Back in How do we prepare for a possible economic crisis?, one of our readers asked,
A lot of us, simply do not have free floating (saved) money to worry about. What we have, instead, are huge debts that are closely tied to the so-called, and as yet unrealised, ?equity? we are supposed to have in the assets that we borrowed against.
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But for the rest, all I see is a sea of debt with an island in the hazy distance that is supposed to be my ?equity? in assets held hostage by banks as security. So, to simplify it to the bare bones, the first question for many is, not whether one should buy gold or silver, but whether one should liquidate assets in which one supposedly has some equity.
Now, armed with a new understanding of value-investing and what assets truly are (see Value investing for dummies), you may see this problem in a different light. Let’s suppose you bought a property with a market price of $900,000 and an outstanding debt of $600,000 to go with it, leaving you with an ‘equity’ of $300,000.
Your mortgage debt is an asset to the bank because you are ‘selling’ yourself to it by committing part of your future earnings as money to be put into the bank’s pocket. Let’s suppose your mortgage rate is 10%. At that rate, you will be paying $63,185.16 per year to the bank for the next 30 years. Now, let’s calculate the value of you as an asset. Using a discount rate of 10%, the value of $63,185.16 of cash flow per year for 30 years is $595,641.10. This figure is the present value of your debt to the bank.
Now, look at your property as an income-producing asset. Let’s suppose you can rent it out forever and ever at $600 per week ($31,200 per year) initially. Let’s assume thatt income from that asset can grow at an annual rate of 5% forever and ever (i.e. property income more than keep up with the RBA’s upper band of inflation targeting). Again, we apply the same discount rate of 9% (i.e. your employment income is higher risk than the income derived from your asset). Guess what the intrinsic value of your asset is? In this case, given such generous assumption, it works out to only $780,000!
Now, let’s suppose that instead of borrowing to buy a property, you borrow $600,000, plus your $300,000 equity, buy $900,000 worth of risk-free government bond at a rate of return of 6.50%. For this risk-free investment, you will receive $58,500 of yearly income which you re-invest into the government bond immediately. By definition, the value of that $58,500 of yearly re-invested income is $900,000.
In other words, it is simply not rational to invest in property because you are better off putting that money in risk-free government bonds (or better still, term deposits that currently pays as high as 8%). Some ‘investors’ may use the prospect of capital appreciations as a reason for ‘investing’ in property. But this will only work if there is the next fool willing to pay over-inflated and irrational price for your property. As we said before in Difference between ?assets? and real assets,
That is why there are property speculators ?investing? in houses that are far overvalued and getting caught out in a property price bubble when the business cycle turns. In essence, the property price bubble is a Ponzi scheme that collapses when the economy runs out of money through a credit contraction brought about by the credit crisis or rising interest rates.
Once credit deflation sets in the economy, the economy starts to run out of fools. Many ‘investors’ turn out to be the last fool. In times of deflation, many people will find that the ‘value’ (market price) of their property turns out to be illusionary. You may want to read our other article, Aussie household debt not as bad as it seems? for more details on that.
The lesson here is this: if you purchase the property below its intrinsic present value, you need not worry about its market price.
