Catch 22 is my favorite book. It is an American classic and a literary masterpiece, but we've all read it, so I shouldn't waste time praising its literary merits. What I want to say here is that Catch 22 possesses that trademark of a classical novel - everlasting relevance. No matter what field you're working in, classical literature gives you a hint of what to expect in any kind of situation. And I truly believe that Catch 22 should be a required reading for any investor. [more]
The discussion topic de jour is the probability of another 0.25% cut. Taking the risk of being held accountable for the wrong prediction, I will offer my take: no cut this time. The reasons are: a) inflationary pressures are very real and b) housing is still in sufficiently good shape. This prediction comes with a disclaimer: I'm assuming that Bernanke is not overwhelmed with irrational fear like most housing bears in Caps. This disclaimer is necessary because Bernanke will not hesitate to drop the rates to minus thirty percent if he feels that this is what's necessary to rescue homeowners from possible depreciation of their valuable asset. [more]
Today I was looking at the red part of my scorecard, reviewing my losers. One thing that caught my attention was my MWA score of minus 30. Not that it's a bad business or anything, but for some reason the stock has chosen to go down. All right, I felt confident enough about MWA and saw no reason to cut and run. But then it occurred to me that I could cheat on the system by picking MWA-B to outperform (that would be Caps's equivalent of doubling down). Generally speaking, it's not honest, but since everybody else uses that trick, why should I put myself at a disadvantage? So I typed in MWA-B, selected outperform, and was about to leave the page when I noticed something strange. It was the star rating. Yes, while MWA was a 5-star stock, its sibling MWA-B had got only 4 stars from the Caps community. So let me get this straight: the class of shares that is equivalent to MWA in all respects except that it offers more voting power and is 6% cheaper is expected to underperform MWA? Does anybody seriously believe that paying a 6% premium for the same stock is the surest way to better investment returns? The Caps community says yes. [more]
The National Association of Realtors reported Wednesday that sales of existing homes fell 8 percent in September, the largest decline to show up in records dating to 1999. The seasonally adjusted annual sales rate of 5.04 million existing homes was also the slowest pace on record. The weakness in sales translated into further pressure on prices. The median price -- the point at which half the homes sold for more and half for less -- fell to $211,700 in September, down by 4.2 percent from the sales price a year ago. It marked the 13th time out of the past 14 months that the year-over-year sales price has decreased. [more]
Turns out you don't have to be bearish to score points on a day like this.
I am very satisfied with how this drop is playing out. Crap is plummeting, but good solid stocks don't move that much.
Everything looked so great about IRBT. The first-comer advantage in a hot new field, 2 mln Roombas sold, promising military applications, and God knows what other products these roboticists from MIT are working on at the moment. They started from scratch and they commercialized Roomba before everyone else - before Toyota, Hitachi, and others. And if they did it scratch, how much more can they do now, with $70M on the balance sheet? Now that they are going to hire the best talent and work on the new, ever more complex robotic devices? So the bullish thesis used to go. [more]
In Parts 4 and 5, I addressed the issue of capital mobility, showing that capital doesn't need to and doesn't want to leave housing. The final reason, and that concludes my answer to fransgeraedts, is that it cannot leave.
Part 6. Capital? What capital?
Where does capital come from? I mean, that part of capital that goes into housing? [more]
Part 5. People don't sell unless they absolutely have to.
Let me continue with my answer to fransgeraedts. Apart from the fact that a large outflow of capital is unlikely as housing remains a very attractive investment vs. stocks, there are several psychological reasons discouraging such an outflow:
a) The sale usually involves a 6% commission plus thousands of dollars in relocation expenses. This factor is sufficient to discourage active trading. In other words, if you anticipate a 5-10% dip in prices, there's no point selling to buy back later. It is very seldom that the seller will anticipate a drop big enough to justify this attempt at market timing. [more]
OK, let us continue. In the previous post, I addressed affordability concerns from the monetary supply viewpoint. It appears that those semi-intuitive conclusions that I presented in Part 2 are borne out quite well by the M2 supply numbers, and that despite growing much faster than median incomes, housing has not become more expensive in proportion to the total purchasing power created by the inflationary growth of M2.
I'm still receiving comments about housing. Some of these comments are of the "I'm a poor man, and I really need that house" variety, and clearly don't merit an answer. However, there are other, more serious objections having to do with the opportunity cost of buying houses instead of stocks. Thus, player renegade49 agrees that real estate is better than a CD (in his own words, "Stocks and real estate will beat out bank savings and money in the matress"), but he thinks that real estate is just too overvalued at the moment, so I assume he prefers stocks. QualityPicks also believes that stocks will outperform housing (he expects to earn annualized 7% from the stock market). Player fransgeraedts agrees with me that the extra liquidity (he insists that I call it "capital") is being produced in "excessive" quantities, which generates bubbles, but he suggests that capital is mobile and will move from housing to stocks.
There is certainly some truth in this argument. The "stocks or housing?" debate has been going on forever and there was always some competition between these classes of assets. During the 90s housing was relatively cheap as every enterprising young man was putting his spare change into Microsoft and Pets.com. After the stock market's debacle, stock enthusiasts turned into would-be Donald Trumps, and for two years, housing advanced while stocks stagnated. Today's relative strength of the stock market is suggesting that some would-be homebuyers are going Buffett again.
So, should we expect homeowners to sell their houses and buy into S&P? I wouldn't expect that. The main reason this is unlikely to happen is that a house remains a better investment than a stock.
Part 4. Why housing outperforms stocks.
Yes, I know that what I just said is anathema to most readers. We've all heard the Foolish mantra: a house is not an investment, it's an object that appreciates in pace with inflation. Then, when pressed to the wall, the Foolish stock enthusiast confesses: well, it's actually inflation plus 1-2%, not a big deal. Then, when you ask the stock enthusiast how his picks fared in the market, he grows less sanguine. He's learned from his past mistakes, he bought the best stock portfolio in the universe, he is sure about his future 20% annual gains from now on, but the fact is, up to this point, he earned only about 7% a year. Still this is better than housing, which has returned only about 6% a year in the historical perspective. So yes, upon a second thought, he will grant that housing is not that inferior to stocks. But he still believes it's inferior. Especially when you count that onerous real estate tax and the trouble of mowing the loan (you may wonder what other chores he's going to quote when his Rule Breaker pick IRBT introduces a Mowba).
So did the Foolish enthusiast win the argument? Not by a long shot. Now, here comes the next question. How much did he pay in rent while earning his 7% annual returns on stocks? At this point, confident smile disappears from his face, and his tone becomes subdued. "Umm, well, I haven't thought of that" is the standard reply.
OK, let's now do an honest calculation. For starters, a house always generates rental income. Either you're renting it to someone else, or you're renting it to yourself. In either case your revenue equals the average rental rate in your neighborhood. Apply the income tax to that revenue if you're renting to someone else, otherwise don't apply the tax. Subtract the operating expenses - heating, water, repairwork, condo association fees, insurance, and real estate tax. Apply tax deductions where applicable if you were already itemizing deductions on your tax return prior to the purchase; otherwise, if you were using the standard deduction, the incremental benefits may be negligible. Divide the net profit by the price of your house to obtain the annual yield. In most cases, it should be around 2.5%-4%. Think of it as the dividend payed out by your housing stock.
And then, count the capital gains returns via appreciation. Taking the conservative 5.5% estimate for long-term appreciation and the even more conservative 2.5% yield, we get 8% a year, comfortably ahead of the stock market. Compare the taxation of capital gains for stocks and housing, and housing gets still farther ahead.
A 2.5% yield is virtually guaranteed to the investor even in those markets which are considered extremely overpriced. For example, in my area, new 2-bedroom condos start from $500,000. The rental rate for a similar apartment would be no less than $1600, and the maintenance fees would be around $200. Then $16,800 is the cash flow generated by the apartment, and the yield is 2.8%. Furthermore, if you run the numbers for 1997, the yield will be only marginally higher. It is the same "bubble" as it has been 10 years ago.
Or consider QualityPicks's second example (the first was a $450K studio) here. Mind you, QualityPicks is bearish on housing, so I doubt that he went out of his way to find supporting evidence for the bulls. Note also that he is talking about one of the most expensive markets in the country. Still, in his example, a homeowner renting a $600K house to himself pays himself $2300/month, pays $120 in association fees, $200 in insurance, and some $580 in property tax. We'll assume no heating bill (it's Southern California) and a generous $600/month for water, garbage removal, and repairs, leaving the net profit of $800. Suppose QualityPick bought this house for cash, and suppose he's itemizing his deductions. Then he can subtract a) $7000 in property taxes, b) most of the repairwork -should be some $4000, c) amortization - should be about $6000. Applying a 30% income tax, we get $425/month in additional tax savings, and the effective yield is $1225/month or 2.5% per year.
Projecting 5.5% CAGR from here (and if rental rates follow the trend), we beat the stock market hands down. With the CAGR of only 4.5%, we still match the stockmarket's performance, and with much less volatility along the way. As a boon, his $600K capital gain will be essentially tax-free (currently the limit is $250K if you're single and $500K if you're married, but it will surely increase with inflation).
And if that 2.5 yield doesn't impress you, keep in mind that QualityPicks has selected a place where one buys a lifestyle rather than a cash flow. Irvine is one of the most pleasant towns in California (I would place it right after Santa Barbara, Malibu, Huntington Beach, Laguna Beach, Dana Point, Cambria, and Santa Cruz) that will continue to attract all those who are rich enough to afford a premium location but fall a bit short of affording the coastline. As a buyer, you're making the correct bet that people will be moving to California, that Irvine's economy will prosper due to its top-notch University, and that rich people will be willing to pay up for a premium location. Second, you're paying for the proximity to that dairy cow - UC Irvine with its 20000 students. With those 3 bedrooms and 2 bathrooms, it's not hard to rent a room to a student. A room in a private townhome starts from $600 and goes all the way to $900, and this way, many Irvine homeowners are able to squeeze this much additional income from their primary residence. Third, Irvine has excelled in the art of using ecology as a pretext to deny construction permits, so it will always maintain its deficit of housing. And finally, rental rates in Irvine are bound to go up because of the monopolistic position of Irvine Apartment Communities. This future potential helps justify the current price tag.
Finally, for those of you who might say that if the yield is real, then the appreciation potential must surely fictitious, I must repeat a simple fact: most of that appreciation is nothing but the ordinary monetary inflation. When M2 supply grows 4 to 6 percent a year, there is no way to avoid inflation, and in particular, asset inflation that grows faster than consumer prices. Why would someone want to buy that 2.5% yield? For exactly the same reason that people are happy to pay a PE of 40 for GOOG: future cash flows. When the Fed doubles the money supply, and the lion's share of the newly printed dollars winds up in the hands of the top 10%, the money competing for houses in Irvine can easily triple or quadruple. That's why current yields are low. If you look at less fashionable locations (think Detroit!), you will see that their yields are much higher. This is because investors realize that these places will be attracting less than their fair share of the Fed's incremental liquidity, and are asking for higher yields to compensate for that. The market is not stupid and it is baking appreciation into the current price only when this is justified by the location. [more]