"The Founding Fathers of this great land had no difficulty whatsoever understanding the agenda of bankers, and they frequently referred to them and their kind as, quote, 'friends of paper money.' They hated the Bank of England, in particular, and felt that even were we successful in winning our independence from England and King George, we could never truly be a nation of freemen, unless we had an honest money system. Through ignorance, but moreover, because of apathy, a small, but wealthy, clique of power brokers have robbed us of our Rights and Liberties, and we are being raped of our wealth. We are paying the price for the near-comatose levels of complacency by our parents, and only God knows what might become of our children, should we not work diligently to shake this country from its slumber! Many a nation has lost its freedom at the end of a gun barrel, but here in America, we just decided to hand it over voluntarily. Worse yet, we paid for the tyranny and usurpation out of our own pockets with "voluntary" tax contributions and the use of a debt-laden fiat currency!" ~ Peter Kershaw
Bankers, Bubbles and Fools
Exclusive to STR
There are two kinds of people in this world: those who pay interest and those who receive interest. ~ Darrell C. Simms
Central Bankers eventually make fools out of most investors, especially real estate investors. This is because they get to create capital (credit money) where none existed before (out of thin air). The infusion of credit money into an economy sends false signals to investors as to the time preferences of consumers and savers alike. This leads to the "boom-bust cycle" as well as making people save less and buy more (typically on credit). First credit expansion leads to an asset price bubble, then the market punishes the investors left holding the bag when the inevitable correction comes. The real estate market today is a case study in this type phenomenon.
The tight rein that producers typically exercise over their hard-earned savings is significantly more restrictive (considering the potential uses and rates of return that it could be loaned out for) than the loose availability of credit money controlled by people who don't care (much less understand) where the funds came from. Consumers and investors, always on the lookout for a free lunch, typically line up to get a piece of this action. The structural balance of an economy is altered as capital resources are misallocated from production-oriented uses to consumer-oriented uses. This process undermines future potential earnings in favor of present consumption. Traditional investment criteria then are labeled "outmoded" and a New Era of Perpetual Prosperity is trumpeted such that some investments even become "fool-proof" or "can't go wrong" opportunities. Like, say, condos in Florida .
The history of real estate booms and busts are fairly well known, yet in every boom the buyers come to truly believe that real estate prices "will never go down." Further, the bust is always blamed on "greedy speculators" and never on the "greedy bankers" who sent the false signals that fooled the speculators. What's seen are the actions of speculators while what's not seen are the actions of the enabling, nay, the encouraging credit money creators (state-sanctioned counterfeiters). To add insult to injury, the bankers will foreclose on real property for repayment of funds created out of thin air and then complain that they had to "write off" a portion of the loan. When this begins to happen more frequently, prices will come down. It appears to be happening now.
In order to understand how even the most sophisticated real estate investor can be fooled by "artificially low" interest rates, it is helpful to examine traditional methods of valuing real estate. The market price of a property is the price at which a buyer and seller agree to exchange a property for, though the market value based on long established investment criteria may be less. Further, the seller will wish to sell his property for the most he can, so will take the highest offer even if from the biggest fool of all. The potential buyers make offers based on their perceived future returns from that property. This decision is straight forward when considering income-producing (commercial) property if not for strictly residential property purchased for living purposes. However, even personal homes can be rented so that the same methods can apply with some caveats.
The three traditional approaches to value are the Cost Approach, Sales Comparison Approach and the Income Approach. The Cost Approach examines the cost to buy a similar site and construct similar building improvements on it less any depreciation. The Sales Comparison Approach simply compares the subject property to other recent sales of similar properties. The Income Approach estimates the future income of the property and capitalizes that income (either directly or for cash flows over a specific time period) to a present value. All of these approaches are based on the principle of substitution.
The Cost Approach assumes that a buyer would not pay more for a property than what they could build an identical substitute property for. However, no two properties are identical, the hassles and time involved going through government approvals for constructing a new building are significant and the estimation of profit and depreciation are very subjective. The Cost Approach works best for newer properties where land is abundant and is less reliable for older properties.
It is important to note that cost does not equal value, because the typical buyer in the market does not recognize some features to be as desirable or valuable as do some individuals. For instance, Shaq built a gymnasium next to his house that some people may find desirable, but probably not pay the full cost when buying his house. A more extreme example is a guy who recently purchased the miniature version of The Great Wall of China salvaged from the now defunct Splendid China tourist attraction to put in his yard. The miniature version of something that can be seen from outer space is still quite large and very few potential buyers will be willing to pay even part of the cost for such a monstrosity. Yet the proud homeowner argued that the cost of the wall should be added to the value of the property dollar for dollar as if the rest of the world saw its value the same as him.
The Sales Comparison Approach is also based on the principle that people will not pay more for a property than they would for a similar property. The most recent similar sales are adjusted for differences in order to provide a value indication for the subject property. Differences include location, size, age, condition, quality, amenities and other factors. The difficulty in this approach is finding recent sales of similar properties. Unique properties typically appeal to a smaller pool of potential buyers and make comparisons more difficult. But property designed and constructed to meet the norms of market expectations can make this approach very reliable absent market interventions, especially for residential properties.
The Income Approach estimates the potential gross income and deducts vacancy and collection losses as well as operating expenses to arrive at an estimate of net operating income. The net operating income is then "capitalized" via a direct capitalization method or a discounted cash flow at a rate that takes into consideration the cost of financing and return on and of equity. These rates consider the relative risk and the return on alternative investments such as bonds.
All three of these approaches are then reconciled to a final value estimate depending on the relative strengths of each individual approach including the availability and quality of data, and the marketability and type of property. A single-family home valuation will typically rely primarily on the Sales Comparison Approach while an apartment complex, shopping center or office building will rely on the Income Approach. This is because home buyers have more emotional factors to consider than commercial property buyers, who focus on income.
It all comes down to choices. Buyers making choices between different properties dealing with sellers who must make a choice as to whether a buyer's offer is high enough to make him part with his property. I have yet to find a crystal ball that works perfectly, but the above methods seek to simulate the decision-making process of buyers and sellers. The problem is forecasting future actions and expectations of buyers and sellers based on historical data. It becomes nearly impossible to see the turns, both up and down, until it occurs. Rising interest rates are one indicator of a coming slowdown that is clear. What the breaking point is may not be so clear.
So how does credit money throw a monkey wrench into this decision-making process? The changes are subtle and the responses of market participants lag the initial interventions. The Central Bank sees the economy as not vibrant enough (bank profits are down) and decide to "stimulate" it. So poof, some new money is created by the purchase of Treasury Bills that are used as reserves to lend to member banks that then see an increase in the supply of funds available to loan, thus lowering interest rates. The government gets to sell bonds at below market interest rates to give money to favored clients, and banks get to create money out of thin air to lend at below market interest rates. So it's a win-win situation for the government and the banks. At the beginning, it also looks good for the borrowers (whose numbers begin to increase) because cheaper money is available, but bad for the savers (whose numbers begin to decrease) because their returns decrease.
The "more money in circulation equals more wealth" crowd focuses here on what is seen. More projects are being built, stimulating employment in construction as well as in businesses supplying materials, creating a booming economy. The small, nearly imperceptible effects are not yet seen: the funding of projects that do not have sufficient demand and/or are poorly designed because a developer "can make the numbers work" to get a loan. Let's look at how these effects creep into valuations.
First the lower interest rates are factored into capitalization/discount rates used in the Income Approach. Therefore, with no change in equity requirements, income potential or vacancy rates, the value of most properties has increased on paper. Buyers then look at the current level of sales prices to see that more "deals" are suddenly available. Prices appear low because the lower interest rates increased equity returns at current price levels. So the prices being paid for properties increases as they are bid up by investors who can now leverage a higher price with a lower financing cost.
After a little while, the construction boom gets going full swing and the intense competition for labor and materials bids up these prices as well. "Creative financing" with adjustable rate mortgages and "negative amortization" entices more marginally qualified "investors" to buy property that they will have trouble making mortgage payments when interest rates increase. Since their strategy is to flip the property, most don't care. So the stimulus of lowered interest rates cranks up the construction industry with members getting more work than they can handle at increasing fees and wages. Life is good; so pay no attention to the man behind the curtain.
The theory supporting Central Banking assumes that if the Central Banker can use the proper amount (read slow and steady) of stimulus to outwit the market, stymie the greed of mortgage brokers and developers, then this pyramid scheme will keep going forever. However, even if an omniscient Central Banker were somehow humanly possible, he would simply find the true market interest rate that would have been the case had no interference been used to begin with. The intervention process always ends in a bust, and instead of giving up, interventionists just start all over again, promising to get better at screwing up the market dynamics. When the most popular economic indicators are consumer spending, consumer confidence and a fake inflation rate, it should be obvious that some sort of scam is in the works.
Usually a lot of stupid decisions are made when banks start giving away practically free money to people who don't have a clue what to do with it. People buy homes that they can't really afford because they "qualified" for a monthly payment without any concern for the price. Novice investors come out of the woodwork buying "investment" homes like they were cars. This tendency increases as prices continue to escalate and a comfort level becomes predominate that the "market will automatically increase and erase any mistakes." The "greater fool theory of investment" kicks in. Projects and even homes are purchased based not on sound investment criteria, but on the projection that someone else will come along and pay more than you did no matter what you paid. The old adage of "buy low, sell high" becomes "buy high, sell higher."
The good news is that most of the commercial real estate markets are pretty sound and not nearly as overbuilt as in past booms. There are some retail sectors that have over-expanded, but fads are typical in retail construction. Office space has a healthy inventory in most markets. Warehouse/distribution properties have remained fundamentally strong. Apartments are getting stronger because the biggest misallocation of funds is in converting apartments to condominiums and building speculation single family homes.
The influx of novice investors acting as lemmings fleeing the dot.com busted bubble has pumped up the residential real estate bubble. This large pool of small investor money combined with easy credit money has fueled record price increases and equity returns for residential real estate. This great entry level real estate investment vehicle has enticed people to gamble on a game that is more risky than they know. In the 2003 to 2005 period, homes and condos were flipped two or three times within months with 10% to 30% price increases with each sale. I have heard this process called "stupid-money" because it was so "easy." Just put a contract on a house/condo during the pre-construction phase and sell it after it's built at a higher price. Sure sounds easy enough if historical anomalies can continue unabated.
When capitalization rates increase due to an increase in interest rates, the value of property decreases if rental rates are not increasing fast enough. The increased supply of new product increases competition, which tends to keep rental rates low. When mortgage payments stop being covered, then the fantasy of "automatic increases" starts to fade away. Further, the undermining of incentives to save and increasing the incentives to borrow have led people to look at their homes as ATMs. The days of refinancing after every rate drop to 'pull out equity' are over. There is no more equity when values drop and there are no other savings to fall back on.
Mr. Greenspan took the discount rate from 6.0% in 2000 down to 1% in late 2002 in order to shift the bubble from stocks to real estate. I don't know if this was his "brilliant" plan or if he was just lucky, but shifting the bubble to real estate lowered unemployment and kept the stock market from panicking into a crash. Since 2004, the discount rate has climbed back up to over 5% in an effort to keep the economy from "overheating." Sir Alan made fools out of stock investors (mostly the little guys) and his legacy will be to do the same to real estate investors (mostly the little guys).
Real estate does, however, have one great advantage over stocks in that people can use it and if they choose not to sell, then it can retain value much better than stocks. Also, increases in population increase demand for housing. The proverbial "soft landing" is hoped, prayed and wished for. As long as foreigners keep immigrating and investing their savings here, we could have one. The Dow has hovered around 11,000 for six years and perhaps real estate could do the same: no more increases for years, but no crash either. After considering inflation, stocks, and more so bonds, have been taking a beating, though.
The ripple effect due to a downturn in employment as construction slows is a big wild card for the entire economy. The construction and financial services industries have been the only life lines in a battered economy that is overburdened with too much government and consumer debt. As Bill Bonner likes to say, "Americans buy too much stuff they don't need with money they don't have." Don't get me started on government budget deficits, Medicare and Social Security obligations; God help us if we invade another money pit to fix up. These policies have turned America from a creditor nation into a debtor nation in a short period of time. That is, from a sound economy into a banana republic.
So to sum up you start with a fractional-reserve fiat money machine and then go to small investors making stupid money. The artificial increase in equity returns fuels increased demand until a mania ensues due to unrealistic expectations of future returns based on recent phenomenal returns projected into perpetuity. When sales prices (or stock prices) cannot be justified by net operating income (or profit), then the market has been distorted beyond sanity. When the prices paid for investments are based on fantasies about the future instead of the demonstrated ability to produce income, then investors have been fooled. As this becomes apparent to the masses, then pop goes the bubble.
The sign of the end times is the red hot condo market. Condos are always the last product to get hot and the first to crash. The smart play right now is to sell your house, rent a nice place and put your proceeds into commodities such as oil, gold and silver. Within two to three years you will be able to buy twice the house you had for a fraction of the price you sold your previous one for (sell high and then buy low).
I doubt that bankers will ever learn even after the coming debacle that will make the Savings and Loan Crisis of the late 1980's look like a cakewalk. Just don't let bankers and bubbles make a fool out of you in the process.