Cornering a Market

As a review appraiser, one of the biggest problems with appraisals of residential investment properties -- rental homes -- has been the lack of careful attention by the appraiser to the actual return on investment anticipated by the investor. If the investor were putting money into a stock, he would surely be interested in whether that stock was likely to earn money and pay dividends. The investor would look at the money in hand, examine the alternate choices (i.e., bank interest, other stocks, bonds, state lottery, etc) and see what rate of return could be expected. That caution has been lacking in recent decades, as investors look at stocks from the standpoint of their possible resale value (buy low, sell high) rather than their income generation potential (long term gain through dividends).

When it is realized that the entire rationale for the existence of the stock market is the generation of capital for start-up and expansion of a business enterprise, the prostitution of the market by those who use the change in stock price as their sole reason for participation should give shareholders and directors reason to very seriously consider the potential negative consequences of going public with the stock, for, at that point, the financial stability of the company becomes hostage to the perceived profit-taking ability by the market at large.

The real estate industry has been taken over by this same mind-set. It was the anticipation of a quick profit by the property "flippers" that drove the real estate bubble, much the same way that stock "flippers" have driven other "bubbles" in financial markets. The "flippers" made their money by buying low and selling high. Just as the stock market attracted non-traditional investors, the real estate market attracted "flippers" across the spectrum. It was not unusual during the bubble years for Average Joe to buy a house, live in it for a year or so, then sell and buy another, making a small (sometimes large) profit and moving up in the world. Indeed, there is nothing wrong with that kind of approach to real estate. The problem arises when Other Peoples' Money (OPM) enters the equation.

If you have a few spare shekels of your own, what you do with them is your own business. You can engage in risky economic behavior because it is YOUR money. If you went to the local bank and said, "I would like a personal loan so I can buy some lottery tickets, and I will offer the tickets as collateral", any rational banker would either throw you out or die from laughter. (That is not to say that if you looked hard enough, you could find an irrational banker.)

The basic underpinning of the study of economics is an understanding of the relationship between supply and demand. That relationship is never perfect; it is always in flux. Today I demand eggs for breakfast, tomorrow I demand cereal. What I pay for breakfast today is determined by how many eggs there are to be had, and how many other people want eggs. If eggs are scarce, and many people want them today, I may have to pay the California Gold Rush price of $100 per egg today, and if everybody wants cereal tomorrow, the guy who wants to sell a dozen eggs tomorrow may not get $1 for the whole dozen. Supply and demand; the market works in cycles and despite the claims of experts, is unpredictable because it involves the perceived wants and needs of people, and every day brings a new itch to be scratched.

Therefore, if I go to the bank to borrow money for an investment, the banker wants to know what the value of that investment will be over the life of the loan. He wants to know if it will be a winner or a loser. If I want to invest in Pet Rocks, he wants to know if they produce dividend income, or if they have good resale potential. For that reason, few sane bankers will loan money for an investment in a day at the horse races, or even an investment in the stock market. Such gambles are heavily regulated.

When the public fell for the canard that residential real estate was a good investment, most people failed to recognize that what they were falling for was a property flipping scheme, and not a dividend stream investment. The mantra was that real estate never goes down in value, therefore it was "safe". It was thus felt that using OPM was legitimate for property "flipping", whether done by investors who had that as their sole objective, or by Average Joe, who just wanted to make a profit when he sold his house.

Enter government social engineering. Very few economists are elected to Congress. This is also a result of the Law of Supply and Demand, but I will leave the reader to figure out what I mean by that. Official government policy for several decades has tried to maximize home ownership, without regard to whether the new homeowners understood their responsibilities. This has resulted in lowering the equity barrier for entry into the real estate market, and the lowered requirements have been extended even to non-owner-occupied dwellings.

In previous years, it was believed that a loan to value ratio of 80% was a reasonable risk, and borrowers with less than 20% down were required to purchase mortgage insurance, either through a GSE (FHA insurance) or through private mortgage insurance (PMI) companies. The insurance was then used to guarantee the repayment to the lender in the event of default.

Because of the common belief that values were increasing (based partly on government indexes that measure the buying power of the dollar) the property "flipping" could continue as long as a higher resale price could be obtained by the investor. Little real attention was paid to the actual return earned on the investment. This was where the Operating Income Statement -- the Form 216 -- should have been of greater concern. It is also where the use of Gross Rent Multipliers (GRMs) lead to false impressions of value.

Enough for now, I have other things that must be done at the moment. The investment idea that I am toying with will be developed over the next few posts.