So, IR, what about a non-dividend paying stock held by a retail investor?  Is it not an “investment” because it has to be sold to be profitable?  Buffett’s approach isn’t really applicable to most of us, as we don’t have the capital to purchase entire companies.
——-

Real estate is both investment and speculation for those of us you call “cash flow investors”.

As opposed to most stocks (but similar to those who pay a dividend), with real estate we are getting a return on our investment while renting out property.  The tax benefits are also better with real estate than stocks.

We are also speculating on the price of homes, which have historically increased.

Those of us who are capable of riding out the lows while buying and selling the right kinds of homes over a 10 year cycle make a lot of money.  It is actually difficult to lose money in real estate if you have the financial strength to hold on to your property for a reasonable period of time.  Of course it is possible that this will change, though highly unlikely.

Those who wildly speculate over a short period of time are on average going to lose in real estate, just as those who day-trade stocks usually lose in the stock market.

Your “rent saver investor” is not an investor at all.  He is an ordinary homeowner who is smart enough to buy rather than rent.  In the long run of history, it would not matter if he bought at the absolute peak of any real estate bubble.  He would still be better off than the renters ten years later.  Once again, some people will say that “this time is different”.  I think we have all heard that one before. 

Whether we are talking about real estate bubbles or renting versus buying, history repeats itself and those who buy and hold real estate are better off financially in the long run.  There may be a few “exceptions to the rule” who post on this board, but the rule stands the test of time.

IrvineRenter,

IMHO, this is in your top 5 post, excellent…..

the only thing I could see adding is something on location

Fantastic post.  Clear and concise.  Well thought out.  Great!

I do think that many rent savers will assign some value to the intangible benefits of ownership, but I don’t think it impacts your analysis meaningfully.

> So, IR, what about a non-dividend paying stock held by a retail investor?

zaleriana,

B-H itself doesn’t pay a dividend, but that does not mean you cannot analyze it as a cash-flow investment.  Buffet himself assesses B-H (and each of its internal businesses) performance based on its incremental return on investment capital.  Each year B-H produces earnings.  The earnings need to be sufficient to cover the cost of B-H’s capital, plus a premium to reward investors. 

As long as the earnings are much greater than the cost of capital, and the earnings can be re-invested at a high rate of return, the stock appreciates based on its fundamentals.  That is, it appreciates not because people think they can sell it for more in the future, but because they are buying the net present value of the earnings. 

Buffet has long stated that B-H will begin paying a dividend when it can no longer invest its earnings at a high rate of return.  As the earnings have grown larger, finding high return uses for them has become a more difficult task.  But as long as B-H can continue to get a high rate of return on its earnings, it makes sense for investors to forgo a dividend.  The lack of a dividend doesn’t mean that the business is not producing free cash flow, nor does it mean you cannot do a discounted cashflow analysis on it, it just means that buffet is investing the cashflow instead of the individual investors (which up until now has been a pretty good deal for the investors, though that could change in the future).

Excellent analysis on economic and financial basis. I believe some discussion on the emotional impact of owning a home may be warranted. After all, an owned home does create many emotional satisfactions beyond just financial consideration.

Great informative & concise post. It should be required reading for any would-be real estate buyer.

I rent a house in Carlsbad where the homes typically go for $650,000 to $800,000. My rent is $1800 per month - better than the typical rent around here which is around $2400. A GRM of 120 would have the homes around here selling for less than $300K (I’m using the average rent for the calculation.

Possible? Certainly something to think about. What I do know is that if I were to buy right now, it’d be financial suicide.

You can still be a “investor” with these types of stocks. However, you need to make a couple of assumptions.

1) That the company can invest the cash it generates internally with a higher rate of return than the rest of the market.
2) That management will only invest when #1 is true.

In essence, you are trusting management of the company to invest your money (the profits it makes) for you.

Under the above assumptions, the PE ratio is still a good guide. Cash Flow (with care taken with respect lumpiness of investments) is a better guide, but harder to determine.

IR

Excellent post.  One question that people continue to ask is what causes the rapid uptick in price caused by speculation to end?  The 60 minutes piece last night didn’t mention what caused prices to stop rising, just that they did.  I don’t see the cause / trigger mentioned in your article.

I would assume one logical answer is there are no more speculators left to continue to bid up prices—but if money was so free during the boom, what caused these speculators to reach their end in purchase capacity?  Or was the fed’s simple raising of rates enough to quash the 1% teaser rates that were key to funding the purchases near the top of the bubble enough to simply stop appreciation and let the bubble pop?

I’m not disagreeing with your post / analysis of cycles—just want to get some views on what is the trigger that causes the bubble to pop?  You do an excellent job of saying what will be the trigger to cause the downward cycle to pop but what is the converse.

ps—you got me yesterday with your post to catch trolls—didn’t pick up your sarcasm—and yes I guess I was too polite in a post back thinking you were serious!  Next time I’ll take the gloves off so to speak!

IR,
Thank you for that thoughtful and well-written post. If there were such astute analyses in the MSM, we would have a better educated populace.

“I would assume one logical answer is there are no more speculators left to continue to bid up prices — but if money was so free during the boom, what caused these speculators to reach their end in purchase capacity?”

Even with as loose as credit became, there is an ultimate limit reached when everyone is tapped out, and there are no more buyers to enter a market and push prices higher. The top of a bubble is like an airplane engine stalling in a steep climb, there is no immediate danger, but it will go down, and it will not end well.

I understand all of that.  I was asking based on these two statements of IR ‘s:

An investment is an asset purchased to obtain a predictable and consistent cashflow.

and

In fact, true investments need never be sold to be profitable.

There is NO WAY that both of those statements can be true and non-dividend paying stocks (i.e., most (not all, duh!) of NASDAQ) can be “true investments”.

“I do think that many rent savers will assign some value to the intangible “

And like last down cycle, most of the rent savers and many of the home owners will assign a negative value to those intangibles as they again recognize the risk, illiquidity, costs and hassles of owning are on par with renting. 

An abusive HOA, crappy neighbors, foreclosure brown lawns, leaking roof, inability to move with a job change, taxes, mello-roos are just the start.  When the house isn’t an ATM, people will realize just how expensive it is to do the upkeep of everything in the house.

Sure, sure.  But the key sentence in the post is In fact, true investments need never be sold to be profitable.  So, to the retail investor in B-H (i.e, not Warren or Charlie), B-H is not a “true investment”, but is rather speculation.

I agree that the definition might benefit from more nuance, but it can actually still be true.  The non-dividend paying stock can simply start paying a dividend at some point in the future, potentially after earnings have increased greatly, and the dividend is very large compared with the original investment.

Since in the long term, the real value of any investment is based on cash actually paid to the owners, all purchasers of non-dividend paying stocks are betting that the stock will eventually pay a solid dividend relative to the purchase price (though maybe not in the near future, and maybe not even while they own the stock).

It’s still a cash flow, just as if you had a mutual fund that invested in only divided paying companies. Just because they don’t send you a check, doesn’t mean that you don’t have a positive cash flow. Otherwise, we would all have zero cash flow (on average) because no one keeps a lot of cash around.

The key difference is that when you invest in a company that does not pay dividends, you are trusting the investment discipline of the managers. I was a little obtuse in the sarcasm with respect to assumption #2. Managers have an incentive to keep the money and not pay dividends, because that makes the company larger and the chance for them to have larger paydays in the future more likely. Warren Buffet can get around that by buying enough of a company to get more direct oversight.

I think Amway is getting into the RE business.

That should bring prices back up.

May I show you my catalog?

Yes, and a house is a cashflow, too.  A negative cashflow, but still a cashflow. 

“Obtain a cashflow” shouldn’t be dfined to include “obtain a indirect cashflow which doesn’t actually produce a cashflow to me, the holder of the ‘asset’ obtained”, especially when tied to an assumption that the asset need not be sold.  Riddle me how those two statements work together.

Realistically, 98% of stock market investing is speculation. If you analyzed earnings and put a cap rate to it, most stocks on a pure cashflow basis rarely earn more than 4%-6%. The last time the stock market was at parity with its cash value was 1974. Most players in the stock market are betting on earnings growth and playing a risky game of speculation (me included.) That is why stock markets are prone to violent corrections. The fundamental valuation of most stocks on a cashflow basis is so far below its trading price that even the violent corrections do not generally push prices down to their cashflow value.

Stocks, unlike real estate, spend almost all of their time well above cashflow value. Investors (speculators) began using historic P/E ratios to find low-risk entry points for various stocks to compensate for the rarity of stock prices falling to their cash value. Is this investment or speculation? It depends; mostly it is speculation.

My comment is that it is one thing to read about not acting on emotion.  It is another thing entirely not to act on emotion.  I’ve read similar analysis for over 20 years and I still haven’t been able to put the “non-emotional” thing completely into practice.  People have great capacities to rationalize and even when you think you are leaving your emotions out, you can still rationalize a position in congrugence with your emotional state, giving youreself a false sense that you are acting rationally when you are not.  And homes are the most emotional investments we make.

The only way out is to follow the simple rule… Before buying ask yourself.. do I really want to live here?  then if the answer is yes ask yourself.. can I really afford to live here?

If people had only bought the house they could afford where they wanted to live, our country would not be in this mess today.

Well done IR.  Despite a few nits here and there, your post is clear and concise dissection of how two common terms have been conflated in real estate.

Thanks.

Hey Bob, that was me, not IR, who got you! 

“The people who bought late in the rally and are now holding on to the asset while they drift further and further underwater: they are not so lucky…”

I’m glad to see the rhetoric has toned down a bit.  This blog has always been so well written with reason and analysis free of all the “grave and dire predictions” you can easily get elsewhere.  People who bought late (a home they could afford and want to live in for 7+ years), have simlpy made an unfortunate financial decision leaving much less room for error with other financial decisions.

Is this another “Alan” than the one from a month or two ago?  I agree with everything this Alan is saying.  Back then, not so much.  Weird.

And just to clarify, I definitely wasn’t looking to catch trolls.  I was looking to trip up people who “get it” and who are just comparatively new to the bubble-blogging world.  Like I said, was feeling uncharacteristically snarky yesterday.  I was catching up on old Forums posts and awgee and eff must’ve gotten to me. 

Last year, there were so many bulls in denial, some of the rhetoric was necessary to make a point. Now that it is becoming widely accepted that we have witnessed a bubble, and things are going to get worse, it doesn’t serve anyone to be over the top with the commentary.

This does serve to underscore the main point I was trying to make in Houses Should not be a Commodity.

http://www.irvinehousingblog.com/2007/06/25/houses-should-not-be-a-commodity/

People either make huge gains or huge losses depending more upon life’s circumstances and pure luck than anything else. Everyone likes the good times, but it is really a shame for those who have to endure the bad times. A stable real estate market without the highs and lows is far more beneficial to everyone.

there is no difference between investment and speculation, nor is there any crystal ball to know where a market is.

look at the bank stocks back in may - most of them appeared to be solid-yield companies with books that, if not transparent, were as transparent as they had been for the past 4 years. 

so, by the logic of most of the posters here, loading up on C at fifty bucks would have been more of an ‘investment’ than ‘speculation’.

stable markets will never exist with an imaginary currency.

Weren’t bank notes backed by gold subject to more manipulation than today’s currency?

A median OC home last year was somewhere around $675K.

On a 30 year fixed, you’re out somewhere in the neighborhoood of $5000 a month once you figure it all out.

Is there a derth of pepole who bought late (a home they could afford and want to live in for 7+ years)?  If the articles I read in the OCR are any indication, that answer is no.

I was discussing markets with my dad and my brother this weekend.  My dad and brother farm for a living, so they understand markets better than a lot of people.  The discussion came to markets and fundamentals - you can have the fundamentals dead center perfect, and the market may not agree with you at that moment.  At the end of the day, fundamentals are fundamentals for a reason and you can’t fight them.

But you can run bad for a long time in the face of them.  For me, that has been from 2002 till 2006.  Before, it was 1998 and I sold my whole stock portfolio (roughly 20 months too early). 

When the GRM gets to 180 I’m dropping the hammer.  I know I’m going to be a knife catcher.  At 180 times rent, I don’t care.  Since 2004, the GRM in every neighborhood I lived in was never below 400!

Sorry, that should of read 2002-2006 not 2004.

IR,

What have the historical GRMs been from 1985 to 2007? Is there a graph you might have posted that you could refer me to?

Thank you.

PH

Non dividend paying stocks are usually tied to growth companies.

True, by IRs definition this would be speculation, however, the growth of a company can be measured and it is an active process.  Growth companies create and control their own growth via their management.  Dividends are paid indirectly to manage the growth of the company.

Residential RE or other speculative “objects” ( futures, precious metals, etc…) are purely passive.  Value growth is driven by outside forces.

So, I guess you could say that growth companies are more of an investment than a speculation.

*shrug*
Both “investing” and “speculation” are looking for money for nothing.  (Or, in marketspeak, for their “money to work for them”.)  Instead of working for a living, investors and speculators expect others to do the work for them, whether it’s a greater fool, a renter/flunkie, or a CFO with a plan for growth and an agreement to kick some of it back.

For some reason, we as humans are obsessed with the idea that money can just come our way if we’re smart enough or lucky enough.  Mock the “Puritan” work ethic of an honest day’s work for an honest day’s pay, but at least they produced something.  Our “service economy” built on speculative “investment” schemes does not have the fundamentals to keep the music going forever.

“Is there a derth of pepole who bought late (a home they could afford and want to live in for 7+ years)? If the articles I read in the OCR are any indication, that answer is no.”

I would agree that it’s likely the majority of late Irvine purchasers bought homes they could not reasonably afford.  We are strongly influenced by the company we keep, and the few people I know that bought in the last 2-3 years bought homes they could afford.  So my viewpoint is biased by this.

Speculative investment must be good for the economy, what else would explain why it gets preferential tax treatment.

only insofar as their backing by gold was in question.  if they were genuinely backed, and easily redeemable, how would one ‘manipulate’ that?  a better critque of a gold-based system, at least historically, is that the economy would endure inflationary pressures when the supply spiked, as happened in the california, klondike, and south african rushes.  but that wouldn’t apply now - 4/5 of the world’s gold has been mined, unless there’s some jules verne technique to harvest ocean gold cheaply coming down the pike, which is highly unlikely.

um, the political influence of wall street?  much as how ethanol is pushed at the federal level despite being a net wash on energy production due to our warped senate structure?  but, in any case, this isn’t precisely true, short term cap gains are still well above long term.

Seems to me that the difference between speculation and investment is the “reason” the value is expected to increase.  If the value is expected to increase because the company in which you own stock is profitable and growing, that would be an investment—dividend or not.  If the value is expected to increase because you think someone will pay more than you did down the road (i.e., the tech boom), that is speculation.  Because houses (structures) depreciate and land is fixed, it seems that an RE investment is speculation if you don’t meet IR’s cash flow guidelines.

Gambling is always good for the house. 

The argument against gold is that like fiat money, it can not achieve the three goals of a monetary system:

1) stable domestic price level.

2) stable relationship against other currencies.

3) freely convertible into goods and other currencies.

Pre-Bretton Woods, gold did #2 and #3, but was very bad at #1.  There was violent domestic price volatility, periods of deflation and periods of inflation.

In 1933, Roosevelt suspended the ability to convert dollars into gold, and regulations restricted the ability of Americans to hold foreign currency.  Thereafter, Bretton Woods met #1 and #2, but not #3.  Neither incarnation of the gold standard addressed all of our money policy goals.

And while the current system does not achieve all three goals either, it is easier than gold to manage in a way that minimizes the extremes.

Here’s a nice example of speculation gone awry:

http://www.homeseekers.com/Scripts/detail.asp?_org_id=casocal&_uid=5B21F26D-9AFA-4068-86E5-E080FC7F794B&_current=36&mls_property_id=P619702&_per_id=&_vp_cb=

Purchased in 2006 for $1.3M.  Fast-forward a bit less than two years later and they are listed at $949K…  After commissions at that list price, we’re talking about a $400K+ loss.

There is $32K worth of back taxes due on this property so obviously it’s a distressed sale.

Is there a derth of pepole who bought late (a home they could afford and want to live in for 7+ years)? If the articles I read in the OCR are any indication, that answer is no.

I think you mean, the answer is Yes, that there such buyers were scarce (i.e., there was a derth (or dearth), but I’m a little unclear.

Look at it this way.

When you buy into a growth stock, you buy into the company and its management.  You take into account their sales market, their management plan and their track record.  The company does have an intrinsic value but it’s future worth is as much at the hands of their managers as the marketplace.

Hence, with a stock you are buying a “living entity” that is making active “investment” decisions for you.  Instead of paying you, they are” investing” it back into their growth.

OTOH, a house is just a lump of inanimate stuff that sits there.  It’s value is tied to a host of external things over which the house has absolutely no control over. 

Thus, STUFF like a house is always speculation ( or more speculation than an equity ).  Even if you have positive cashflow there is nothing the house is doing to protect itself from future downturns -price wise.  Of course, you could get insurance, but that’s expensive and is reactive, not proactive.

as i mentioned, the relationship between new gold supply and present gold supply due to giant ‘strikes’ made gold a bit volatile.

but what ‘other currencies’ would be considered in a gold-based system?  oil?  silver?

in any case, it is really an issue of semantics.

it also bears noting that the foreign convertibility of gold against dollars meant that there still was a ballast to the greenback until 1972 (when gold was still around 40 bucks/troz).  also, for historical research purposes, the relationsip between silver and gold from 1840-1973 is also interesting.  the inflationary powers of war are certainly evident in the late 19th century.

also, it bears mentioning that the current system is far inferior to almost any other - the broadest measures of money supply in dollars, euros, and pounds have all been consistenly flying upwards at a rate well north of 10% for years.  how can this be sustainable?  how can we not expect serial bubbles in this kind of a climate?

as quixotic as Paul’s quest has been, hopefully it has at least turned a lightbulb on in a few heads - that the immorality of imperialism and the immorality of giving real labor fake money are linked.

but what ‘other currencies’ would be considered in a gold-based system? oil? silver?

Exactly.  Oil.  Silver.  What is it about gold that makes it the only commodity suited to approximate currency?  Gold is a commodity no different from oil or silver, and its price is volatile.  A money fixed to gold will also be volatile.

You point out that most of the known gold reserves have been mined.  If the world’s gold reserves fail to keep pace with the global economy, gold backed money will suffer from deflation.  Another strike against.

You make some good points about the current system, and I agree that Paul’s contribution to the GOP primary has been refreshing, even if he’s destined to be a historical footnote.  I wonder if you think returning to a gold standard is politically feasible?  I think not.

If the cost of owning of a home reaches bottom when the cost of ownership equals the cost of renting, then why would one ever buy a house? That would indicate that over market cycles the cheapest one could ever buy a home would be at a cost equivalent with renting. Assuming the cost of renting is either equal to, or less than the cost of owning at all times, then why shold anyone ever own a home?

ISM, as IR has mentioned before, we are a housing blog, not a bubble blog, right?  :]

with love-

SCHB

If you buy a home at rental equivalent, you do capture the inflation hedge, and if you finance with a fixed-rate amortizing mortgage, you build equity with the forced savings of principal repayment. Other than that, there are the emotional reasons everyone is familiar with. Of course, you can always speculate on the foolishness of our fellow man, and their ability to create another bubble…

no, i don’t advocate return to a gold standard.  a better standard would be something like shares of gsg - that’s the etf based on the gsci, the goldman sachs commodity index.  but the point is moot - bankers will never give up control over money and the ability to magically create ‘wealth’ (and strip value from labor) that this facilitates.  nor will the average citizen ever be smart enough to see past the game of 3-card monte.  this goes doubly so for the average american, whose gullibility and ignorance is exceptional.

but as for gold exceptional properties and unique capacity to serve as money, that’s an easy one - an ounce or two of gold can be hammered into a sheet which covers acres, and the material itself never oxidizes, except in the presence of aqua regia.  it is also the softest metal by far.  this means that it is exceptionally easy to divide it or amass it into an endless variety of units.  a newly minted maple leaft (which is a gorgeous design, btw) could well contain gold from the original ark of the covenant.  it is NEVER comsumed.  silver, of course, oxidizes, and platinum (which is truly scarce and currently enjoying a massive squeeze) is too important industrially.

but thousands of years of history say a bit more than our odd experiment from the past 35 years, and the existence of pages like these show quite well what a pure fiat standard does to an economy.

Great post, thanks for the insightful analysis.
BTW, love today’s musical choice.
Theme song from Beauty and the Geek, one my favorite shows on t.v.

The cost of buying doesn’t bottom out at the cost of renting.  The cost of buying bottoms out below the cost of renting in such a way that renting provides a positive ROI for investors after compensating them for the risk and expenses of managing the property.

That’s why people in the rest of the country buy.  It is cheaper than renting.

You could also say that they are trying to limit their loss to only $400k.  Since this property hasn’t sold, the loss can only go higher.

Owning your own home, it’s the American dream, or maybe American nightmare, not sure which.  People buy when they think they can afford to buy…  I think the Average Joe looks at affordability from a pretty short-term perspective.  Bubble or no bubble, the psychology of the masses will remain unchanged.  Most people simple want to own their own home.

Indeed, very true Alan.  Tustin Field is getting killed worse than Northwood II.  Many houses came online in early to mid 2006, right at the peak, and the area is much less desirable location-wise than Woodbury or Northwood II.  The declines at Tustin Field and some of the early VoC neighborhoods (like Alexandria - Desert Willow profiled here) will be quite spectacular…

Non-dividend-paying stocks purchased for later resale are for speculators, not investors.

Almost no one likes their landlord?  I know, I’ve been one. 
Plus, most rentals are just that - rental grade carpets, easy upkeep landscaping, mass appeal color paint - can you say beige? and rent increases just below what would make you find a better place.

Red- is that you?  We haven’t seen you in the forums for-like-ever?

SCHB