December 1994
Vol 18 No 4
A couple of years ago I took a trip around the world just to see for myself what the changes the end of the cold war had made. Since my first trip abroad, courtesy of the U.S. Airforce, at the tender age of 19, I've been fascinated with the differences between Americans and citizens of other countries. Someone once said that Americans tend to judge other people more by the sophistication of their plumbing and the food they eat than by any other criteria. That may be truer than you think, but setting aside those differences together with cultural differences and language, most people share many of the same aspirations and values that Americans do. Of course there are differences too.
Let's start with similarities. Regardless where you go, it seems that WHO you know has more to do with eventual success than WHAT you know. Because most people know their families better than others, a high degree of family loyalty and cooperation is evident everywhere. This is accompanied by a healthy degree of distrust where government is concerned, regardless of the particular form it takes. In the 7 years I spent living abroad under democracy, monarchy, socialism, common law, civil law and constitutional law, at the level of the man on the street, there seemed to be few differences among people, and many similarities.
As a landlord in Japan, I found Japanese bureaucrats to be about as obnoxious as our own when it came to obtaining necessary permits. As a Tenant in Italy, I signed a lease just as I might sign here in the USA. When I built a house, I had to search title just as I might have to do here. When I did my banking, procedures for opening an account, the checks and deposit slips seemed identical to those used in American banks. People in foreign countries have savings deposited in banks just as we do. They obtain credit for loans, barter services, trade properties, speculate and invest just as we do. Major differences lie in the availability of long term, low interest rate financing; tenant rights, taxation,
Today, as the banks close in one time zone, great waves of credit measuring in the $billions sweep into the next zone, and the next; proceeding around the world from London to New York to Los Angeles to Tokyo to Hong Kong to Singapore to Delhi to Riyadh to Frankfurt and back to London. In order to do business internationally, it is necessary to be able to tap into the capital and credit markets everywhere, thus international banks, working together, are in position to control much more than divided government leaders who constantly bicker among themselves, threatening both trade and military wars.
What's all this got to do with real estate investing? Everything! The credit markets drive the real estate market and prices. Easy, low interest credit translates to thriving construction and real estate sales activity. Understanding how credit is influenced by international currency fluctuations, trade imbalances, interest rates can we make any predictions as to how the real estate markets will perform. This can completely reverse the feasibility of a project.
LOOK BOTH WAYS BEFORE YOU CROSS THE STREET!
The saying goes on to say, 'Use your ears, use your eyes, then use your feet.' As a youngster, always in a hurry, I was runover three times by cars until I learned that lesson. It has happened to me a few times as an investor as well. Anytime you make an investment decision, it should be to achieve a specific result. This might be after-tax net income or capital gain. Both will be affected by the cost of money world wide. Here's why.
The money you borrow from most lenders will be funds that they in turn have borrowed from someone else. A small percentage of a bank loan will be from zero interest rate checking account deposits. Almost all additional money will come indirectly from long term savings accounts, C.D.s, Bonds; or the secondary financial markets which include GNMA, FNMA, Freddie Mac, etc., or other mortgage-backed securities. All of these sources are supported either by government or by investors. Each of these has the choice of investing in a way that ultimately – directly or indirectly – funds the mortgage markets, or of investing in an alternative investment that would provide a more attractive yield with commensurate safety and convenience.
WORLD FINANCIAL MARKETS CONTROL YOUR REAL ESTATE YIELDS
World credit and financial markets influence the results of almost every decision you make. Every morning, I tune in to the financial markets to see what's happening. So do millions of people all over the world. Thanks to Ted Turner, you can pick up CNN virtually everywhere on the earth's surface. Investors everywhere are scanning the financial news to try to anticipate events which would offer better opportunities to increase investment yields. South African Eskom Bonds are yielding 20%, but with political risk. The Yen is rising against the dollar. Even at low interest rates, these funds can realize high yields because of the currency swings. In 1993, stock mutual funds specializing in the Pacific Rim, South America and Turkey saw yields that exceeded 100%. In 1994, many Gold Shares experienced a 40% increase. Meanwhile, 30 year fixed mortgage interest rates started to climb from a low of about 7.25% to 8.5%.
If it were simply a matter of the highest yield, there wouldn't be any mortgage money available. But, the quality of the collateral and long term yields are attractive to investors who are able to sleep better with a safe, long term investment so long as inflation isn't allowed to wipe out these yields. Still, mortgage credit must compete with the corporate and government borrowers, who willingly bid up yields to get the money they need for their operations. So long as the dollar is firm, both Americans and foreign capitalists will invest funds to be loaned in America.
When the dollar starts to drop on world markets, these funds are diverted to more stable currencies. Then, the U.S. Treasury has to raise the interest rate yields it will pay to lenders to offset the drop in currency. This, in turn, forces all competing borrowers to raise their rates. Ultimately, real estate interest rates will rise, the market will contract, sales and construction will slow down, and prices will start to fall off. There's a long term way to predict all of this activity, and a short term way.
LONG TERM, STABLE AFTER TAX PURCHASING POWER OF INVESTMENT CONTROLS RATES
Let's say that you've got $10,000 to invest. You can buy a seasoned discounted mortgage Note which will yield 11%. You can buy a 30 year T-Bond which will yield 7.5% or so. You might put your cash into an money market fund with checking or debgit card privileges that pays 3%. You can buy a 90 day T-Bill that will yield 4.25%. You can buy or finance a mobile home to rent out, and with a little work, realize 30% on your investment. You can pay off existing mortgage liens on a property to make it free and clear. You can invest in a domestic stock mutual fund and expect about 8% total return without currency risk, or you can invest in an off-shore stock mutual fund that will earn about 18% with some currency risk. What factors might influence your decision?
LIQUIDITY: Which of the above could you liquidate quickly with little discounting or loss of principal in the event you needed the money for personal reasons? The money market fund, stock market mutual funds, both foreign and domestic. A foreign stock market mutual fund denominated in a foreign currency would be helped or hindered by the current daily exchange rate, and this in turn, is based upon the world market value of the dollar. The 90 day T-Bill would require no more than 90 days, and might be liquidated sooner with a small penalty. The 30 years T-Bond could also be liquidated fairly quickly, but its discount would be based upon the current 30 year bond rate. The liquidation value of the bond could be at a premium if interest rates were below 7.5% or at a discount if they were higher.
Liquidty of the free and clear house would be 99% dependent upon the availability of mortgage money and it's cost, which would relate to the current yield on 30 year bonds, but that would only be half the story. You'd have to either find a lender who'd make you a loan or find a buyer who'd get the loan and buy the house from you. This could take a long time, depending upon the market factors and the property. The mobile home might be slightly more liquid, but the retail cash sale market for used mobile homes is pretty thin. It could take a long time to sell unless you discounted it heavily.
SAFETY: Which of the above would make the safest investment? Let's ignore physical risks to safety such as fire, theft, earthquakes, hurricanes, tornadoes, floods, etc. and concentrate on investment risk. The bankruptcy laws make a mockery of every form of contract, so physical possession of a tangible asset would seem to rank higher than promises of payment when it comes to investment security. Leading this category might be the free and clear house closely followed by the mobile home. Next, I'll put the U.S. and any stable foreign government obligations which might include the money market funds as well as the T-Bills and T-Bonds. Following this would be the mortgage note.
Over the past 6 or 7 years, I've had almost 20 creditors file bankruptcy to avoid keeping their promises to pay off loans they'd made from me. In his book, 'Bankruptcy 95', Harry Figge premises that the U.S. Government will be forced renege on its debt at the current rate of compounding deficits, or as soon as people refuse to buy government debt instruments as investments. This wouldn't bode well for investments in government money market funds, T-Bills or T-Bonds. Figge can see only one other scenario. In it, government merely has the Federal Reserve issue credits to banks against which the treasury can print money, creating hyper inflation. In such an case, all financial investments would be wiped out for pennies on the dollar. This would include the stock, bond, mortgage and currency markets. Only tangible assets such as the house and mobile home and investments denominated in stable foreign currencies would be able to survive. Credit and liquidity would disappear for the vast majority of the population.
TOTAL INVESTMENT YIELD: We've pretty much considered yield when we listed the above investment alternatives. But, in general, there are several aspects of yield we should keep in the forefront when comparing investments. When considering yield, one must measure it in terms of purchasing power after taxes. Let's look at the return on $100,000. Invested in tax free government bonds, we'd achieve a pretty good mixture of liquidity, safety and yield after taxes. This might be an acceptable alternative for someone looking in the 39.6% income tax bracket looking for a passive investment. For a more active person, tax sheltered real estate investment has demonstrated attractive yields over the long run, and it's less susceptible inflation. Anyone who is engaged in the business of buying and selling has a built in edge when he can adopt methods to accommodate new technology and products. Investment in these types of corporate stocks offers little in the way of tax shelter, but much higher potential for capital gains and income.
SO MUCH FOR THE PROBLEMS, WHAT ARE THE SOLUTIONS?
Let's say that our investment objective might be to maintain liquidity, safety and security, and after-tax profit margins. It seems that there are different risks and rewards with almost every type of investment decision we might make. Because no one can accurately foretell movements in financial markets, political upheaval, sudden changes in demographics as has been seen in south Florida over the past two years, and currency exchange rate volatility which can so seriously disrupt the best laid plans of mice and men, we're left with that magic word: DIVERSIFICATION as our best strategy.
When we speak of diversification, what do we mean? Suppose two spouses each held one half of a family's estate comprised of $100,000 each. Let's chop each $100,000 bill up into 10 parts without regard to any particular weighting. Think of these parts as spokes in a wheel, all of which support the hub and the rim. First, let's paint a 50% sector of the wheel green to represent foreign investments and the other half white to represent domestic investments. Let's further identify each half's 5 spokes in terms of the type of investment they represent. #1 spoke in each half would represent real estate rental income investments, either in physical form or in the form of shares in a Real Estate Investment Trust. #2 spoke would be for Cash or near-cash deposits in banks, money market funds, short term government or government paper, etc. #3 spoke would stand for corporate stocks spread over several industry groups including a heavy weighting in gold shares. #4 spoke would identify long term, high yielding debt such as discounted notes, high yield bonds, etc. #5 spoke would be for speculation. Included in this category would be stock trading accounts, highly (non-recourse) leveraged real estate, automobile 'paper',land speculation, shares in small up-and-coming businesses, index option futures, etc. Now, what might we have accomplished?
SEPARATING THE ASSETS CAN MAKE PLANNING A LOT MORE EFFICIENT
A. By dividing the pie into parts at the very start, we've now got the spouses' estates separated, making estate planning a lot simpler and eliminating a lot of discussion between them as to what, where, when, how and why any particular investment decision should be made, and by whom. Furthermore, if fate should conspire to have one spouse's investments all turn bad at the same time, at least half of the balance will still be intact. Half a loaf is still better than none.
B, Splitting the entire estate into foreign and domestic halves, protects each half against attempts by private citizens and various levels of government to convert accumulations of a lifetime from your pockets into their own through fair means or foul. At the same time, these assets are insulated to some extent from economic problems that loom on the horizon in the USA. We're already seeing thinly veiled government seizures under the auspices of vague infractions without due process. As the economy begins to founder under the weight of massive deficit spending, what is now a trickle of seizures will become a torrent. Assets placed out of reach off shore will be able to survive better than assets held here.
C. Investment in high quality rental real estate – and I'm always going to come down on the side single family houses or mobile homes – will provide tax sheltered income, inflation protection, loan amortization, and real appreciation. Residential real estate in foreign areas can be a lot harder to handle. When looking for alternatives, the specific country where located should be carefully considered together with the applicable tax laws and tenant's rights. A house on the Isle of Man, a condo in Campione d'Italia on the Swiss border or an apartment in the Bahamas might be better than a rental in Tokyo where eviction is virtually impossible and prices astronomical.
D. In or out of the country, there's no substitute for cash when you need it! Other forms of short term investment are equally acceptable so long as they can be liquidated swiftly without adverse effects. Having liquid assets out of reach of the U.S. Courts gives you the option of living abroad comfortably is you so elect to. Growing reverse migration of American citizens back to their countries of origin has swollen from a trickle into a healthy stream. Many countries offer a second passport in return for investment capital. And a surprising number of Americans are renouncing their citizenship to get away from the omnivorous IRS and to take advantage of the unregulated business opportunities in some of the emerging countries.
E. Investment in foreign company stocks in Latin America, Japan, the Pacific Rim and Europe over the past 5 years has produced almost twice the total return of investment in the U.S. stock market. But, in 1994, this changed considerably, and it could change again. The USA economy dwarfs all others and thus influences all others. As emerging countries' economies grow, they'll consume prodigious quantities of high tech goods and services that American companies will provide. Still, labor intensive industries that are situated in low cost foreign sites will make companies there extremely profitable. It's a lot easier for a $100,000 company to grown to $200,000 than it is for a $100 Billion company to grow to $200 Billion. We'd want to touch all these bases here and abroad.
G. A lot of serious thinkers see deflation as a very real prospect. That means that the price of everything will be going down, along with our standard of living. Leading the parade will be stocks. To hedge this, a portion of the portfolio should be placed into top rated foreign and domestic debt instruments, bond mutual funds, etc. When inflation is rampaging, these investments will go down, but when everything else has become illiquid, having nice steady income checks coming in, denominated in a variety of currencies, will be very nice indeed.
H. This final spoke is for the demon inside all of us that craves the excitement that only high risk yields can satisfy. It keeps us satisfied to hold everything safely in the other spokes for the long term future. A fellow called me the other day and told me of a 100 room hotel on the Black Sea in Bulgaria that I could buy for $40,000. Wheeling and dealing in index options retired one of my tenants in a year. I'm currently speculating on land near the new casinos in Mississippi and apartments in Houston. All of these carry high risk, but yields in the hundreds of percentage points. Many of these will fail, and hopefully, a few will succeed. In the meantime, I'll be having a good time. That's what this category is all about. A chance to pit yourself against events so you won't be paying too high an opportunity cost for safety and serenity.
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