The Current Period Statement Of Cash Flows Includes The Following An Unconventional Way to View the Property Market

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An Unconventional Way to View the Property Market

I’m going to discuss an interesting way of looking at real estate investing that might be a bit unconventional to most real estate investors.

A while ago I watched a video of Charlie Munger who is known as Warren Buffet’s business partner and his famous quote “Tell me where I’m going to die and I’ll make sure I don’t go there. “

In this video, Charlie, who was 83 years old at the time, shared his wisdom on becoming a billionaire with a group of graduates about to start their careers.

There is one particular statement that really interests me; said, “You have no right to an opinion unless you can make arguments against your opinion better than your opponents can.”

I find this statement quite profound but very difficult to apply in real life, so I thought I’d run it through some of the opinions that are widely held in the real estate investment field and see how it goes.

Before I get entitled to an opinion about “how helpful Charlie’s statement is,” a counterargument of “how useless it is” might go something like this:

  • We are all entitled to our own opinion about anything, whether it’s right or wrong, it doesn’t matter what other people say.
  • Sometimes an opinion can be completely wrong, but still applicable in life. “The earth is flat and still” is a good example of this, completely wrong but doable! Wouldn’t it be more practical to think that you are walking on a still and flat surface than on a spinning ball?

So for the rest of the article, let me focus on how useful I think Charlie’s statement can be to help us as real estate investors.

What I did was go back and look at some of the principles of real estate investing that we’ve taken for granted without examining the arguments to the contrary, then see if we can learn anything from it, and more importantly see if we can uncover investment opportunities that most people miss out because they don’t see the other side of the story.

I have found that the most common opinion about real estate investing is: Land is increasing in value due to limited supply, so buy real estate where land supply is limited!

If you look at property performance in Australia since 1996, all quality built suburbs share this land scarcity factor, they all perform very well on this principle. For example, while construction costs are rising 3-4% per year following the CPI, land values ​​have increased by as much as 12-14% per year, which is an average of 10% growth for a property over the past 15 years.

It is very easy not to question the opposite side of this opinion when the facts overwhelmingly support this argument.

What if we follow Charlie’s suggestion, the counterargument might go something like: “Land is falling in value due to limited supply, don’t buy properties where there is limited supply.”

I have to say when I first wrote this down, I thought this must be considered crazy by anyone with any sense in the investment industry, it just goes against everything we’ve been told about real estate investing.

The only reason I didn’t stop there was Charlie, he didn’t become a billionaire because he was stupid, he has to see enormous value in this exercise in counterarguments to spot investment opportunities that most people miss. So I ‘forced’ myself to see under what circumstances this counter-argument might make sense.

Interestingly, it didn’t take me too long to see that this counter-argument not only had value, but could also help us spot investment opportunities that most seasoned real estate investors are missing in today’s market.

Let me explain.

It is obvious that land appreciation has been the main driver of real estate price growth over the past 15 years. But property prices are ultimately limited by the income people have to qualify for a mortgage, which is even more the case in today’s loan market where freeing up equity without income support has become increasingly difficult.

So you can almost say that in the long run we should see something like:

Income growth = real estate price growth (which can be broken down into land and building price growth)

So if income growth is 3% and construction cost growth is 3%, then land price growth should also be 3% for this formula to work in the long run. For example

Income growth (3%) = Real estate price growth (3%) [Land Price Growth (3%) & Building Cost Growth (3%)]

However, in the last 15 years, our income growth has been accompanied by construction cost growth, which is around CPI (3-4%), but land price growth has been 12-14% per year. So you have something like:

Income growth (3%) < Real estate price growth (10%) [Land Price Growth (12%) & Building Cost Growth (3%)]

You can see that land price growth is much faster than income growth. When investors are looking for a place to buy, they have been buying in areas where land price growth has been 12%+ per year, usually in established suburbs where land supply is very limited. And they have succeeded in this in the last 15 years (from 1996 to the present).

The question is “how long can the gap between income growth and land price growth last without land price growth having to slow down?”

Graphs of Melbourne’s median house price between 1978 and 2009 show that house prices grew much faster than incomes for a long period up to 1990 (reflected by the mortgage repayments on the average house taking up an outsized percentage of average incomes), House price growth then stopped for about 5 years to wait for revenue growth to catch up.

These charts show that a similar phenomenon is looming if you turn your attention to 2009.

So I can see the counterargument “Land is falling in value due to limited supply, don’t buy real estate where land supply is limited” it makes sense when the land scarcity factor has been oversold for too long to the point that land values ​​have been seriously overestimated. In other words, lack of land can be the main reason why investors can make good money, but it can also become the main reason why investors can make less or even lose money.

Before we all rush out of traditional high-growth areas, we all know that there is a shortage of real estate supply compared to demand, so real estate prices are likely to continue to rise for some time. Traditional strong growth areas did not become high growth areas without reason.

After a period of flat performance (like 1990-1996), it will always recover and pick up growth, so I personally think there will always be good areas to hold your properties for the long term.

The question is where should you invest your money to work intelligently over the next 5-7 years to get the best returns with the least risk?

At the moment, if you buy an old house in a traditionally strong growth area within 20km of the CBD in most major cities, expect to pay $700,000+ with a gross rent of 2.5-4%. Some of these properties were only worth $200,000 to $300,000 less than 10 years ago.

Unlike these areas, you can still find property prices of around $350,000 to $400,000 within 20km of the CBD, whether it’s houses in some transitional areas (areas being converted to residential) or lower priced apartments in more in established areas, gross rent can still be around 4.5-6%, with the IRS helping cash flow for the first 5 years if the property is relatively new.

Let’s look at an example.

Let’s say you have the capacity to buy investment properties worth up to $800k, your salary is $100k a year and you can borrow 100% plus note and fees at 7.5% interest because you have equity from other properties.

Let’s compare the following two possible options using data from Melbourne as an example:

Option 1:

  • If you buy 2 $400k properties, two brand new houses, a $200k building and a $200k land, in a transitional suburb 17km from Melbourne CBD.
  • Realizable gross rent is currently 4.6%, we can assume the potential growth over the next 5 years is 9.4% pa (Melbourne average for the last few decades) due to the relatively lower price compared to the Melbourne median house price of $550k and its distance from the CBD.
  • So 5 years later, each of these properties will be worth about $627k.

Option 2:

  • If you buy 1 x $800k property, 25 year old house, $200k building and $600k land, in a well known and traditionally high growth suburb, also 17km from Melbourne CBD.
  • Realizable gross rent is currently 3.5%, we can assume a slightly lower growth of 6.5% in the next 8 years due to relatively inflated land values ​​after 15 years of excellent performance.
  • So, 5 years later, this property will be worth about $1.1 million. (Note that a $1.1 million house in the same neighborhood at 7.5% interest will attract an annual mortgage payment of $83,000, which comes from the family’s after-tax net income.)

So let’s look at the following charts to compare the cash flow of the above two options.

Option 1 (2 x 400 thousand USD):$75 per week or $4K per year out of pocket the first year. A total of $19,000 out of pocket for the first 5 years. (see table below)

Now – property value $400,000

First year – property value $437,600, weekly holding cost $75

Year 2 – Property Value $478,734, Weekly Holding Cost $97

Year 3 – Property Value $523,735, Weekly Holding Cost $82

Year 4 – Property Value $572,967, Weekly Holding Cost $65

Year 5 – Property Value $626,825, Weekly Holding Cost $45

Option 2 (1 x 800 thousand USD):$489 per week or $25K per year out of pocket the first year. A total of $113,000 out of pocket for the first 5 years. (see table below)

Now – property value $800,000

First year – property value $852,000, weekly holding cost $489

Year 2 – Property Value $907,380, Weekly Holding Cost $465

Year 3 – Property Value $966,360, Weekly Holding Cost $436

Year 4 – property value $1.029 million, weekly holding cost $405

Year 5 – property value $1.096 million, weekly holding cost $375

Let’s compare the total money earned over a period of 5 years simply using: capital gain + cash flow.

  • Option 1 (2 x 400 thousand USD):Capital gain ($627kx 2 -$400kx 2) + cash flow (-$19kx 2) = $416k.
  • Option 2 (1 x 800 thousand USD): Capital Gain ($1.1M – $800K) + Cash Flow (-$113K) = $187K.

On top of that, the difference in fees was: $43k – $7k x 2 = $29k.

So option 1 is better than option 2 by: $416k + $29k – $187k = $258k. This does not include the following two main factors in favor of option 1:

  • Easier finances:it is much easier to get 95% financing on a $400k property, and nearly impossible or too expensive to do the same on an $800k property. In other words, option 1 requires less money from you!
  • Less risk:The risk of a $400K property losing $100K in value is much less than an $800K property in the current hot market. In other words, option 1 is a lower risk for your money.

Before I rush to claim that “Option 1 is better than Option 2”, I need to see under what circumstances Option 2 will be better than Option 1, if I am to follow Charlie’s teaching “You have no right to an opinion unless you can make arguments against your opinion better than your opponents can.”

So the argument for buying a more expensive older house in an established suburb for investment purposes in the current market conditions is that good suburbs will always be in high demand and rich people get richer faster. One can never underestimate the long-term potential of these high-growth suburbs, even as they may experience a temporary slowdown resulting from a long period of strong growth. These suburbs may ‘lose the battle’ over the next 5-7 years against the upcoming transition suburbs, but they still have what it takes to ‘win the war’ over a much longer time frame.

Can you see the power of applying Charlie’s teachings to just one of the principles of real estate investing? The benefit can be enormous when we apply this to other areas of our lives, such as relationships, work, values, moral standards and spiritual beliefs, it can teach us to avoid extreme ideology and be more accepting of people who are different from us.

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