This past weekend my wife and I were invited to a friends home for a social gathering and wine tasting. We always look forward to such events, not just for the company, food and wine, but for the opportunity to informally gauge investment trends. We do this by watching and listening for strong opinions regarding various investment and retirement plans among fellow attendees met randomly. Anyone who employs a Benjamin Graham inspired approach to investing should welcome anecdotal evidence of both prevailing and uncommon investment psychology. This weekend proved to be very informative, especially when observing that most investors haven't changed much in the last decade.
It was unintentionally that we began observing the markets through the eyes of social event participants. During the late 1990's we noticed that conversations quickly turned to one dot-com investment or another, sometimes within a few minutes of meeting someone. People were not that interested in learning about one another's children, their music teacher, where the best restaurant was in town, or what they thought about a certain wine. Investing in dot-com was the focus. Fair to say that this was a good indicator of an inflating bubble. After the technology bubble peaked and burst, people abandoned the markets and the focus of conversations turned to "flipping" real-estate. In effect they jumped from one inflating bubble to another, in time for each to burst.
Of Binary Emotions
Any long-term observer of crowd behavior will note that the majority of people that consider themselves investors react in a binary manner. They are all in, or all out, of a particular investment category. They express strong affection, or complete disdain for particular assets classes, or even entire marketplaces. These days they justify their avoidance of stocks by citing that the market is rigged and that investing is nothing more than a form of gambling, a casino as many put it. Instead of seeing the market as what it truly is, a marketplace devoid of emotion, existing to support the exchange of shares. They look only at indexes such as the Dow Jones or the S&P and lump all investments that trade in that marketplace as something to avoid at all costs. While there's nothing wrong with having a strong preference and razor like focus in investments, this focus should come from within, not be based on herd dynamics. The prudent investor would know the difference.
The Emerging Trend
The nascent investment theme is to liquidate one's 401(k) and buy rental properties. On the surface there seems to be ample reason to do so. Stock market indexes are volatile and defy logic. Millions of Americans who have lost their jobs, their homes, have poor credit scores due, and can't buy a home. As a result there is a surge of rental demand. Builders of rental units can't meet investor demand by building quickly enough, and distressed properties are being purchased for quick restoration and placement on the market. Property owners report that they can be very picky selecting renters. It's truly a property owner's market right now, but these "investors" are just reacting, not forecasting long-term possible, or at the very least ... probable outcomes.
The most probable outcome of course is that if there's money to be made in a market somewhere, and there's no way to stop new participants from joining, that they will indeed come en masse. For now, the main barrier to entry is the 20-25% deposit for property purchasers, but we're observed that credit and leverage work in cycles. At some point the trickle will turn to a stream. There will be years, perhaps many years, of out-sized returns for early property owners, but the market will invariably overshoot, and at that point there will be a saturation of rentals in the market. That's the best case scenario, a normal search for equilibrium over time in a relatively free market. But there are other factors to create complications, and as we observed at this social gathering, they were not discussed along with the wine list.
A Foundation for Risk Management
Other than the best case scenario, there are risks that fall outside of what one would expect in most markets. The very factors that support a renter's market are in fact contributing to an erosion of government financial stability. Unemployment benefits, EBT, Social Security and Medicare funds all play their part in supporting rents, yet at the same time they are stressing state and federal government finances. How many investors look at their respective government's cash flow before looking at a property's cash flow prospects? And if there are healthy returns from rentals today, do investors really expect these to remain unencumbered in the future by their host cities and municipalities?
In order to bolster their finances local governments will have to do one of two things, perhaps both, and neither is attractive to the property owner. The first is to increase income, and absent economic growth there's little choice but to raise property taxes, and institute other fees. Along with new entrants into the market, this will reduce return on investment. The second option is to reduce the size of local government expenditures. Property owners need to look at the size of the public servant employment market, relative to the private markets in their local communities. Everyone should determine how much of the rental market income derives from government salaries. Should significant austerity be on the horizon, then this would dramatically reduce a renter's buying power, and the owner's ability to raise, or even maintain rents in the long-run.
What about monetary risks due to that estranged spouse of austerity, aggressive stimulus? From the property owner's perspective, if income deflation is bad for leveraged property owners, what about inflation? No one that we have met appears to have considered the impact of high inflation on rents. Perhaps the greatest threat to the property owner's bottom line, is inflation that spawns government mandated rent controls otherwise known as rent ceilings. Yet, when monetary inflation causes rents to increase too quickly, well meaning governments respond by instituting rent ceilings to protect the "common man", at the expense of the landlord. During the late 1970's and early 1980's renters in most big cities enjoyed the benefits of such government programs. It is notable that these same rent controls stayed in place even after inflation subsided. The current legal framework that supports the prohibition of rent controls in many jurisdictions is not written in stone.
Given the state of public finances it seems naive to consider that any market will be able to remain in a Goldilocks world; neither too hot, nor too cold. The ongoing "all-in" approach to investing ignores probable threats, and writes off other opportunities based on past performance. Clearly the average investor has yet to develop a foundation for risk management, and maintains an emotionally driven approach to this day. For the observant investor anecdotal stories may continue to serve as an indicator of when to remain cautious, and when to become interested in an investment category. Besides, how can any observer of trends pass on the opportunity for good food, wine and conversation?
