Dear Thoughtful Investor,

a series of letters on real estate, finance, and economics

#5 Good to Great(er) (fools)

Dear Thoughtful Investor,

Are you looking for safety? Or are you looking for return?

 

When we talk about ‘safety’ we are talking about the preservation of purchasing power - the ability to buy the same amount of stuff later as we can buy today. We want to make sure we do not lose our purchasing power and are therefore able to buy less stuff in the future. When we talk about earning a ‘return’ we are talking about increasing purchasing power - to buy things with our current purchasing power that we hope to sell later to achieve more purchasing power. In looking to earn a ‘return’ there are three ways to get there: 

1) speculation: buy something today and find someone later to pay a higher price for the exact same thing we bought

2) we ‘add value’ to the thing we bought by combining resources, creativity, and doing some work to get there

3) we give our money to someone else who adds the creativity, does the work, and makes the thing better and profits are split between those doing the work and those that provided the money. This is really a subset of #2 but there’s enough nuance there so as to give it it’s very own bullet

Good to Great(er) (fools).png

Speculation was rampant in the real estate run-up prior to the 2008 financial crisis. Someone could buy a house with 0% down or 3% down and hold it for a few month and turn around and sell the house for more dollars. In a Finance 201 course we would call this the greater fool theory - the idea that even if you foolishly bought it at a high price a greater fool will come around and buy it at an even higher price from you (muhahaha). A ‘Momentum Trade’ in the stock market is the same thing: prices of stocks have momentum so you can buy a stock, hold it for a little while and sell it higher even though nothing has materially changed about the stock during the time you held it. When we think about financial assets / paper assets / digital assets (that is stocks, bonds, bank account balances) we usually consider that the purchasing power of the dollars are fixed and the prices of the asset (stock / bond / etc) changes. But what happens when we talk about physical assets?

Real estate is a physical asset, it is land and any buildings or improvements on the land. Real estate can fit into any of our three categories above in that it can be held for a while with no improvements made (speculation) or it can be improved by combing concrete, 2x4s, glass, tile, carpet, and drywall and with (a lot) of work, turned into a house…or money can be given to someone else who does the work of combing the resources and creativity into a house. If an investor buys a piece of raw land for $100,000 and holds it for a year doing absolutely nothing to it and then sells it for $110,000. We could say the investor earned a 10% return. But did he really earn that return? If all equivalent parcels of land cost $110,000 now then he didn’t earn a return he just preserved his purchasing power. 

Think about it like this: Today an investor has $100,000. They can buy a piece of land for $100,000 or they can buy 5,000 pounds of coffee (at $20 a pound). The investor buys the land, holds it for a year and sells it for $110,000. “Great! I earned a 10% return” he brags to his friends. But when when he goes to buy coffee he finds that coffee is not $20/pound, now it’s $22/pound. He can still only buy 5,000 pounds of coffee. He preserved his purchasing power but he did not create additional purchasing power, his return was actually zero because price inflation swallowed all of his return (we could say dollars were devalued by 10%, but we’ll save that for another letter).

Holding real estate is typically an excellent inflation hedge to preserve purchasing power. At times it may generate a return above inflation, but usually not for long - especially if those dollars need to stay in the region. For instance, I live in a house in Bend, Oregon. The ‘price’ has gone up about 65% over the 5 years I have owned it and I am tempted to sell now and keep all the additional dollars and brag about my great real estate investment. But everything else within driving distance of Bend has also gone up about 65% so the only way I can realize a return is to sell my house and move somewhere else - like a suburb of Detroit. All I have really done is preserve my purchasing power over these five years. 

If you are looking for ‘safety’ and the preservation of purchasing power - buy and hold some real estate. If you are looking to earn a true ‘return’ in real estate you either have to enter and exit speculative markets, or you have to ‘add-value’ and improve the asset.

Sincerely,

A Thoughtful Investor

#6 Hard Assets and Hardly Assets

#4 Are we in a bubble??