Wednesday, October 15, 2008

Looking Ahead

It probably seems as if I'm a gold bug. Well, that's partially true.

You probably would never guess it from reading these discussions on a day to day basis, but my ultimate investment goal is to generate as much yearly income as possible from owning apartment units. I have looked out over a 20 year time frame and have put together a strategy to accomplish that goal.

Gold is a horrible investment over the long term. It generates no income, no interest, and no dividends. Income is the reason stocks and real estate provide the absolute greatest investment over the long term. Real estate also provides amazing advantages with leverage and tax loopholes. Those two advantages are what makes real estate the greatest long term investment in my mind.

As we've discussed before, however, markets move in large secular cycles. We are currently in a period where American stocks and real estate will continue to fall in real value for the foreseeable future. There are periods throughout history where commodities become the best store of value, and they are usually when stocks and real estate are in a downturn.

I don't own gold, silver, oil companies, agriculture, ect. because I think they will be the best long term investment. I own those things because I think they will allow me to purchase the greatest amount of real estate when they peak in value and real estate has bottomed. When will that point be? Ah, that's the most important question, and that's the reason why I follow the market as closely as I do.

Every day something changes in the world to control that date. For example, if the government had not taken the extraordinary actions it has over the past twelve months we would be very close to a great buying opportunity for real estate. Stocks, real estate, and our currency would have all fallen in value considerably.

Real estate (residential) becomes a strong buy when the median price of a home in an area is at a level where the median public income can put down 20%, and have the mortgage only be 28% of their total debt. This is the level where the private market will lend to the public and feel confident with their return of investment. In most areas of the country prices would have to fall by at least 50% to reach that level. At these levels you can purchase real estate and rent it out with cash flow, making it a real investment and not just speculation.

The price of real estate is controlled directly by the amount of money you can borrow. This is what created the artificial bubble the past few years, and that artificial bubble still exists. The government is now holding it up with its take over of Fannie Mae and Freddie Mac. These entities will now buy mortgages from buyers who cannot afford to pay for them. Their job is now to keep real estate prices from falling, not to make homes more affordable. Prices falling to levels people could afford them would make them more affordable, but the government will not allow that correction to happen. (It still will happen, but only in the cost of everything else rising faster than the rise in real estate)

So what does all this mean? Things have changed considerably from where I saw them playing out a few years ago. The free market still exists except on a much larger level. What we are seeing now is the United States government standing behind all the bad debt, instead of the private sector who initially took on the risk. This means it will not be the private sector that loses value, but the credit rating of the United States who is now guaranteeing all of it. The losses will still be taken, but it will be shown in the value of our currency and the ability of our country as a whole to borrow.

This will push down the value of our currency, and greatly push down the value of our bonds, as countries demand a much higher interest rate to take the risk of borrowing from the United States. For the first time ever, investors are taking out insurance (Credit Default Swaps) to buy US treasuries. The basis points (cost) for investing in our country are now higher than investing in McDonalds and Exxon.

To go back to a previous analogy; instead of dumping the bad cargo off the ship and moving forward, the entire ship is now going to go down.

How does this change the big picture? It makes investing in gold, silver, oil producing companies, agriculture, ect., all that more appealing in the short term. The returns from these investments will now be much higher at the end of their run, but the period of transferring those gains into real estate will pushed a little further into the future. The swing will ultimately be greater, as commodities will ultimately go higher and real estate will ultimately fall further.

I'll have future discussions on the value of commercial real estate because it is a much different beast than residential and will need a more in depth analysis.

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