Philip Brewer makes an interesting observation – a correct one – that land is only worth the income that it can produce.
The argument is that if you live in a house, the equity that it produces (by increases in market value) is imaginary, because you have to live somewhere and all land is equally increased in value.
Yet, I still suggest that you should buy a house!
My reasoning is simply insurance: if all else fails, your 401k and the equity in your house can help to fund your retirement … or, earlier, fund your comeback from a failed venture etc. etc.
Again, my reasoning is simple: you can release equity in your house by down-sizing (moving into a smaller, cheaper home), cross-sizing (moving into a cheaper neighborhood), or simply borrowing against your equity (remember the good old HELOC?).
However, the general principle of ‘asset rich, cash poor’ still applies …
My grandmother was an immigrant after the war: from rich beginnings in Europe, she emigrated to Australia with her husband and teenage daughter, virtually penniless.
Yet, she and my grandfather managed to build up a property portfolio worth many millions of dollars.
The problem is that the properties – whilst in prime, downtown areas – gradually became run-down and weren’t bringing in enough income. She became the classic ‘asset rich, cash poor’ person always struggling to pay her tax bills.
My wife’s mother was the same, although in a different financial class: her only asset was her house, her only income her meager pension, yet she refused to sell or refinance the house and lived a virtual pauper.
Ironically, dividing the house into three when she passed on was not really life-changing for any of her three daughters, so it was a financial sacrifice IMHO not worth making … she should have taken a reverse mortgage; even $10k would have made a dramatic difference in her own life, especially since she was too proud to take handouts.
In both cases, Philip’s “house [or asset] rich, cash poor” certainly holds true.
But, it need not be so …
Philip points to times long passed by, where “land was wealth because it produced income–crops, grazing, timber, game, etc. If the land didn’t produce an income, it wouldn’t be considered especially valuable”.
Nowadays, this is simply called ‘rental real-estate’.
If you buy land/real-estate, you no longer need to till the soil yourself to generate an income, you can be the middle man who ‘introduces’ the land to the person (nowadays, usually a business) who is willing to till the land and pay your fee – called ‘rent’.
You still run risks:
1. Related to the land: repairs and maintenance, depreciation, floods, fire, vandalism, and so on, and
2. Related to the business: If the business goes under, you will be left with an empty building.
But, these risks are one step removed from the ‘feast or famine’ risks of land ownership such as for a farmer, that Philip talks about: “it was possible to ruin the income from your land through poor management or bad luck. That was how you found yourself land rich but cash poor.”
These days, as a landlord, you can manage these risks through good selection and management of tenants, provisions (i.e. put aside money for a rainy day to cover vacancies, repairs and maintenance, depreciation, etc.), and insurance (e.g. agains floods, fire, public liability and malicious damage).
If you buy right, add value, manage your real-estate investments well, and allow some time for your investments to ‘mature’ a little (i.e. your loans to be paid down a little, and rents to go up a little) there’s no reason why you can’t be both asset rich and cash rich.
I’m speaking from personal experience 😉
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Okay, investing in rental real estate = good. What about buying a house for you to live in yourself? I believe you are a proponet of this, but would love to see the reasons why and circumstances that make it a good deal.
BTW, this would be a good counter-point to it: http://www.jamesaltucher.com/2011/05/why-i-would-rather-shoot-myself-in-the-head-than-own-a-home/
@ Chris – Philip covered your own home in his article, but didn’t mention rental property, hence this post. However, you are right, I am a proponent of owning your own home DESPITE it’s financial underperformance:
http://7million7years.com/2010/03/22/is-your-home-an-asset/
Hi Adrian
At the risk of creating a note of discord, this is one of the very few times when I disagree with statements made in one of your posts.
“The argument is that if you live in a house, the equity that it produces (by increases in market value) is imaginary, because you have to live somewhere and all land is equally increased in value.”
This is obviously not true – both as a matter of theory and as a matter of historical fact. The divergence between changes in rents and capital values is enough to disporove this assertion. The fact that property price appreciation may diverge from CPI also acts as a rebuttal as does the fact that many buyers will use leverage when they buy.
I also struggle with the statement that “that land is only worth the income that it can produce”. If this was universially true, then the discounted cash flow (as a percentage of current price) would be the same for all properties – it’s not. Also, there are many other asset classes whose value does not depend on the income it produces – why should real estate be different? Factually, people will pay a premium unrelated to cash flow for housing in premium locations – a fact which pretty much debunks the claim made.
Happy to hear contrary views, but it will take a lot of convincing to persuade me that I am wrong.
Cheers
traineeinvestor
@ traineeinvestor – I’m not an economist, but I paid $6 mill. for a house that would rent for less then $100k p.a., so it’s a given that I agree … at least on a micro economic scale. For the purposes of this post, let’s insert the words “all similar land that you are likely to want to live in …”.
My humble 2c worth:
Any asset is only worthwhile if there’s overall growth. Whether that asset be a property with either a high capital growth or high rental return,
or stocks with high growth or high dividend.
Here in Perth, there are plenty of people trying to pedal off small blocks of sand in the outer suburbs for half a million dollars in an over-inflated (and falling) market, with a rental return no higher than the rate of inflation. Fewer new-home buyers are feeding the “bottom of the pyramid”, so the top won’t keep growing higher. And property is a low-liquidity item. If you make a mistake you’re often locked in for a long period of time.
On the flip-side of the coin, there’s also a very good argument to be made for being cash rich and asset poor. Mark Cuban (billionaire – owner of the Dallas Mavericks) is a big proponent of this. He keeps a very high portion of his asset base as cash. This seems counter-intuitive, so why does he do it? Historically on average there is a major crash (whether in stocks, property, or even currency) every 5 years or so. If your money is already wrapped up, then at worst you’re exposed, and at best you can’t capitalize. Only those with cash in hand can capitalize on the best bargains. He believes the rate of return is far better than those “asset rich and cash poor” people who were in the market all along.
He also runs his businesses with a lot of cash on hand and he has the luxury of buying in bulk – which in the long run means cheaper costs. When there is a market down-turn is the cheapest time to make acquisitions, and it’s also the best time to hire and grow the company (as the most talented people are in the job market).
@ Nathan – I think our US readers will recognize Perth’s “blocks of sand” as the pre-crash rush on desert homes on the outskirts of Vegas and in Arizona => they know EXACTLY where this is all heading 🙁
Like Mark Cuban, Suze Orman keeps the bulk of her holdings in cash. Just one question: how did they accumulate the cash … ?
@Adrian – Agreed. It confuses me how the real-estate institutes over here still advocate that you cannot lose money on property in Australia – even though the pattern is the same. That somehow down here we’re different, perhaps because we have kangaroos?
To begin any sort of investment you need cash (or perhaps equity); for example a deposit for a home. The question is whether it’s best to ‘get in now’ and purchase that home (which may / may not be a good investment), or whether you’d be better off hanging on to that money waiting until you can find a very good bargain – which will likely over-perform your home.
I think in terms of investments, land might be only worth the income that it produces.
However, land can have other value, which is more difficult to measure. I grew up on 80 hectares of untouched (except for about half a hectare which was used for our homestead) natural African bushveld. It never produced a cent of income. But it provided a quality of life which is pretty much unparalleled by multi-million dollar homes in the city. And in terms of the contribution of that upbringing to my own emotional wellness and internal wealth, it is priceless.
@ Ashton – I think that’s traineeinvestor’s point, as well: $7million of Life Value in 7 years 😉
If you’re interested in doing the work of being a landlord, then buying some rental property is a great idea: you can probably earn a excellent return on your capital and on your labor.
On the other hand, if you (like me) think that being a landlord is dreadfully unappealing, then buying rental real estate is a mediocre idea. You can hire someone to manage your rental property for you, but they’ll end up with most of the outsized returns—you’ll just an ordinary return on your capital, about the same as you might get on a stock or bond. (It might still make sense—it is a kind of diversification—but it’s not a slam dunk.)
Buying property to serve as your residence is a different story altogether. What matters in that case is whether you can afford the place, and whether you want to live there. If you do, then it’s a fine idea. (Whether it’s a good investment or not is a different question—that depends mainly on whether you get the property at a good price.)
“if you (like me) think that being a landlord is dreadfully unappealing”
@ Philip – LOL. V Nicely put. I’ll take you off the Boy-Do-I-Have-Some-Swampland-To-Sell-You mailing list then, shall I? 😉