The Power of Belief

 

The problem with markets is that they are composed of people, sometimes millions of them, and those people can be both unpredictable and irrational in their behavior.  Anyone who can predict what people will want to buy, when they will want to buy it, and at what price, stands to make a lot of money.  The reverse can also be true.  Large groups of people tend to adopt herd behavior, and the herd can be easily spooked into a full scale stampede, sometimes over the edge of a cliff. History is replete with countless examples of bizarre group behavior and the madness of crowds.   In financial matters, bubbles are created in one asset class or another because of certain beliefs that spread like a virile contagion, and the seed of that contagion is almost always that someone can get rich quickly and with little effort or risk.  Emotions will usually trump reason, and humans will suspend disbelief; they will suspend their critical judgment.  When even minor circumstances turn negative, however, the masses will panic and rush to the exits and the resulting market crashes can reverberate around the world.
 Most recently this happened with the bubble in real estate.  In certain geographical parts of the country, such as California, Florida, Phoenix, or Las Vegas, the demand for real estate outstripped the supply and the price of housing was bid up to unrealistic and unsustainable levels.  Everyone knew, of course, that real estate values can not go up indefinitely, and everyone knew that what went up could, and would, eventually come down.  But like the gambler at the gaming tables in the middle of a winning streak, they believed they still had time to cash in.  As housing prices skyrocketed, the affordability rate plummeted, and homes were increasingly purchased with scary financial products that came to be known as Liar’s Loans.  In high demand areas, the buyers, who often called themselves “investors”, had no intention of living in their acquisitions; they bought them to resell quickly, making an instant profit of thousands of dollars.  Sometimes the buyer fixed the properties up and sold them again, at another substantial profit.  Eventually someone had to stay on title, and to these End-Buyers these rental properties were touted as cash-flowing “investments”.  You heard the words “rich” and “empire” frequently.    In saner parts of the country, such as where I live in Greenville, SC, where property prices pretty much remained stable, and there was no real bubble, “investment properties” were hawked almost exclusively based on their ability to cash flow, meaning after all the expenses of ownership were deducted from the rental income, there was something left over on the table each month.  Over two or three years, I quite literally saw thousands of these offerings on local websites.  The magic numbers for cash flowing properties seemed to be to purchase them at 65-70% of After-Repaired-Value (ARV).  When I did the math, however, I couldn’t come up with the positive cash flow.  I started to wonder what these “investors” knew that I didn’t know.  In most cases, the answer was Nothing.  It was the triumph of hope over reason.  Euphoria prevailed.  It seemed everyone was an investor, and those few who weren’t, were making the big bucks off of “educational materials.”  One guru went on record that ‘if anyone had paid income taxes the previous year, the only plausible reason could be that they didn’t own enough real estate.’Ordinarily, property has to be bought very, very cheaply in order to have immediately positive cash flow.  Today,  in June 2009, I am hearing that properties in California are selling at 30-40 cents on the dollar and are being resold as cash-flowing properties.  My point being that for all of these past go-go years, properties selling at 70% ARV were extremely difficult to make cash flow.  The only way they could is if the buyer would make a 20% or larger down payment, and the sun, moon, Venus, and Mars were all perfectly aligned, and you didn’t step on a crack in the sidewalk.  In other words, nothing could go wrong or your profit margin would evaporate.

Was any wealth being created or accumulated during the bubble years?  In some cases yes, in most cases no.  When someone did turn a property quickly and at a substantial profit, that only became wealth if they reinvested their profit into a different, and undervalued, asset class.  Those with the cash reserves and business acumen to manage their rental properties effectively now have tangible assets to show for those years.  The rest have most likely already spent the quick cash they made flipping properties.

When we play the board game Cash Flow every month here in Greenville, it always draws a belly laugh when someone draws a Small Deal card offering them the opportunity to purchase a stock at the top of its trading range.  What idiot would buy such an overpriced asset?  A human one.  In most cases, we are much more likely to make a bad decision in the company of a crowd than a good one alone.  Where have all the investors gone?  Why, property prices have fallen precipitously in the last year!  Who would want to buy at such a time?  Where did the herd, go, anyway, does anyone know?

In saner parts of the country, such as where I live in Greenville, SC, where property prices pretty much remained stable, and there was no real bubble, “investment properties” were hawked almost exclusively based on their ability to cash flow, meaning after all the expenses of ownership were deducted from the rental income, there was something left over on the table each month.  Over two or three years, I quite literally saw thousands of these offerings on local websites.  The magic numbers for cash flowing properties seemed to be to purchase them at 65-70% of After-Repaired-Value (ARV).  When I did the math, however, I couldn’t come up with the positive cash flow.  I started to wonder what these “investors” knew that I didn’t know.  In most cases, the answer was Nothing.  It was the triumph of hope over reason.  Euphoria prevailed.  It seemed everyone was an investor, and those few who weren’t, were making the big bucks off of “educational materials.”  One guru went on record that ‘if anyone had paid income taxes the previous year, the only plausible reason could be that they didn’t own enough real estate.’

Thanks for reading.  John Bechtel, Greenville, SC

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