – the magnitude of all-cash offers. 40-50% of residential real estate purchases have been for cash in recent years. This phenomenon has no precedent in recent economic history. Why is this happening?  We need to remember that a primary goal of the Federal Reserve in setting short term interest rates near 0% was to induce investors to buy “risk assets” – think real estate and common stocks.  By eliminating rate of return in safe securities such as Treasury bonds, CD’s, etc., the Fed essentially forced formerly conservative investors to purchase higher risk assets in order to get any acceptable rate of return.

In good part, the all-cash offers are coming from investor’s intent on buying to rent. Intent on obtaining an acceptable cash on cash rate of return as yield can no longer be found in safer investments. This crosses the boundaries between investors in the asset accumulation phase of life and retirees starved for yield, draining formerly CD-centric bank accounts in order to purchase income-producing rental properties…"

Have you noticed the rise of REITS in the US and Japan? Have you noticed the sudden upsurge in crowd-funding for property deals? How about the investment trusts sprouting up everywhere that are buying real estate? All these ventures are there to try and scoop up some worth-while return on investment in a zero interest rate market.

As these ventures are all cash based we now have a gradual return to the market of cash buyers. That cuts out the interest rate scenario that I mentioned above. It also cuts out the mortgage-based buyer. The cash-based buyer has the advantage. These trusts buy for ROI. That return is based on the initial cash investment, and is not affected by interest rate rises.

From here on in the value of those properties will be based around the ROI, and be completely independent from interest rate movements. This will mean a new form of house valuation will begin to emerge. Investors will be asking what return they expect from their investment. Do they want 10%? Are they happy to put up with 8%? Who knows? Currently, the general market is pricing in returns of 10-15%.

It isn't difficult to see where this is going. Buy a property for £100,000. If the maintenance costs are 5% a year, and the investor wants 10% return on his funds, and the fund charges, say, 2% management fee, that means that £100,000 has to return 17% gross, or £17,000 a year. That has to come from the rent charged. That also means that the price of the house is directly related to the rent achievable, which is what I have always maintained is the true valuation of a house.

I will dwell on the implications of this in the next article in this series.


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