October 18th 2010 The New Normal Things look good for the real estate market. Interest rates are low. You can get an 8% plus return on your investment. There are below market value deals galore all over the place. The banks are beginning to lend again. Prices are higher than they were a year ago. The worst is past. Things can only get better from here on. Okay, do you actually believe that? Hmmmm..... Let's pull this thing to pieces and look carefully at all the elements. I'm going to deal with this in a series of sections. 1   Below Market Value 2   ROI 3   Interest rates 4   Market cycles 1   Below Market Value Okay, let's start with that hip phrase Below Market Value. Anyone who falls for this is sadly seduced by the new normal. If you get sucked into this you are, by definition, a sucker. Let me remind you of the old normal. Market value is what something sells for at the time in the open market. Below market value is a value somewhere below what something sells for. Therefore, if you buy something at a certain value, that is what it sells for and therefore that is its market value. That means if you have fallen for this one you have bought at market value, not below market value. That's a definition. No-one who is in business sells something for less than it's worth unless he knows something you dont. If he is advertising something for less than it's worth you are being screwed because you are ignorant. You shouldn't buy into the deal because it is advertised as BMV, instead you should do some essential maths. Any deal advertised as BMV is so advertised because the seller has a problem shifting units. You shouldn't buy BMV. You should buy below intrinsic value. If you dont know what that is, you need to go to my site, and buy my book which tells you how to value real estate. (http://www.property.org.uk/unique/book/index2.html) You will probably also be told that the market value has been set by the bank's valuer. That means you should be careful. Do you seriously mean to tell me that a valuer paid by a reputable bank (if there is such a thing) will value a property at less than what it is supposed to be worth? That means a bank is setting out to diddle itself by loaning a sum of money on a security that isn't worth the amount of money loaned. Now, why the heck would a bank do that? The reason is simple. The bank probably has a loan on the property. The builder/developer cant pay the interest. The bank needs to shift this non-performing loan. It hopes you will come along and get it off the hook. Do you want to do the bank a favour? What's that other little phrase the smiling salesman loves? Instant equity. Wonderful stuff isn't it? Just what you need to build your portfolio. But, have you ever tried taking it down to the supermarket to buy a crate of wine? Instant equity indeed. Try taking it to another mortgage broker. Try looking at it in a year's time. Try stacking up that price against a whole slew of second hand properties. If property prices are stagnating or going down then where will your instant equity be next year or the year after? I know it's the old normal to say this, but you should never buy a falling market. And if the market is rising no-one in their right mind would sell a property below valuation. Instant equity! Bah! There is no such thing. It's panic-speak to get you to buy in a dodgy market. Never mind chasing chimeras, work out the maths instead. Can you make money out of this deal? Is the money real or imaginary? Instant equity is imaginary. Cash flowing into your bank account is real. Maybe the seller claims you can rent out this white elephant. Can you? Have you checked? If it's in a tourist area the odds are you cant. Try renting out a property in Spain or Portugal or Bulgaria, or..... oh heck, any of the sad old places. You may be lucky, but do you want to build an empire on luck? You should never buy something because it is listed as BMV, or chase instant equity. What you should do is work out intrinsic value. If you dont know what that is, buy my book,  (http://www.property.org.uk/unique/book/index2.html) or take up a business you understand. BMV. It is ad-speak. It is a concept designed to persuade idiots to part with money. Instant equity. It is ad-speak. It is a concept designed..... come on guys, wise up, use some old fashioned common sense. Buy the new normal at your peril. 2   ROI What about my number two: ROI? The most important calculation you can do is work out what is your return on investment. Let's say you invest £50,000, and get an income of £7,000. Not good. Two points here. The first is: what do you want to get as a return? The second is: what could you get elsewhere? What are you going to use as your control? I look at a safe investment, and look to see how safe that investment would be into the future. At the moment I am invested in green oil which brings me in 13.7%. I could be invested, but have just sold, a bank share bringing me in 17% in dividends. And I have just been offered a guaranteed return of 30% on carbon credits. I think I would have to say I would not invest in anything else that brought me in less than the lowest return I can safely get elsewhere. Can I get those returns in UK real estate? Yes, but only in an existing investment bought way back in the mid nineties. I cant get it on a new deal. Sorry, that puts UK real estate out as an investment in one simple move. That was last decade's deal. That was the old normal. It most certainly isn't the new normal. Typical returns are about 7% for a lot of hard work and some risk. Not for me. If I can invest my money into a company that does the work, brings me the dividend, and all I have to do is check that the money comes in on time, why should I hassle with houses and tenants? But what about capital gain? Let's use a stupid, and incorrect piece of evidence. House prices go up on average 7% a year over the long term. That is not correct for several reasons, and I have charts going back to 1760 to prove that it is nonsense. Prices tend to move with inflation, and with bubble cycles. They also move in relation to the availability of finance. They also only move up to a maximum percentage of income. Once that maximum is hit they cant rise any further as there would be no money available to service the loan. The bad news is that the maximum was hit a couple of years back. Further bad news is that for several years the rise was in excess of 7%, so common sense tells you that to keep to the average, prices must rise much less than that figure for some time to make up for the previous big rises. Forget the nonsense about smaller families, immigration, shortage of houses etc. Those aspects have no effect whatsoever on house prices, never had and never will. After all, all those aspects didn't suddenly disappear in 1990 and then suddenly reappear a few years later, did they? I cover all these points in considerable detail in my book: The Property Investor's Bible. You can buy it at http://www.property.org.uk/unique/book/index2.html To realise a capital gain you need to buy low and sell high. Currently we are a little off a major high. You cant buy for capital gain at such a point in the cycle. At these levels prices must come down or stagnate. Obviously a big factor in your return on investment will be interest rates, so let's move on and have a look at that thorny issue. 3   Interest rates The sensible person buys when interest rates are coming down. You cant do that at the moment because they are already as low as they have ever been. The next move has to be up. You never buy when interest rates are rising. If you dont understand why I will explain. The most important point about house prices is not the sale price but the cost. They are different. If a house price is £100,000, and you need an 80% mortgage, you are borrowing £80,000. The most important calculation you can do is to work out if you can afford the mortgage payments. If interest rates are at 1%, and your bank is charging you 2% over base, then you will be paying 3% interest on the money borrowed. That works out to £2,400 a year. Add that to the repayment figure of the mortgage and that is your annual cost. If the mortgage is a repayment loan over twenty years you are going to have to pay £2,400 plus £4,000 every year to service and repay the loan. Total: £6,400. If interest rates rise by 2% your total repayments for a year will be £8,000. That's a heck of a difference. The crucial question is: how much can you afford? If interest rates go up you can afford less and therefore will not be able to chase up house prices. Now look at the current situation. If interest rates in the UK are 0.5% your mortgage payments are piddling. No problem. Great news. But what happens when they rise? You get squeezed into default. There is a way round that. I'm sure you can work it out. If you cant you shouldn't be in this business, but for those who are just starting out, here is the simple way to deal with the possibility of rising interest rates. You take out a short term mortgage, say 15 years. If interest rates go up to a level you cant cope with, then you go to your broker and arrange for the loan to be adjusted over a longer term. So, how about things right now? I have news for you. Interest rates will rise. They have to. Just look at the charts. I have them back to 1200. Is that far enough back for you? Look and enjoy. Rates between 3% and 7% appear to be the norm. We will assuredly return to the norm sooner rather than later. Can you afford those rates? If not, you are heading for wipe-out. That's why the professional always buys when rates are high but coming down. Life gets easier that way. Buying when rates are low means things can only get harder. Which do you prefer? The interesting thing is that when interest rates are high house prices tend to be low. This means if you start to buy as the rates come down you get two benefits; an increasing return on your investment as your mortgage gets cheaper, and so your expenses come down and therefore your profit goes up; and as interest rates come down houses generally become more affordable so people start to buy, and prices start to rise, so you clock up some capital gains as well. Interest rates are geared to the rates the central government has to pay to borrow. It is interesting to watch the cost of government borrowing. If the government does not need to borrow then generally speaking rates can stay low. That is not always the case. Interest rates may have to remain high for other reasons, but I dont want to get too technical here. All we need to know is what is driving the rates at the moment, and how things are likely to pan out in the future. We have recently seen what happens in Greece. They run out of money, so they have to borrow. Investors dont want to lend to a bad risk. They will continue to do so, but only if the return is attractive enough. That return is the interest rate. It goes up when times are tough. Greece's borrowing costs went rapidly from about 3% to 23%. That would normally reflect in the rates governing all borrowing within that currency. However, Greece got bailed out by Germany and the IMF. All is well for the moment, but for how long? What about the UK? The government's borrowing requirement is very high. If there is a whiff of fear that the government wont be able to repay its borrowing, then interest rates will rise, and, as we saw with Greece, they can rise sbstantially very quickly. One of the things we have to watch for is the probity of the government of the country we are invested in. That puts the USA right out of court. The currency will survive as long as it is the currency of last resort. That situation is likely to change drastically sometime during the next ten years. However, maybe the euro will implode first. Who knows? But one thing is certain, there are two ways governments can deal with their problems. I am ignoring the proper solution, which governments never take, and that is, to cut their expenses and run a tight economic ship. The two popular alternatives are: print money and pay debts with that; or encourage inflation which reduces the value of the debt. Usually, the first alternative encourages the second in any case. (Strictly speaking, an increase in the money supply is the definition of inflation. There can be a delay in that supply feeding through to the market, and that is what is happening at the moment.) Controlling the level of subsequent price rises under these circumstances is well nigh impossible. Have a look at what happened during the last cycle of interest rate rises: Interest rates up to 15%. Excuse me, but that is financial suicide. You have been warned. 4   Market cycles You buy when a market is in its infancy. You look for low home ownership, little or no mortgage activity, and a rising middle class. You get in early and ride the market up till it reaches its maximum possible range, where income no longer allows for an increase in mortgage payments. As you approach that level you sell and look for another market. Every so often there is a crash, and those who know what they are doing wait for interest rates to start falling and then snap up houses at severely reduced prices. When prices rise into bubble conditions they sell again. And that's how it works. Where are we know? Interest rates are low. Fine for the time being, but for how long? And when they do rise, how much will they increase mortgage payments, and how much damage will that do to personal wealth and the real estate market? We have had a decade of rising house prices. We will now have at least seven years of no increase, or falls. Affordability is an issue. Affordability is not good anywhere in the UK. This means houses will become even less affordable when interest rates rise. That will lead to lower house prices. Because of the rules of the new normal, governments will pretend all is well, figures will be fudged (look at the employment figures in the USA, and the cost of living index). Central banks will continue to bail out inefficient profligate banks, and will continue to support failing institutions. Money will continue to be printed, and wasted, and the general level of debt will rise, and eventually, god knows when, inflation will kick in, interest rates will rise, and we will all feel seriously unhappy. Those who know this scenario is coming can of course escape it. There are two ways to do that. The first is to run. Forget the USA and Europe. Move your operations and investments to South America or South East Asia. You can make money in advancing economies far more easily than in stagnant economies. I have been advocating that for the past three years. The second way is to steer well clear of real estate in the West, and keep your investments relatively liquid, and invest in commodities instead. They are in a long term bull run. Good investing! john

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