If you’re new to this series, we’ve been discussing some of the things a new investor-in-training should consider before investing.
A person can spend money for today’s wants, or she could invest it and thus effectively move today’s purchasing power into the future. That way, she pays today for tomorrow’s living expenses. One way to move money through time is to tuck it in the back of your unmentionables drawer. For small amounts, that’s not a totally bad idea. Everybody occasionally needs an immediate source of ready cash for unanticipated things. It is a mistake, however, to think of this as an investment. It does not grow. It generates neither interest nor dividends or rents. It lies there, just in case.
To invest is to buy various streams of income. We talked in general terms about what an investment is, what an investor does, and the 4% Rule in Part 1 of this series.
Part 2 was a general discussion about what drives value. We also talked about synergism, the times when more than one value-driver is active at the same time. Synergism supercharges returns.
In Part 3 we began to focus on real estate investments. We used a simple smart phone calculator to parse Net Operating Income and Debt Coverage Ratios to determine (a) the maximum loan a building will support; (b) an appropriate down payment; (c) a reasonable purchase price; (d) the monthly cash flow to the borrower, and (e) cash-on-cash yield on the down payment.
Income property is a splendid investment due to four benefits: Appreciation, Depreciation, Equity-Buildup and Cash Flow. These benefits generate the returns found in most income property investments. But not every building is a good investment, so in Part 4 we turned the discussion to a possible worst-case scenario: the zombie building. This is the building that refuses to die. It just barely pays for itself so there’s no sense in giving it back to the bank and ruining your credit, but there’s no net cash flow so there is no sense in keeping it. The owner is stuck. But even under those conditions we found that a zombie building can generate a long-term return of 5% (after inflation) just from equity build-up and tax advantages. As we’ve seen over the past several years, there have been periods in this market cycle when a mature, emotionally balanced and fully composed person would set her hair on fire for a 5% return.
Having discussed zombie buildings and the four benefits to income property investing, we now turn our attention to the risks of investing in apartments. There are four of them, nicely balancing the “four benefits”. These are the things that could go very wrong. This month and next month, it’s all about permanent damage to capital. William J. Bernstein has written on this and identified the sources of catastrophic loss: Inflation, Confiscation, Devastation and Deflation. This month we’ll focus on Inflation and Confiscation.
The most likely risk is inflation, simply because it has become a structural part of a modern economy. In modest amounts it greatly benefits debtors, including the various levels of government, through debt relief on the one hand and revenue enhancement on the other.
Inflation: Inflation is the most likely risk to the purchasing power of the dollar simply because (a) the government benefits from it, and (b) it is institutionalized. The compounding of inflation pushes people into ever higher tax brackets, thus increasing government revenues. It also permits debts, both public and private (including mortgages) to be repaid with ever cheaper (in the sense of reduced purchasing power) dollars.
We have discussed inflation previously. Inflation is when prices increase faster than productivity. Inflation reduces the purchasing power of the dollar. The fact that some people invest in ways that maintain purchasing power does not make inflation benign.
Example: As we know, inflation reduces the purchasing power of the dollar. Over the last 50 years the value of the dollar has eroded a touch over 4% annually (compounded). That means that $1 tucked away in a shoebox when you were a babysitter in 1966 would today, in your retirement, have only 14 cents of purchasing power.
Probability: Over the past 50 years we have witnessed 49 years of inflation. That is a 98% probability rate. No other asset risk is so pervasive.
Severity: Since 1966 inflation has exceeded 10% (annual rate) four times. It was 11.03% in 1974, 11.22% in 1979, 13.58% in 1980, and 10.35% in 1981.
Discussion: Big winners in an inflationary environment are those who own (a) streams of inflation-adjusted income (b) acquired with long term, fully amortized debt (c) with relatively low interest rate caps. The interest rate on the loan will obviously be at full market rates at the time the loan is made, but a portion of that overall interest rate reflects the lender’s inflation expectations. As inflation increases new loans will have ever-higher rates. One day the rate you agreed to when you got the loan could look really low. It did not seem so when the loan was acquired. It became so as rates continued to climb due to persistent inflation.
Inflation is the most common risk to un-invested (or mal-invested) wealth. As we have seen, it has compounded for 49 of the past 50 years and is now at the point where the 1966 dollar is only worth 14 cents (purchasing power parity). This is a terrible thing for people who lend money, whether it’s by buying savings bonds or bank Certificates of Deposit or even Treasury bonds. In many cases, it is probably not realistic for the private investor to expect a net income (after taxes, inflation and an appropriate risk adjustment) from the lending of money.
While savers are hurt, borrowers grow fat in inflationary periods. Their loan balance, in terms of purchasing power, reduces every year by the amount of inflation. Typical investments that have historically compensated for inflation include adequately diversified stock accounts and income properties.
To illustrate the effect of inflation on an income property, assume we enter an inflationary period with high (and rising) inflation rates. Nonetheless, a certain investor is under contract to buy a $1,200,000 apartment building. The investor agreed to put $400,000 down and to borrow the remaining $800,000 with a mortgage that is variable from the get-go and has no interest rate cap. There is not even an initial “fixed” rate period to give the owner a little room to breathe. With no cap, the interest rate rises with inflation and can theoretically adjust right up to the sky. This particular mortgage transfers every bit of the risk of future inflation to the borrower. It is clearly not a loan I would personally want unless there was just no alternative.
But even with the Worst-Loan-in-the-World, the principal amount borrowed never goes up. And when inflation doubles the price of the building to $2,400,000, all of that increase goes right to the borrower. The loan remains at $800,000 (minus the paid-down principal). Rents will have increased with inflation (a rising tide raises all boats) and the investor will have turned her $400,000 into at least $1,600,000 (original building value x 2 minus remaining balance on the loan). Even though the building will be paying a higher interest rate on its mortgage, the borrower quadrupled her down payment (equity). And in the meantime, the $800,000 mortgage continues to be paid off, a little each month.
Eventually, however, increasing rates of inflation will rise past the level of political acceptability and the Fed will seek to reduce them. Historically, inflation is resolved by forcing interest rates even higher, high enough to squeeze the vigor from the economy. This is the counter-point to the benefits of inflation on income properties: The value of a building at any moment in time is balanced on tip of a needle. If interest rates change, or vacancies, or net rental income, the market value of the building changes as well. Enough of a change and the building becomes unsellable at the (former) price level. Imagine what would happen to the market if mortgage rates quickly rose to parity with credit card rates.
Confiscation: Technically, to confiscate is to appropriate property to the use of the state (Black’s Law Dictionary). Both personal and real property is subject to seizure by the state. We will talk about two types of confiscation today. One type involves eminent domain: the state wants your property for public use and takes it. This type has been around a long time.
A more recent variation is civil forfeiture, where the law permits government agencies to attach any property the agency (usually a police agency) deems to be somehow involved in a drug crime. The property can be taken whether or not the (former) owner is convicted or even charged with a crime. It is not even required that the owner be arrested. Civil forfeiture laws include real estate that “has been involved in a crime”. As you might expect, the sale proceeds from confiscated property accrue to the benefit of the police departments involved. Asset forfeiture is not an arms-length transaction and no due process is involved.
Example 1: Eminent domain, the right of government to seize private property for public use, is one form of confiscation. Recently (as civil suits go) the City of New London, Connecticut, took real estate from an unwilling private owner (Kelo) and transferred it to a private developer. This was a private owner to private owner transfer. It was not for the public use of the City of New London. Kelo sued.
The US Supreme Court found in favor of the City of New London, holding that because the developer forecast that his development would create 1,000 jobs (which in turn would assumedly benefit the city) the seizure and transfer was a legitimate use of government power. By extending the penumbra of “public use” to include private employers the Supreme Court significantly reduced private property rights.
Example 2: An example of asset forfeiture is the case reported by CNN (Sept 8, 2014) where police seized a house, on the pretext that it was being used for selling drugs, after a couple’s 22 year old son was arrested for selling $40 worth of illegal drugs. The homeowners themselves were never arrested for a crime, never charged with a crime, and never convicted of a crime. But they still lost their home, without even a trial, because an adult person (not on the deed) elected to break a drug law while on their property.
|Probability: The probability of being personally affected by confiscation (either civil, like eminent domain, or criminal like asset seizure) is unknown. There have been reported cases of seizure simply for carrying a large sum of money. No apartment owner can be sure some tenant’s teenaged child won’t do something stupid. There is no easy way to insure around confiscatory government action.|
Severity: Unmitigated asset forfeiture (excludes actions like eminent domain) has been going on since 1989. From 1989 until now the total value of seized property has approached $13 billion. In 1989, the first year of the program, the annual seized total was $285 million. Seizures grew to $1.7 billion in 2010 (last year available). That comes to very nearly $5 million each day. Makes you wonder how much of that was precipitated by some kid selling one of his father’s prescription pills from his bedroom.
Discussion: While robust argument could be made establishing that confiscation in the form of asset seizures reduces the profitability of the illicit drug trade, there is an offsetting position. The ability of government to seize property without first requiring a criminal conviction or civil judgment reverses the relationship of a citizen to his or her government. “Innocent until proven guilty” is cast aside and replaced with the relationship of a farmer towards his dairy cows.
This article is for informational purposes only and is not intended as professional advice. For specific circumstances, please contact an appropriately licensed professional.
Klarise Yahya is a Commercial Mortgage Broker. If you are thinking of refinancing or purchasing five units or more, Klarise Yahya can probably help. Find out how much you can borrow. For a complimentary mortgage analysis, please call her at (818) 414-7830 or email [email protected].
If you’ve missed some of the prior articles, basic guidelines on successful investing are in my book “Stairway to Wealth” available at www.LuLu.com