Where people reside and why they choose to live where they do are important trends to assess when investing in housing. Over time, those that have done well in identifying these trends have been able to create wealth for themselves through real estate. On the other hand, maybe they were just lucky. To quote Deng Xiaoping, "black cat, white cat, whatever gets the rat."While for some the destination is all that matters, I think life is more about the journey. In the world of investing this means working hard and deriving enjoyment from the challenge of trying to see a little bit further ahead and more clearly than others so that opportunities can be taken advantage of and disasters avoided.
Historically people have settled where nature was most giving. Yet, over time, those locations that continued to focus their economic output on their natural resources have tended to lag far behind those that have largely given up producing commodities. In fact, those locations with the greatest density of population have virtually no natural resources at their disposal such as food, energy, and building materials, yet they have tremendous wealth to devote to luxury, culture, and material goods far beyond the necessities of life. More importantly, for our needs, they also have very high housing values. Why do those areas with the least natural resources (think Japan) have the greatest wealth while those with the most often times squander the wealth generated by these resources (think Saudi Arabia and Russia)? These factors point to the notion of wealth and capital going far beyond natural resources and even money and have important implications for investing.
For a long time I have been fascinated by the concept of wealth. We all have our ideas about what it means to be wealthy. As far back as 1776 Adam Smith broached this subject when he wrote his famous book An Inquiry into the Nature and Causes of the Wealth of Nations. Most people think wealth means having a lot of money, which is probably just fine for the vast majority. I pride myself, however, on obsessing over things that most people take for granted, particularly in the realm of economics and finance. When trying to learn about such concepts I often find it helpful to go back into the past to divine what others thought. I find the thinking of dead economists particularly interesting because they pondered concepts far before they seemed relevant to do so. This usually meant they were pretty deep thinkers who probably had some meaningful insights to communicate that are pertinent to today. While I strongly believe that wealth goes far beyond the realm of money and embodies things like a great family, spirituality, friendships, passion, and a strong sense of self, the focus of this article will be on the economic aspects of wealth.
A couple of years ago I was strolling through a used book store and came across a 1926 edition of Progress and Poverty written by a political economist named Henry George. As I browsed through the book I noticed that it was a commerative edition of the fiftieth anniversary of its first printing in 1876. As mentioned above, I have a particular interest in reading economic literature from long ago because enough time has passed to assess how accurate the authors' theories were. For an economics book to have been continuously reprinted for fifty years as far back as the early 1920s impressed me greatly and suggested to me that I should take a closer look. Not surprisingly, as I started reading some of the book I was struck by how logical, well written, and accurate the book was in large part. Ironically, the material I agreed with went to support a conclusion for which I disagreed. Namely, that landlords skim too much of the increase in prosperity from labor and capital as society progresses and that land speculation is the primary cause of the volatility of our business cycles and misery of our laborers. Only by aggressively taxing real estate can there be a more equitable distribution of wealth and efficient allocation of resources. Rather than focus on what I don't agree with, I would rather concentrate on the positive, particularly his discussion about population, urbanization, wealth and capital.
Many people believe that overpopulation is the cause of a great deal of misery in the world. One of Henry George's goals was to disprove the Malthusian notion that population grows geometrically while food expands arithmetically thereby setting the stage for population outstripping the food supply and creating widespread hunger. George wholeheartedly disagreed and, in fact, believed that hunger and misery were man made conditions. "Everywhere the vice and misery attributed to over-population can be traced to the warfare, tyranny, and oppression which prevent knowledge from being utilized and deny the security essential to production." (p. 123) A number of countries in Africa are constantly battling hunger and these same countries suffer from wars, dictatorships, corruption, oppression of women, tribalism, superstition, and little societal value for education. These are all enormous impediments for societies to organize in ways as to create divisions of labor that will allow these countries to either produce food in excess of their survival needs or tradable goods that can be exchanged for food by freeing labor resources to produce other more highly valued goods and services away from the farms. Free societies allowed to innovate in response to the needs of the market will always be able to feed themselves for, according to George, "even if the increase of population does reduce the power of the natural factor of wealth, by compelling a resort to poorer soils, etc., it yet so vastly increases the power of the human factor as more than to compensate." (p. 149)
Despite George's optimism about human ingenuity, it does seem hard to imagine that it can increase in perpetuity at a faster rate than population. Yet George believed that societies have a way of regulating their populations to suit their needs.
"The tendency to increase, instead of being always uniform, is strong where a greater population would give increased comfort, and where the perpetuity of the race is threatened by the mortality induced by adverse conditions; but weakens just as the higher development of the individual becomes possible and the perpetuity of the race is assured." (p. 139) In other words, poor, underdeveloped societies tend to grow their populations more rapidly because they need more bodies to support the family through subsistence farming because there is very little mechanization and employment opportunities outside the farms. There is also a shorter life expectancy that requires a greater birth rate to compensate. In addition, women tend to have very few rights and are typically treated as reproductive objects then as thinking, feeling human beings that have value to society beyond bearing children. On the opposite end of the spectrum advanced societies tend to experience far slower rates of growth as people have little concern about their ability to feed and clothe themselves but tend to see large families as a big financial burden when factoring in the lifetime costs of education, housing, medical care, taxes, etc. In addition, women have a much greater tendency to work and focus on their own intellectual, physical, and spiritual development that helps to lower birth rates. Only advanced societies can publish books like One Nation Under Therapy, currently a bestseller in the United States.
There is overwhelming evidence of slow population growth for industrialized economies as we roll into the 21st century. Western Europe is barely growing and countries like Japan and Italy are going to be experiencing very substantial population loss over the next fifty years assuming no change in immigration policy. Even Russia, which is not an advanced industrialized country but has a relatively well educated population that can see the hand writing on the wall regarding the challenges of bringing children into the Russian society and economy, is experiencing the largest peace time population decline in world history with the exception of times of mass disease.
At the end of the day, according to George, "the law of population accords with and is subordinate to the law of intellectual development, and any danger that human beings may be brought into a world where they cannot be provided for arises not from the ordinances of nature, but from social maladjustments that in the midst of wealth condemn men to want." (p. 139) If the world needs what nature produces, then why do those countries with tremendous bounties of natural resources often times find themselves economically and socially less developed than those devoid of them? We can turn to Henry George for the answer to this as well.
"The richest countries are not those where nature is most prolific; but those where labor is most efficient...The countries where population is densest and presses hardest upon the capabilities of nature, are, other things being equal, the countries where the largest proportion of the produce can be devoted to luxury and the support of non-producers, the countries where capital overflows, the countries that upon exigency, such as war, can stand the greatest drain." (p. 147)
They also have the highest housing values! Perhaps another way of stating this is that necessity is the mother of invention. "The denser the population the more minute becomes the sub-division of labor, the greater the economies of production and distribution." (p. 150) Survival and prosperity tend to go to those species, societies, businesses, and organizations that can specialize and adapt. Dense, urban populations require cooperation and specialization to succeed. Whenever I walk through neighborhoods in New York I am taken aback by how restaurants, bakeries, delis, and stores are able to make the most of such little space and offer such extraordinary quality and specialized products and services. The foods I see in the window are works of art; the delis I walk into have an amazing selection of high quality items crowded into very small spaces.
Frank Sinatra was definitely right when he belted out "if I can make it here then I can make it anywhere" in "New York New York". The incredible competition for real estate not only offers business owners access to an extraordinary mass of people for which they must pay dearly, but it also requires them to be great at what they do because there are others who are either competing with them or willing to do so and because the customer is very sophisticated, discriminating, and demanding. Real estate constraints make it difficult for business owners to be all things to all people. They must pick niches to serve and do the best that they can. If they do it right, then they can prosper greatly. If not, then the high rent and overhead will eat them up and they'll have to be in the words of a famous New Yorker, Billy Joel, Movin' Out. This process of specializing creates a very efficient and vibrant ecosystem that can adapt and prosper. It is also the best positioned for incredible wealth creation and with wealth creation comes higher housing values as people pay premiums to have access to wealth creating opportunities and the cultural amenities that result from the spillover of the excess wealth.
As I stated earlier, most people think that wealth is having a lot of money. If you were stranded on a desert island and no one knew you were there and you had no access to communication or transportation, then your money would be useless because it can't be exchanged for anything you need. Thus, money only has value to the extent it can be used as a medium of exchange. Henry George had a lot to say about what constitutes wealth and a subset of wealth, capital. These are very important concepts for investors to think about.
As I alluded to above, the simplest understanding of wealth is anything having an exchange value. This is far too broad and not surprisingly, Henry George goes into more detail with the following:
"Wealth is labor impressed upon matter in such a way as to store up...the power of human labor to minister to human desires...[Wealth] is the object and result of what we call productive labor - that is, labor which gives value to material things. Nothing which nature supplies to man without his labor is wealth, nor yet does the expenditure of labor result in wealth unless there is a tangible product which has and retains the power of ministering to desire." (p. 42)
This notion of stored labor is vitally important when thinking about wealth, capital, and investing. Think about a vacuum cleaner. This machine represents the embodiment of previously expended labor applied to the manufacturing, distribution, marketing, and sale of the vacuum cleaner. Although machines and equipment were used to create the vacuum cleaner in the manufacturing process, these too also represent stored labor. In the words of George,
"By the storage of labor, which is involved in the production of wealth, it becomes possible for man to change the time in which a given exertion shall be utilized in the satisfaction of desire, thus greatly increasing the sum of satisfactions which a given exertion may procure. And by the using of wealth as capital, which is the calling of past exertion to the service of present exertion, he is enabled to concentrate exertion upon a given point, at a given time, to call in, as it were, forces of nature which far transcend in their power those which nature has put at his use in the human frame." (The Science of Political Economy, Part II, Chapter 13)
The above quotation is a little difficult to grasp so perhaps an example is in order. A bull has powerful horns and when applied to a human can inflict terrible damage. A human has very little physical capability to respond in a defensive manner. When labor is applied however to the production of a spear, then force can be concentrated in such a way as to provide momentum and velocity to the spear so that it can penetrate the bull and cause harm. Expend more labor, ingenuity, and access more raw materials and a bow and arrow can be created, and then a gun to "concentrate exertion upon a given point, at a given time, to call in, as it were, forces of nature which far transcend in their power those which nature has put at his use in the human frame" as George stated in the quotation cited in the paragraph above. These weapons can be used over and over and provide so much more power than what an individual can harness despite the fact that it is noting more than human labor impressed upon matter and stored up for future use.
Many people are offended by the estate tax but it does have some potential societal benefits. If wealth represents past exertion stored in such a way as to satisfy human desires so that it has exchange value, then the assets that we inherit represent the stored labor of others. It probably has very little to do with our own stored labor. This disconnect between those who created the wealth and those who inherit it can have negative consequences for society.
Most people have heard of the notion of rags to riches to rags as the wealth created by previously poor but ambitious, hard working, and intelligent individuals is passed on to those who become custodians of the wealth. They seek to preserve their lifestyle without necessarily having the same skills, interests, or work ethic as those who earned it. It's one thing to manage your stored labor; it's another to be the custodian of others. Eventually future generations squander it because they were never prepared to honor the capital in the first place and it goes to waste.
The estate tax forces creators of the wealth to think long and hard about how they want their stored labor to be used in the future. There is a great deal of incentive to give much of it to non-profits. Perhaps a charity would be a better custodian. After all, primogeniture, the practice of wealthy European families leaving their entire estates to the eldest son in order to preserve it for generations, proved to be a policy that led to stunted societal development, tremendous inequalities, and unproductive capital tied up in large land holdings and spent on luxuries versus capital investment to increase the productive capacity of society. In a way, the estate tax attempts to do some of the same things. I offer these views more to be provocative than to communicate my viewpoint.
As investors it is absolutely critical to remember that you are not really passive when investing your money because it represents the past exertion of labor that has been stored for future use. Investing your money with CWS, or others, means that you are unleashing this stored labor. It is working side by side with the labor of the fiduciary for whom you have entrusted your money. At CWS, we never lose site of this and for this reason we take our fiduciary role very seriously.
There is an important distinction between wealth and capital. Capital is all wealth that is used to produce more wealth. Where does housing fall in to these categories? It is clearly wealth because it is stored labor that satisfies the human desire for shelter and has exchange value. But generally speaking, it is not capital. Although a nice living environment can clearly be beneficial for people's well being, this adds to the capacity of labor to be more productive, but does not help create more wealth. A new home being built adds wealth to society. Homes going up in value do not necessarily do so because it comes at the expense of those who desire housing but cannot afford it because of the higher cost. Housing adds virtually nothing to the productive capacity of our country to produce future goods and services assuming that people are not working out of their homes. As George states,
"When we speak of a community increasing in wealth...we mean that there is an increase of certain tangible things, having an actual and not merely a relative value - such as buildings, cattle, tools, machinery, agricultural and mineral products, manufactured goods, ships, wagons, furniture, and the like...The common character of these things is that they consist of natural substances or products which have been adapted by human labor to human use or gratification, their value depending on the amount of labor which upon the average would be required to produce things of like kind." (p. 41)
This is why I find asset bubbles, particularly in housing, to be dangerous. Home prices doubling in Orange County while employment and wages have grown fairly modestly over the last five years doesn't represent real wealth creation. It represents the repricing of an asset that can be aggressively financed with increasingly cheaper money via lower interest rates and more flexible loan repayment programs. The higher housing values lead to greater investment in a non-productive asset class that has very little capability of adding to the nation's ability to produce more wealth in the future. Conversely, capital is diverted from more productive uses. Perhaps I shouldn't have been so critical earlier about George's conclusion regarding the dangers of real estate speculation.
Here is what I would like to leave you with. The greatest wealth creation occurs in the most densely populated locations with the least constraints upon society from government interference. In turn, this typically leads to relatively high values for housing.
Although urban housing can become overvalued and go through cycles in which home prices stagnate or drop, over the long run they should grow in value at a more rapid rate than in suburban or rural locations. For this reason, do not be surprised to see more urban investment opportunities from CWS similar to those we have carried out in Uptown Dallas, one of the nation's most dynamic urban areas.
With this being said, the current growth in housing values in certain areas of the country, particularly coastal California, is not sustainable because it adds so little to the nation's productive capacity. Either too much investment will be allocated to housing such that too much supply is created, or too little will be put into other areas of the economy such that economic growth will stagnate and employment will suffer which will hurt the demand for housing. These are very long-term trends, however. The point is to put housing into perspective. It represents shelter, a basic human need, and is a source of wealth for society. It does not constitute capital, however. Finally, do not forget that your wealth represents stored labor by you or others. When making an investment it is useful to think about how many hours of work this amount of money represents. If you view it from this perspective, then it might lead you to consider the risk and rewards even more carefully than you have previously.
