CHAPTER 2

CONSPIRACY THEORY

There are two fundamental ways that the mass media, in my humble opinion, misrepresent how good real estate is. The first relates to how the media compare increases in house prices with increases in the values of other assets.

Increases in Asset Values

On Wednesday, December 27, 2000, a headline in USA Today read, “Housing Market Beats Stocks in 2000.”

The first paragraph read: “When the numbers are in, 2000 will go down as one of those rare years in which Americans count their houses, not stocks, as their best-performing assets.”

A table in the article, reproduced here, details how the value of various assets changed during the year.

Homes Beat Stocks in Value

The average value of a home increased more this year than many investments.

These results are appalling! Not because the statistics show that housing outperformed most other forms of investment, but the notion that in other years property trailed behind! A rare year? Get out of here!

The media’s inability to grasp what I consider to be a fundamental advantage of investing in real estate is, I am sure, one of the prime reasons why potential investors, goaded on by financial advisors who have not yet figured out a way to profit from advising clients into property, stay away from property.

In any comparison, it is important to compare the proverbial apples with apples. Thus, in comparing the investment performance of your money invested in various sectors, it is important to always consider how the asset performed in relation to the capital put in. When you buy a CD—certificate of deposit—you have to put up the face value of the CD. As we have already seen, when you invest in the stock market (or money market funds), nearly all investors have to put up all of the cash representing the investment.

On the other hand, when you buy a property, you may choose to pay the full price in cash, but you can also (very easily!) get a mortgage for 20 percent, 50 percent, or 70 percent, of the value. There are mortgages available for 90 percent and more of the purchase price. In other words, it is not comparing apples with apples to compare the performance of a $100,000 investment in CDs, money market funds, or the stock market with a $100,000 property. And yet this is what most market commentators will do, and certainly what a lot of financial advisors do to convince their clients that property really is not that great.

What we should do is compare the performance of a $100,000 investment in CDs, money market funds, or the stock market with $100,000 invested in property. Thus, if this $100,000 was used as a 10 percent deposit on a $1 million property, then a 7 percent increase in property values would translate to an increase of $70,000 on our $1 million property, which is an increase of 70 percent on our original $100,000 investment in real estate.

Once again we have come up against leverage, or gearing. The same would apply to leverage in other forms of investment, but like it or not, banks and financial institutions love lending money secured against property, and shy away from lending money secured against nearly all other assets. In other words, gearing is readily available to property investors, and rarely available to investors in other asset classes.

So, if we can show that statistically most property investors are geared, while most money market and stock investors are not geared, then I believe it would be perfectly fair to compare the performance of property relative to other investments by taking this phenomenal power of leverage into account.

Calculated this way, even if the stock market goes up by 15 percent, and real estate goes up by only 5 percent, then any property investors with a modest mortgage of 70 percent would still have done better than their property-averse counterparts.

Since the average level of gearing on property in most Western nations fluctuates around 50 percent, is it not more accurate to show the percentage increases in house prices relative to invested capital, rather than property value? That would immediately double the returns for real estate!

Of course leverage also works in the other direction: If the market goes down, then the downside is amplified just as surely as the upside. But that brings me to a very interesting observation. . . .

Consider all the properties you have ever owned. And then consider all the properties your relatives and friends have ever owned. Have you ever known one to plummet in value by 60 percent, 90 percent, or even disappear off your balance sheet entirely?

That is exactly what happens to stocks and shares traded on markets around the world. In other words, a stock market may have an increase of, say, 5 percent in a year, but that really represents the average of many wildly disparate stock gyrations, with some going up phenomenally, others going under, and everything in between. Whether your collection of stocks does well or not is, it seems to me, a bit of a gamble.

On the other hand, it is much easier to see which properties will go up in value: Trends are slower, less volatile, and with fewer deviations from the average. Thus, the city with the highest growth in any nation in a particular year is very likely to be at or near the top again the following year. In other words it is stupendously easy to beat the national average! (That’s probably what investors of technology stocks thought when they were popular, to their eternal regret.) We will explore this concept of beating the averages later in this book.

There is one more aspect that the newspaper failed to mention. Not only did the value of the property rise by more than the other asset classes, but the home also provided accommodation for the family. If they didn’t own that home, then they would have had to pay rent somewhere else. And rent on your own home is not tax-deductible, whereas mortgage interest in most countries is. Yet the table at the beginning of this chapter fails to take any of these factors into account.

Yields

The second way in which the performance of property is often misrepresented is when reference is made to the relative yields of various investments.

Just to clarify, the yield is, by definition, the ratio of the annual income generated by the investment, divided by the dollar amount of the investment.

A typical scenario is as follows. It is boldly claimed that while yields on properties averaged, say, 6 percent in a given year, the average yields on stocks averaged, say, 19 percent, so why would you be bothered with all the hassles of real estate investing when you can get a better return from something that requires much less involvement?

On the face of it this seems like a sensible argument, and I know from the countless people who have told me so in person, by phone, fax, e-mail, or letter, that such advice was an ongoing reason why they did not get into the real estate game at a much earlier stage.

To understand why such a comparison is nonsense, we have to, once again, compare apples with apples.

When you invest $100,000 cash in the bank, and you receive $6,000 per annum in interest, then the yield is simply 6 percent. (The true yield will vary somewhat depending on whether the interest is paid monthly, quarterly, annually, or even weekly, daily, or continuously, and whether it is paid in arrears or in advance. However, in all cases it will be close to 6 percent, so let us just generalize and agree that the yield is 6 percent.)

Similarly, when you buy a property for $100,000 and you receive $6,000 per annum in rent, then the yield is, by definition, 6 percent. (Again, technically there will be a difference depending on whether the rent is paid weekly, biweekly, monthly, quarterly, or annually, but let’s again generalize and agree that the yield is 6 percent.)

On the basis of yield alone, it would be fair to say that both investments returned the same amount.

Many advisors who are property-averse are quick to quote the relatively low yields of real estate, and go on to steer their clients into other investment arenas.

However, is that where the comparisons should end? By now you should be jumping out of your skin saying, “What about leverage?”

Whereas the $100,000 deposit in the bank required $100,000 in cash, the $100,000 property could be bought, using our 90 percent loan-to-value ratio, using only $10,000 cash. So the rental return of $6,000 should be considered relative to the cash input, not the arbitrary purchase price.

Of course, if we do that, then we have to take the interest payments into account. If the interest rate is, say, 5 percent, then we would be paying $4,500 in interest, and we would be left with $1,500 per annum ($6,000 in rent collected minus the $4,500 mortgage interest payments). Done that way, the return would be 15 percent ($1,500 divided by the $10,000 cash input).

As the owner of the property you also have property taxes, insurance, maintenance, pest control, management fees, and a variety of other expenses that have to be taken into account.

Then again, on the plus side, for taxation purposes, you can depreciate the building, usually at around 2.5 percent to 4 percent depending on where you live. Furthermore,...