The Changing Housing Market - Part Two
(You can listen to the podcast
instead. Click the control button to the right.)
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
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
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
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
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
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
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