August 2009 - Sue's Pension
Sue's worried about money and her pension. She has enough cash to buy a
couple of small houses. She thinks that's a good way to preserve her
capital and bring her in an income. Let's have a closer mathematical
look at Sue's idea and see if there is any merit in it.
She is buying in Chippenham, in the wilds of Wiltshire. I have no idea
what the real prices are in that neck of the woods, but let's make a
guess. A two bed house costs £150,000, and the rent is £600
a week. You can adjust the figures to suit your own case so it doesn't
matter if my figures are a little out. It's the principle that is
important.
Two important start points: First, what can you get for your money
invested elsewhere? Second: what is it you actually want from your
capital?
Let's say you have two over-riding desires; first, not to lose money,
and if possible to increase your capital base; second, to bring in a
respectable income.
Okay, let's go back to the first question. If you are going to buy two
£150,000 houses then you obviously have £300,000 available.
Sue is going to buy with no mortgage. If she put that money into the
money markets she would not get a big return. She would be looking at
about 3%, or £9,000 a year, which is not much of a pension.
Alternatively she could invest in solid companies that are not going to
be kicked to death during bad times. You have companies such as Coca
Cola, Johnson & Johnson, and similar household names which are
rated higher than most government debt. They are solid and secure. They
will pay you about 5% a year. That knocks the income up to
£15,000 a year, which is not bad, but not brilliant.
Alternatively she could invest in less secure companies, but those
which are relatively secure in that they provide a service which will
always be needed. She can invest in companies that build and maintain
oil pipelines, or companies that provide staple resources that will
always be needed, such as copper, tin, iron, steel, soya beans, and so
on. Generally you can choose solid investments in this area and get
about 12% return on your capital. That would bring in £36,000 a
year, which is far more like it.
The great thing about these investments is that as time goes on the
dividends get bigger relatively speaking. Over the longer term values
go up and the dividend tends to go up as well. That means that in, say,
ten years time, your dividend is based on what you put in ten years
ago, whereas it is listed as, say, 6% of what someone is putting in
then. That could well mean you are getting 10-12% on your original
investment. That, of course, is speculative, but only mildly so. (Check
how the Coca Cola dividends have performed over the past 25 years, and
see what % return you would be getting now if you had invested
£100,000 in the shares 25 years ago.)
Now we have a base to compare, let's have a look at what you would get
if you bought these two houses.
£600 a month on each will bring in £14,400 a year. There
will be running costs, and replacements. There may well be agents' fees
as well. If each come out at 10% of the net rent, that will slice 20%
off the income. It will reduce your income to about £11,500 a
year. That represents roughly 3.5% return on capital. It is no better
than stashing your loot in a building society account. It also doesn't
take into account rental voids.
Next you need to consider the possibility of capital growth. That means
we have to look at two situations. First, we need to consider the
financial situation generally. Secondly, we need to look at a straight
forward valuation. After all, we need to know if we are buying wisely
in the first place. The fundamental question when buying anything is,
are you getting value for money, and better still, are you buying
cheaply?
Let's look at the second question first because it is obviously the
more important.
This is a commercial transaction, we must therefore value it
commercially. You are not paying any kind of premium for a nice view;
or because you really like the place; or because it is close to your
sick auntie Mildred.
You value companies quite simply by looking at how much profit they
produce. A staid boring, going nowhere company values at ten times
earnings. That's what your buy-to-let is. Income isn't suddenly going
to take off sometime in the near future. In fact rents are going down
at present.
Go back to the maths. You are getting 3.5% return on your dosh. That
means it will take you 28.5 years to get your money back. That's a PER
of 28.5. It should be no higher than 10. You are being right royally
ripped off. The cost of the houses is nearly three times higher than it
should be. It's a lousy deal.
Now let's look at the economic climate. We are in the grips of a
depression, pretty similar to the depression of the 1930s. The previous
economic model is broken. That is part of the definition of a
depression. That means when we come out of this things will work
differently, or we will head straight back into another depression. To
see what I mean look at Japan for the past 18 years. They have been up
the spout for that long, and their stock market is still only about 30%
of what it was in 1990.
It is perfectly reasonable to assume that most of the western world is
going the same way, into a long slow period of deflation. That means
the value of everything except cash goes down. That means your money
would buy more house in two years time. That means investing in things
like houses that cost money to support, and are currently over-priced
(PER of 28.5!) will just float gradually downwards. The classic
description is: you get sandpapered to death.
The alternative view is that because countries are still running on
massive amounts of debt, and because selling government debt is
becoming increasingly difficult, that debt has to be monetised. The
classic example is Germany's bond auctions which are regularly
under-funded. I remember earlier this year they tried to sell €90
billion euros worth of bonds, and actually sold €4 billion. Yikes! What
that means in laymen's terms is that the government has to buy it's own
debt. For the average person that is a piece of insanity, or a bit of
prestidigitation, depending on how you look at it. In reality what is
happening is that the government just prints more euros which it uses
to buy its own bonds.
There are two scenarios here. The first is, dont monetize the debt. The
alternative is to ramp up the return on the debt, or the interest rate,
to attract customers. That feeds through to the market place, and as
interest rates rise across the economic board so the seeds of recovery
are choked off. It also starts to crucify your average buy-to-letter.
His mortgage payments start rising. A rough rule of thumb is that a 2%
rise in interest rates equals a 30% rise in the cost of a mortgage.
That will put most people out of business, and cause a massive sell-off
in the property market, leading to much lower property prices. That, of
course, is bad news for the average property investor who is making
bugger-all on income, and is hoping to be saved by capital
appreciation: garotted on both fronts.
The other scenario is that the debt is monetized, and that leads to a
large increase in the money supply. Governments simply print money to
pay their own debts. It is happening on a vast scale in the US, and to
a lesser degree in Japan and Europe, although Japan has been monetizing
its debt for twenty years. It hasn't caused inflation, which is the odd
thing. Standard economic theory states that inflation always follows an
increase in the money supply.
Inflation leads to high interest rates. Hold on, we've just seen what
that does to the property market.
What this means is, you have two basic scenarios possible. The first is
that we are entering a period of deflation. This will attack the value
of the properties. You will suffer a gradual capital loss. If you have
a good rental cover that shouldn't be a problem because your pension
scheme is providing what it should; an income. However, that income
should be in line with proper business practice, and should be at the
very least about 10% ROI. If it is less then you are in the wrong
business.
The alternative scenario is that we enter a period of rising interest
rates and inflation. The former will cut property prices as most people
start having difficulty in meeting their mortgage commitments. This
will lead to lower house prices.
It's what happens after that which is interesting. As interest rates
start normalising back down again the property market will be showing
good value. That will be the time to consider getting back in, as
prices will start to rise to catch up with the effects of inflation,
and capital gains will be made.
I draw the following conclusions.
First: I dont have a crystal ball so I dont know what the future holds.
However, I dont care. At least I know the alternatives. One is bad for
property over a longish period. The other is good for property over
that same period, but then it becomes bad for property for a period of
about 3-4 years, and then once again becomes good for property. The
critical question here will be: can you ride out the bad times? You can
if you have little or no mortgage. If you are highly geared you will be
bankrupted.
Second: Interest rates have never been this low. They can only go up.
They will go up. When is not known. When they do go up they will
adversely affect the property market.
Third: I buy things when they are cheap. Houses currently are
expensive, so I believe buying them to be a very risky venture. Those
houses in Chippenham are extortionately expensive.
Fourth: we are undoubtedly in a depression. That means prices will tend
to move downwards making cash more valuable than goods. Items which are
over-priced will fall in value more.
Fifth: you not only buy houses when they are cheap and sell them when
they are over-priced, but you also buy when interest rates are high but
falling, not when they are low, with the possibility that they will
rise. The former brings buyers into the market, the latter sends them
out broke. The former raises prices, the latter lowers them.
What am I doing?
I am hanging on to properties that bring me in a return of more than
10%. They are value for money. Those that bring in less I would sell,
but I dont have any that bring in less.
I would seek to invest in other areas altogether. I particularly like
plays in infrastructure, such as oil pipelines, and alternative energy
plays, hence my move into jatropha trees. I would also keep a certain
amount in cash to invest where the banks wont go. That means investing
in private deals with secure backing and paying 18% p.a. or more.
I would make one other remark. Your average person always gets it
wrong. People wont buy into the stock market when it has just gone
bust. They are scared of it. They buy in after it has been going up for
months or years, and see how well it has done in the past. That is
exactly the opposite of what one should do. You buy after a major bust,
and get out after a major upturn. It's simply really. You buy low and
sell high. Most people are too scared to buy what they should buy.
That's why I just look at the maths, and nothing else.
I also dont like risk. Property investment is highly risky at the
moment. I cant see the future, so I will steer clear until I can. I
will wait until interest rates ramp up, and then start to come down
again, when everyone is fed up with property because they see it as
speculative. That will be the time to buy in again. I can wait.
If my analysis turns out to be wrong, who cares, at least my outlook
means that in the meantime I am safe.
best wishes
john
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