February 2009
An Open Letter to Scott
Huggins, who's latest article in the Hot Property Alert suggests people
go out and buy in the UK.
Hi Scott. Nice article in the February edition of Hot Property Alert
about now being a good time to buy property in the UK. However, I think
you've got it wrong.
I have been in this business for a long long time. I started my career
in property back in the sixties. My mother was a serial mover, and I
was a big fan of algebra, so whenever she moved I used to do the
calculations to work out what we could afford, and see which was the
best deal. I even got so hooked up by the whole business I started
inventing my own situations so I could solve them using equations.
I have always taken a very simplistic and commonsense view of the
property market, which led me to develop a series of charting
techniques which I have used ever since. I can say that over a
forty-five year period they have never once let me down. Better still,
those principles have allowed me to live a rich life, and keep my
property business in the background.
I first discovered from mother's bank manager that the most important
point to get right when buying a property was to earn enough money to
cover the mortgage payments. Without that you didn't get started. That
led me to produce a chart showing earnings and how they related to
house prices. I got the figures from a book that always intrigued me,
something produced by the government called Social Trends.
This led me to produce my Purchase Index. When I was at college I
showed it to one of the professors, who developed it further, and
changed its name to the Affordability Index. It was then taken up by
the Cheltenham Building Society. A slightly different format of my
index was also taken up by a company in Canada, and it gradually spread
across North America.
In America this index works on an income multiple. In the UK it works
by calculating the percentage of income that is allocated to mortgage
payments.
It was some time before the Cheltenham Building Society started
producing regional indices, and when they did an interesting fact came
to light. The index can go up to in excess of 60% in the South East of
the UK, but in Scotland buyers get the heebie-jeebies when the index
goes over 40%.
This knowledge could then give me a very solid indication of how high
house prices could go in any one area. It was also obvious that once
they reached a certain level they could not rise above that level
without wages going up. This gave me a sure-fire method of knowing when
to buy and when to sell.
Mother used to go to property auctions, and I got to be able to value
properties to within a few pounds. In fact several large auction houses
offered me a job to work for them as a valuer, but I wished to remain
an amateur. Instead I started producing an auction index.
Again, the principles of this index were disarmingly simple. Auctions
are quick sale mechanisms. The price is agreed on the day, and
completion takes place a month later. The usual house sale could take
3-4 months depending on how things turn out. This means that what
happens in the auction room is likely to happen outside 3/4 months
later. We have an advance warning system if only we can calculate what
is being indicated.
I quickly found there was a simple principle to be observed. There was
a very clear indication from the bidding as to what people considered
to be a good price. From general principles it was also clear that the
best indication of true value was a large consensus. A market is
functioning at its best when there are an equal number of buyers and
sellers. If buyers are few, then prices are too high, and prices will
fall. If buyers are out in force, then prices will be driven up.
It took a while to work out how the index should function and I have
found it to be a great indicator of an overbought market. It is not so
good indicating an oversold market.
There is another simple method of working out whether markets are
overbought or oversold. I produce a simple index for an area by getting
house prices from estate agents, then getting rental prices, and
plotting the prices against each other.
If you live at number 3, and I live next door at number 5, and our
houses are pretty much the same, they should be costing us the same. If
I am paying rent, and you have an interest only mortgage, then both our
outgoings should be similar. I cant count the payback amount of the
mortgage as that would be cheating, we have to count only the cost of
the borrowing against the cost of the rent, so we have like against
like. Any deposit I class as discretionary spending, and is not
included in the calculation. The deposit is your commitment to an idea
that you are purchasing something of value. That aspect does not
translate to the rental situation and so must be excluded.
When rents and interest payments on the respective houses are the same
the market is in equilibrium. When the spread between the two increases
to more than 20% then the market is out of balance, and is likely to
swing back. You buy houses when the rent is in the overbought section.
You sell when the loan interest is in the overbought section.
One of the most important aspects of buying a house is knowing how to
value it. I have never come across anyone else who has the slightest
clue about valuing a house, yet the country is full of people buying
and selling, and advising others about pricing.
When I started investing I came across a general rule for pricing
companies. It was called the Price Earnings Ratio, and this was
complemented by the Book Value. In my day it was written as P/E (price
divided by earnings), nowadays it is written as PER, which is not quite
so self explanatory.
The theory is that in a static world a boring company with not much
potential is generally agreed to be worth ten times its earnings. Thus
the Universal Widget Co rakes in £10,000 a year in profits, so if
it was put up for sale a safe value would be £100,000. If it was
a go-ahead company which was expanding at a rate of knots, the PER
would be a higher multiple.
If a property is bought in order to make money, then it is a business
and should be valued as one. In 1991 I was buying houses with PERs of
less than 1. In 2004 I was selling houses which didn't have PERs, for
the simple reason that their sentiment value was way too high so they
didn't actually produce a profit.
There is an important distinction here. The true value of a house is
when its PER is between 10 and 12. Lower than 10 and it is cheap.
Higher than 12 and it is expensive. It's value on any given day, say at
auction, is not its true value but its sentiment value. That is what
market sentiment determines on that day. It may have nothing to do with
true value. A businessman does not take market sentiment as true value,
but as another indicator showing whether an item is cheap or expensive.
The lower the PER the better the deal. The higher it is, the worse the
deal. I call this the Pub Index.
If you look in the paper, or at auction, you will find that pubs are
classed as businesses and are valued as such. Their values therefore
stick reasonably close to their respective PERs. A quick way to value
houses in a particular region is to see if you can find a local pub for
sale. Now see, in terms of accommodation and location, how far out of
line in terms of price is the house you want to buy. It isn't an ideal
way to do the valuation, but what is interesting is that in an
overblown market you could buy a pub for a true valuation and turn it
into a house (always assuming you can get the planning consent).
What else do you need to know about working out whether or not to buy?
After all, I haven't yet got to the point I wanted to make. How do I
know it is not time to buy now with interest rates on the floor and
yields getting higher and properties everywhere selling "below market
value"?
Let's start again. There are golden rules for every venture. One golden
rule is: Dont ever ever ever buy a falling market. Only a halfwit buys
something that is losing value. That's common sense. It is always the
case that markets overshoot their reasonable level. That has proved
true on the up side. It will prove true on the downside. This market
will fall further than you think reasonable. You aint seen nothin' yet.
What is 'below market value' (BMV)? Why should you care about market
value? That is sentiment value. Knowing the sentiment value is of no
use to you unless you can plot that value against the true value. First
you need to find the true value of your house. Then look at the
sentiment value. When the latter is more than 20% below the former it
could well be time to think about buying, but definitely not before.
You preferably wait till the falling lift has hit the bottom before
getting into it. You will have anything from six months to two years of
a static market after that, which is plenty of time to get in.
Another rule is that you do not buy into a long term investment based
on short term indicators. Interest rates are on the floor. They are the
cheapest they have ever been. That should tell you they wont stay where
they are for long. They must rise, sooner or later. When they do your
profits will disappear rather rapidly. Those who lock into these rates
for three years and laugh all the way to the bank will find in three
years time that rates have doubled, or quadrupled. That will kill their
profits stone dead. They will go bankrupt. In one of my books I show
how a 2% increase in the interest rate will add 30% to the cost of your
mortgage. If you are getting 10% or even 12% returns on your bmv deals
now, and interest rates go up by 3% sometime in the future, you will be
bankrupt. A 3% rise takes minimum lending rate to 4%. Is that an
unthinkable level 3/4 years down the line? I think not. That rise will
also quadruple the payments on your interest only mortgage. Think about
it.
You need to take account of the general economic environment. We are
not in a recession, we are firmly in the grip of a major depression.
The classic definition of a depression is two consecutive years of
negative economic growth. My preferred definition was only given to me
recently. A recession is when your man has been hurtling along, doing
well, and rushing about to get rich. He has overdone it, and collapsed
in the road. The medics come along, he is taken off for rest and
recuperation, and maybe some uppers. When he is fighting fit again he
is back out there kicking arse.
In a depression it isn't like that. That same guy has overdone it to
such an extent that he collapses in the street, has a heart attack, and
is carried off to the mortuary. You cant give him rest. You cant give
him pep pills. You cant kick him. He aint gonna get up. He's croaked.
This market's croaked. Just look at the mess! The US has been negative
for over a year, and this year looks set to be a major disaster. The UK
is economically in a serious mess, so is Ireland, Spain, Greece,
Portugal. Even China is struggling with the worst mess they have
experienced in decades. We aint coming out of this in a hurry, or in
any good shape. Now is not the time to lock into long term situations.
It is the time to hide with the hatch down, and wait till the
explosions stop. You need to be in highly liquid investments that pay
out a good dividend. They are everywhere.
When we do come out of this depression, the rules will be different.
That is also something that goes with depressions. The old order
passeth. Do you know what the new order will be?
Have a look back. In a recession and in a depression the first casualty
is always real estate. It suffered in the Great Depression of the
nineteenth century. It was hit hard again in 1929-39, and it will be
hit hard now. You will also find property is the last to recover when
the economy gets going again, meaning you have plenty of time to get
back in when the dust has settled.
There is one more point. All the major economies are printing money.
The US is the worst offender. A drastic increase in the money supply
will eventually feed thru to the cost of living, and we shall have
inflation. Inflation brings with it very high interest rates, which is
the death knoll for mortgage holders.
So you see Scott, I think you are wrong, and now is most definitely not
the time to buy real estate. The time to buy will be when the high
interest rates imposed to deal with the inflationary spiral start to
come down. That will be the time when the old order will be dead;
bankrupt, and folks like me will stroll leisurely around the
countryside picking up just what we want for peanuts. And everyone will
think we're crazy. Do you know, I love it!
best wishes
John Clare. The Unique
Property Organisation.
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