The Last Bullet in the Revolver

Today I thought we’d follow up on a couple of the stories we wrote over the last week or so. Plus, we’ve had a rummage through the Money Morning mailbag to see some of the comments we’ve received.

We’ll head back to last week and our comments about property in our article, “How 70% of Property Investors Lose Money“.

To be honest, there wasn’t much in there that was new. We were simply restating our argument that most property investors have little to no interest in earning a positive cash flow from their investment properties.

It’s an argument we’ve made for some time. But on this occasion we drafted in some help from Morgan Stanley analyst Gerard Minack. Minack cleverly showed that right now over 70% of all property investors are losing money on their investment.

When you add up all the interest costs, maintenance costs and management fees, it comes nowhere near matching the amount of rental income received.

To me that makes the argument pretty straight forward. If you’re taking a loss on the income, then you can’t possibly be investing in the house for income. It’s a no-brainer. It would be like buying shares in a company that didn’t pay a dividend while claiming you’re an income investor.

The fact is, if you’re spending more on the asset than the income you’re deriving from it then it must be because you believe the price of the asset will go up.

Yet despite that there are still plenty of head-in-the-sand types who claim that isn’t true. Ah well, that’s fine, we’re never going to convince everyone that we’re right – even though we are.

But aside from the general comments telling us we’re wrong we also received a number of detailed emails from property investors – including spreadsheets – explaining why they invest in property and why it’s working for them.

And we’re grateful for those responses.

However, it alters nothing. In fact, based on the responses from property investors, it’s actually confirmed everything we’ve known:

That the main reason investors buy property is for capital gains, NOT income…

That property investors are happy to take a loss on the income because they believe the house price will go up over time…

That there is no incentive to pay down the principal amount on a housing investment loan. Hence why investors use interest-only loans…

And that property investors use equity in existing properties in order to borrow more to buy new properties.

That’s all fact. Surely not even the most hardened property investor could disagree with any of that. In fact, we’ll bet that 99% of property investors would agree with those statements. Proudly agree probably.

I’ll be honest, looking at some of the spreadsheets and workings we’ve received from property investors, it’s pretty scary how leveraged to the housing market these people are. Change that, VERY scary.

In fact, our first instinct when we looked at them was to suggest it would be easier if they just got themselves a second job if they wanted to earn more money. Rather than have $6 or $7 million of loans against property “valued” at $6.5 or $7.5 million, and with monthly interest payments stretching into the tens of thousands of dollars – interest payments that are less than the rent received…

It would be less time consuming and less stress if they got a part-time job working in a gas station or something at weekends. The income would certainly be higher!

But the biggest upshot of it all is that it doesn’t need the property doomsday scenario to come true for a lot of these investors to get into trouble. As you know, we ultimately believe the housing market will suffer from a massive crash – 20%, 30% or 50%, who knows.

If that happens then property investors will be toast. But even if the housing market goes through the plateau period that most of the spruikers talk about, that is likely to be the final straw for those that are on interest-only loans and who have taken out equity against one property to buy another.

Look, let me get something straight. We understand the tax advantages of property investing. We get it. But, we’ve always remembered the first thing we learnt when studying for our financial licence in the UK… and that was to never make an investment based purely on the tax benefits.

Sure, we probably learned a lot of rubbish in those classes too. Most of which we’ve thankfully forgotten. But we’ve never forgotten the comment about tax.

Tax deductibility is great if you can use it to your advantage. But, the tax aspect should be one of the last things you consider when making an investment.

In other words, the investment should be able to stand on its own merits. If you don’t see the benefit of buying an asset without a tax break, then you shouldn’t buy it with a tax break.

And right now, tax effectiveness aside, there is absolutely no reason whatsoever to invest in housing. None.

Prices are at an all-time high. Prices in cities such as Melbourne have increased by 20% or more in the last twelve months.

Despite the claims of a housing shortage, auction clearance rates have plummeted and real estate agents are now talking about an oversupply of housing! And that’s based on an extra 100 or so properties coming on to the market each week. So much for the 200,000 home chronic housing shortage!

And then you take into account the fact that the rental income on a property investment is significantly lower than the cash costs of the property – about 30% to 40% based on the numbers we’ve seen.

So why would you buy property? Because of the tax break. And that’s the only reason. Plain and simple.

In my book, if a tax break is the sole reason to buy something then it fails as an investment.

But aside from that, we received a number of emails following up on yesterday’s Money Morning. For instance this from Andy:

“So what you’re really saying is: if you borrow $30 billion and waste it away, then the money required to pay it back cannot now be spent on the something else that you originally wanted to spend it on. It is the hidden economic cost of implementing Keynesian economics. (and to make it worse, you haven’t even got $30 billion worth of assets, because you’ve just wasted it all)

“It is no different from any one of us spending $50,000 on a credit card on partying and having a good time. We will have to pay back the debt, and the money for paying it back can’t be used for something else in future. But we couldn’t sell the $50,000 asset to pay it back, because there isn’t one.”

Yep. That pretty much sums it up. A stimulus programme is really just forcing someone to spend money on credit even if there’s nothing they really want.

Sure, the firms you spend the $50,000 with – to use Andy’s example – will get a stimulus boost because they otherwise wouldn’t have received it if you hadn’t been forced to spend the money.

However, after spending the $50,000 the consumer now has to pay for it. That may take them one or two years, or perhaps even longer. All the while the consumer has to forgo things that they may have bought or saved for because they are still paying back the loan on things they didn’t really want in the first place.

In a nutshell, it’s why a stimulus package can give the appearance of working because it creates an immediate high – we’re seeing that with some of the company results that have come out this week – but in the longer term it creates a drag on the economy as individuals are unable to either spend or save because they are too concerned with paying off debt.

Another great example was given by “J”:

“It’s very much like a thief breaks into a store and steals $500. But, in the eyes of some ‘economists’, that’s OK if he spends the money in the store afterwards. The store owner has got his money back!”

That’s what governments do all the time. They violently take money from income earners and then dish the cash out according to the fancy of the bureaucrats.

There’s not much difference with the stimulus. Only in this instance, the shop owner hasn’t discovered that they’ve been robbed yet.

Then there was another longer example from reader “C”. It suggests that in his company:

“For every $1 we receive from those government departments we only pay out about $0.20 in wages $0.09 in GST (which goes to other govts), nil in company tax etc etc
Of the $0.20 we pay in wages, the average employee would pay 16.5% in taxes representing $0.03 for every dollar in income. NOT 22.5 cents in the dollar but 3 cents”

Seems as though Hagen and Gruen were well off the mark there with their claims. Not only that, but it seems as though the stimulus programme may have helped firms to cut jobs:

“Further the government in its stimulus program forwarded a great investment allowance, which we duly recapitalised with overseas manufactured machinery at 50% of a tax rate of 30 cents in the dollar. In our case, this represented an additional lesser potential tax burden of $300,000, or another lesser theft from govt by $300k. But the point is our machinery, runs at twice the speed and double the life of redundant machinery so put retired 4 employees FOR EVER. Therefore my business needs less labour for each dollar earned and at the current rate is about 2 cents in the dollar turnover.”

Evil capitalist? Or someone merely taking advantage of the opportunities created by dumb government policies?

It’s the latter of course. If that particular businessman didn’t take advantage of the government manipulation then odds are his competitors would have and that could have caused the whole firm to go out of business.

Remember what we’ve always said about it being impossible for bureaucrats to micro-manage an economy? That’s a perfect example.

Whenever governments meddle, they without fail cause more problems than they cure. There wouldn’t be a single instance in history where this isn’t the case.

Naturally, there were some who claimed we’re wrong. Such as Vince who said:

“The 5% who remain in employment due to the fiscal stimulus not only earn money and pay taxes, they also spend money which increase the tax paid by others and increases the banks ability to lend money etc. This is why it is called a stimulus. Was it on this website or another that I read about the velocity of money and the analogy of rabbits running around a tree?… Your philosophy on fiscal stimulus doses not stack up. Keynes was right and the anti Keynesians are wrong.”

As is usually the case with the Keynes supporters they’ve got it wrong. Simply because they fail to see the entire picture.

It’s wrong because it fails to identify where the stimulus money has come from. We won’t cover the case again, because we went through that yesterday. But simply put, all the government has done is borrowed from the future.

It has sucked potential demand from tomorrow in order to create a false demand today. The Keynesians will argue that when tomorrow comes all you need to do is borrow from the following day in order to meet that day’s demand… and so on… for ever…

Nice try Keynesians. The problem is, each day the borrowing increases as not only do you need to meet the demand for that day, but you also need to repay the borrowing from the previous day.

The economy has tried that one for the last forty-odd years. It seemed to work for a time didn’t it? Yet now, as the US, UK, and half of Europe have discovered, eventually there’s no-one left to borrow from and the accumulated debt exposure becomes so huge the market collapses.

That’s when the central banks use their last bullet in the revolver, they print the money to buy their own debt from themselves!

Try explaining how that’s gonna work.

Cheers.
Kris Sayce
For Money Morning Australia

Tagged as: asset, income, invest, market, money, price, property