Investing 101 Addendum: Property

In our “Investing 101” article we did not mention anything about residential property.  This may have perplexed many readers as residential property is usually considered a major asset in the arsenal of any serious investor.

In fact in most circles buying a house is considered your one-way ticket to economic freedom.  Once you’ve “got onto the first rung” of property ownership you’ve basically made it and the rest is just details.

This is a badly misleading fallacy.

We left out residential property from our initial discussion for a reason, so that we could deal with it separately and briefly discuss some of the salient features of this misunderstood realm.

Most people regard their properties as investments which will make them money, or at the very least big chunky savings accounts for their retirements.  While residential property can be these things, it is first and foremost a place to live.

No such thing as second hand houses…

Property is a consumer good, just like cars, digital cameras or ballpoint pens.  Like all consumer goods, property suffers from monetary driven price inflation, meaning that over time, house prices expressed in paper currency go up.  Because houses are particularly durable consumer goods they are able to be resold to other people far easier than most other consumer goods.

You will always hear people talking about second hand or used cars, second hand bikes, second hand digital cameras and so on, but you seldom if ever hear people talking about second hand houses, even though that is exactly what a previously owned and used home is.  That deception stems from the durability of houses.

So, where am I going with this?  Well, in Investment 101, our second golden rule of investing was to make sure you understand the asset you’re buying.  Understanding the mechanics of housing is easy – a house is a place to live, it can be rented out and become an income stream.  But the essence of the housing market is far more important. 

Because houses are very durable and, as a result, have good value retention and re-sellability, bankers realised they were consumer goods that could be financed on credit.  Most other consumer goods are not expensive enough to require credit financing, and most do not offer the kind of durability and re-sellability to act as adequate collateral over a long repayment period.

Propped up by leverage

The age of excessive financial leverage and risk-taking within a government controlled banking system has seen massive liquidity and resources pumped into the property market which in turn has raised property prices far beyond most people’s means.

This is a crucial point: While most consumer goods simply experience ordinary monetary-driven price inflation, house prices suffer from the double whammy of ordinary monetary-driven price inflation AND credit-driven price inflation.

Let me explain.  Prices driven up by money in circulation are unlikely to ever reverse unless the pace of physical money creation slowed below the pace of new value creation – an unlikely event in the current fiat money system.  However, price increases driven by credit created out of thin air by banks can reverse when that credit contracts or, worse, disappears.

In fact, price increases driven by credit can reverse sharply and ruthlessly.

The modern day housing market and the house prices that ‘clear’ that market are propped by a globe of excessive consumer leverage.  The level of global consumer indebtedness is so acute that the entire global banking system came within a whisker of outright collapse were it not for the printing press lending this fragile fraud a little more time.  

How much house prices are made up of credit inflation as opposed to just physical inflation of circulating notes and coin is hard to tell, but it is definitely a large chunk.  In fact from 1940 to the height of the recent US house price bubble in 2006, general prices of goods and services in the US economy increased by about 1350% while US house prices rose 5900%.  To put that into a bit of perspective, without leverage US house prices should probably only be about 10-25% of their peak 2006 values.

Getting richer or poorer?

Although the average American family is nearly 4 times better off in real income terms than in 1940, they can currently only buy 75% of the house they could have bought back then.  In fact that statistic is skewed because average house prices these days do not account for the fact that modern homes and condos are much smaller and living space much tighter than it was back in the 1940’s.  I would venture to guess that if you had to take square meters into account, today’s Joe Average, despite being 4 times wealthier than his grandpappy was 70 years ago, can probably afford less than half the actual living space gramps could back then.

There’s something badly wrong with that picture folks.  Humans are supposed to get wealthier as technology and productivity improves, not poorer, and yet for all our supposedly greater wealth in the 21^st Century we’re getting squeezed into ever tighter hovels of suburban box living.

Why?  Ah, the property experts and dull economists have all the answers.  In short, they say, there are more people around nowadays but still the same amount of land, and there’s a greater shortage of houses now than ever before.  Moreover, building costs have escalated far more than the general price inflation rate.

Seductive arguments at face value but still utter nonsense.

Back in the real world, European populations for example have been stagnating while property prices have been soaring.  Hmmm, tricky one for the herd to solve.  How about that shortage of housing?  A few weeks ago Doug French reported how in some US counties there is now a 5-10 year oversupply of housing units.  Never in history have we seen so much housing stock relative to families and yet instead of dragging prices steadily lower every year it seems to pull them higher.  Any ideas from the herd on why that might be the case?

As for building costs, don’t be fooled, they’re driven by credit-fuelled housing demand inflation rather than the other way around.

In fact, the scary thing about the housing market is that, contrary to most herd thinkers, housing demand and house prices are not driven at the margin by a need for living space or building costs but rather by access to capital.  That’s right, availability and access to capital is the key determinant of house prices.

Destroying capital, collapsing house prices

Why scary?  Well, as we’ve explained before, credit creation out of thin air by the commercial banks does not really create new capital but simply redistributes existing real capital and distorts capital allocation in the economy.  Banks have never known a more profitable business than creating mortgage credit, and huge amounts of capital have been sucked into the housing market in all modern economies.

But, even worse that just misallocating capital, creating credit out of thin air ultimately destroys capital and undermines real wealth creation (read a detailed discussion of this here and here).  As real capital is destroyed in the system so there is ultimately less and less real capital for the banks to steal through credit creation out of thin air.

The less real capital, the less capital (ie credit) available to prop up grossly over-inflated house prices.  The less capital in the rest of the economy the less wealth creation and growth and therefore the lower real incomes fall.  Lower real incomes and less real capital means less credit and leverage and ultimately falling rentals and house prices.

To put this in slightly simpler terms, it is like the banking sector is sucking the economic system dry of capital to prop up a housing market that relies on the very sectors from whom the capital is being sucked.  Or to say it even more simply, the monster is eating itself to stay alive – not very sustainable I think you’ll agree.

What I’ve described above is exactly what has just happened in major global housing markets from Spain to the US in recent years.  US house prices should have fallen by 80% and would have were it not for the bailout pyrotechnics of the US Federal Reserve and their trusty magical medicine the printing press.  But that fantasy land only buys you so much time before the monster becomes terminal.

Time for a radical rethink of residential property

Folks, in a normal world residential property might be a good investment.  It is durable, retains it’s “newness” quite well, is fairly easily re-sellable, serves peoples needs, can provide an income stream, and can be passed on to future generations as a useful inheritance and store of value.

But, in the real world, the housing market could be one of the largest Ponzi schemes in history.  House prices have been systemically propped up by a glut of thieved capital, but that capital is starting to run dry, and as it does, so house prices will falter.

The coming collapse of the monetary system and with it the banking system as we know it will be accompanied by not only a wiping out of liquidity of a scale never before seen in history, but also a great and tragic destruction of real capital.  That my friends is when property prices will adjust down to their true value with a violent and unstoppable force.

You may have all the right motives for investing your treasure in residential property, but the underlying structure of the monetary system has rendered it one of the riskiest investments of the coming decade.  Yes you can live in a house, but you don’t need to own it to do so.  Do you really want an overhang of debt many times your annual income for a durable consumer good on which you may only get a fraction of what you owe on it in a distressed sale at a time of potential global market calamity when job security is far from certain and capital destruction is in full swing?

Suddenly renting don’t sound so bad after all.