It’s nice when the relevance of one’s blog posts is affirmed by, if not by actual events, at least by other writers’ works. This week, the indispensable Ronald Bailey reviews Future Babble, a book that, in Bailey’s words, “explains why dart-throwing monkeys are better at predicting the future than most pundits”. And pundits have an easier job than stock analysts: no one is going around trying to make pundits wrong, whereas if an analysts says that a stock price will go up tomorrow, and people believe him, they will rush to buy the stock today and tomorrow, the stock will down.
Then there’s the XKCD cartoon above that demonstrates why the Efficient Market Hypothesis doesn’t work quite so well for real estate.
In my last post, I asked what you should pay for an asset you’re considering buying. Now I would like to ask, what is an asset worth to its owner? Formally, any asset is worth the risk-adjusted net-present value of its benefits to the owner. A long phrase, but let’s take it apart.
”Risk-adjusted” means taking into account not only the value of some benefit, but that chances of actually receiving that benefit. Think about the ultimate in risk, a lottery ticket. The odds of a Pick-7 lotto ticket hitting are 62,891,499; right now, the California SuperLotto has a payoff of $13.5 million, making one ticket worth 13.5 / 62.9 dollars, or about 21¢. That’s pre-tax; after taxes, it’s worth maybe half that. (Why do people pay a dollar for a ticket with a risk-adjusted value of barely a dime? Three reasons: 1. entertainment value, 2. people are stupid, and 3. an interesting phenomenon called “the nonlinearity of value” that I’ll talk about in a future post).
Every investment has some degree of risk. If you keep cash, you run the risk the government will inflate away the value of that cash. Even if you buy gold, somebody might very well steal your gold. There’s always risk.
Real-estate agents used to chirp, “They’re not making any more land!” implying that real estate was risk-free or nearly so. I notice they don’t say that so much since the big real-estate bust. There’s always risk.
“Net present value” A terrible poet named Delmore Schwartz wrote, “Time is the fire in which we burn.” Terrible but wholly correct in this case. Receiving a dollar a year from now, even if it’s absolutely guaranteed, is only worth 95¢ or less received today. In 1626 Peter Minuit bought Manhattan island from the local Indians for a pile of trade goods worth 18 ounces of silver — about $700 at today’s silver prices. A deal? If he’d put that money in the bank at 5%, he’d have $98 billion dollars now; more than enough to buy all the land in today’s Manhattan.
And finally, “benefit to the owner”. As mentioned above, one of the benefits to the owner of a lottery ticket is entertainment: for some period of time, you get to fantasize about what it would be like to win $13 million. Most stocks aren’t nearly so entertaining. They typically allow you to vote on the company’s board of directors, but to simplify things, let’s assume you aren’t Warren Buffett (if you are Warren Buffett, let me just say, “Hi, Warren!”) and so don’t care to vote — and to further simplify things, let’s only talk about stocks that don’t pay dividends. If you own such a stock, the only benefit you receive is the right to resell the stock back into the same market you bought it from.
Which helps the stock market remain efficient. Even assuming you could discover that the stock market had some irrational bias for or against some particular company or type of company (despite some fundamental weakness or strength in the business of that company), it wouldn’t help you, so long as that bias is reasonably stable.
Suppose you had a theory that the stock market undervalued companies with female CEOs. Suppose you knew it for a fact. How could you exploit that? You could buy stock in Avon Products (CEO, Andrea Jung), but it wouldn’t help you, since the bias that kept the price down when you bought the stock would still be keeping the price when you went to sell it.
Consider the other end of the spectrum though, things that you entirely consume yourself, things like food and clothing. You’re never going to resell them, any private theories about how much they are worth to you are more-or-less automatically correct. If you think uncooked pinto beans taste better than filet mignon, you’re right! To you. Bon appetit.
Which brings me, finally, to my actual topic, of this post, of the previous post, and of several posts yet to come: real estate.
Real estate, in particular, real estate used as the owner’s residence, are midway between consumables on one side, where the only benefits are the benefits gained by consuming the asset and non-dividend-paying stock on the other, which is only worth what it can be sold for. A house is yours. You can, if you want, drill holes in it until it collapses in a heap of rubble — but you have very powerful economic incentives not to.
Choosing a house to buy therefore becomes an interesting compromise: you want to buy a house that you like (so you get all the benefits of “consuming” it by residing in it), that other people don’t like today (so you can buy it at a good price), but that other people will like in future (so you can sell it at a good price).
The easy — or at least obvious — way to do this is to buy a house with defects you can correct, but that would scare off buyers less hardy than you. Remember that the real-estate market is much less liquid than the stock market and buyers and sellers typically much less sophisticated.
Real-estate agents are famous for spending effort and money to gussy up houses for sale — renting designer furniture, putting out fresh-cut flowers, even baking cookies in the kitchen to create the homey smell. The flip side of that is when an agent doesn’t make those little touches, there will be less competition and a lower price.
I went to one open house a few weeks back where the owner was still residing. He had declined to “stage” his unit (have it repainted and refurnished for the open house) and only cleaned it sketchily. The place smelled of sweat and old food. The building was a duplex and there was a tenant renting the other unit; the tenant refused to allow his area to be shown except by appointment, so only about 2/3 of the building was even viewable. To top it off, the owner had a small collection of Nazi memorabilia on display in the front parlor!
The average buyer would, I think, be somewhat dismayed by this state of affairs — which is exactly why you, the savvy home-buyer, should be attracted to it. You aren’t going to be competing with all those average buyers. The ultimate selling price will naturally be lower than the better-prepped house across the street. When you do buy it, the owner will move out, taking his shabby furniture, his worn throw rugs, and his swastikas with him. You can replace the worn carpet and the fetid toilet, evict the sullen tenant, buy good cabinetry, and resell the house at a tax-free profit.
And let’s revisit that last bit too. If you buy stock in Google or Avon, and the stock gives you a $100 profit, you owe Uncle Sam at least $20 and your state will probably want a cut too. If you buy a house and live in it, and while you’re living in it, it appreciates $100,000, in most case, that money is yours, tax free. And if you borrow money to buy the house or to improve it, the interest on the loan is tax deductible. Obviously, you want to check with your tax adviser, but we are talking about a serious advantage.
Actually, the Nazi-aficionado’s house was priced above market. Even better. It had been on sale for months (and I noticed, still available today), turning off buyers, discouraging agents, generally making the final price lower and lower. Whoever eventually buys that house — braving the funky atmosphere, the recalcitrant renter, the unrealistic owner, the discouraged agent, the alarming decorations — whoever finally gets that place will get a bargain.