Thursday, May 08, 2008

BOTTOM UP HOUSING

The housing market always rises from the bottom up. In other words, once the value of a small house rises, the family that has out grown it can sell it and afford a larger house and the seller of the larger house now has the down payment to buy an even more expensive house. Why should a small house rise in value? Have you seen the latest rental prices?

Smaller houses in excellent locations in Winston-Salem, near the interstate highway and near the best schools are renting well. A small house valued at $110,000 rents for $900 per month up from $800 just three years ago. An investor with good credit can find an 80% mortgage loan at 6% interest. Taxes and insurance on such a home are less than $2,000 per year. In other words, one can realize an immediate cash flow of $3,500 on an investment of $25,000. The short term rate of return is 14%. With few new houses under construction, the small house market is seeing a steady rise in rents. The buyer of the home needs to be prepared to cover refurbishing expenses after a turnover, but these houses, in excellent locations are apt to increase in value at least 3% per year over the next several years. A 3% increase on $110,000 is $3,300, which is an additional gain of 13.2% on a $25,000 investment. With a little luck, the increase in rents will more than fund future refurbishing costs. A total return of 27% over 5 years is possible if not probable.


The majority of people who look at the above numbers might suggest I have been smoking dope. They might ask, if I am aware of what has been happening to the price of houses for the past three years. Part of their skepticism would be based on what they have read or seen, including the reports about the Case-Shiller Housing Index. This big city index, which includes resort communities such as Las Vegas and west coast and east coast cities, shows a massive decline in the value of American real estate. In reality, the average home, in the 22 states with right to work laws, has gone up in price over all three of the last three years. During this time, the value of the US dollar has fallen dramatically.

Why did I insert the value of the US dollar in the middle of a blog about housing? Because the price of US houses are now being influenced by foreign investment. Population, number of jobs and wages are all increasing in right to work states partly due to foreign investment in these areas.

Yesterday, the Carpe Diem blog, www.mjperry.blogspot.com, summarized an article in the LA Times. The times reports that a Chinese businessman just bought 7 acres in Spartenburg SC. This businessman operates three printing-plate factories in Dongguan, China. He will add a new factory in SC, where the land cost was only $500,000, where his electricity cost will be 75% less than his cost in China, and where he will receive a tax credit of $1,500 for each job he creates. In China, he must work around electrical blackouts and he must provide room and board for the workers he recruits from rural areas of China. The biggest disadvantage to the SC location is $12 or $13 per hour labor costs compared to $2 per hour cost in China. Obviously, this businessman expects that the other lower costs more than justify the higher labor costs.

Over the past couple of weeks, the US dollar has rebounded by around 1.5%. The foreign investor who bought US land or a US rent house a couple of weeks ago, already has a 1.5% return on his investment (about 6% assuming he borrowed 80%). The central bank of England just decided to hold its short rates at 5%. This high rate is causing the economy in England to slow which will take pressure off the price of resources. Lower interest rates and lower asset prices in America, means that the businessman from Dongguan will not be the last new investor in America. Now that the dollar has turned, it will essentially follow the path it followed after the last mid cycle correction in 1995. The dollar gradually increased for 6 years in a row during that cycle.

If you are already in America and your assets are already dollar denominated, how can you take advantage of the turn? The example of the rent house above provides the answer. By borrowing 80% of the value of the rent house, you borrow $88,000 of another persons dollars while the value of those dollars is low, you enjoy the increase in the value of the asset and then you pay the dollars back.

THE DOLLAR - OIL DISCONNECT

Yesterday, the dollar appreciated and the price of oil went up. This represents a disconnect from what is "normal". The people whose assets are held in other currencies were the ones who got crunched. When the dollar rises and the price of oil in dollars rises, the foreign buyer of oil has to use more of his currency to buy dollars only to receive a smaller amount of oil for those dollars.

Did you catch the part of the above story about more reliable electricity costing 75% less in America? The energy crunch in America has been no fun but food and energy are essential to life and they represent a huge part of the cost of living for the people living in developing nations. For the first time in a very long time, China export growth is slowing. To fight inflation, the Chinese have tightened their reserve policies. The tough thing about fighting inflation is that the very policies used to lower inflation in the long run cause inflation to be even higher in the short run. For example, even a rise in interest rates represents an increase in the cost of a good.

A couple of years ago, I was early when I said that I would avoid emerging growth investments. These stocks had a great run after I made that call but many of them have collapsed over the past 6 months or so. The pain in these markets is not over. Inflation in China is above 8%. The growth rate last year was once again over 10% but the rate is slowing, the Yuan has appreciated, the pressure is on China to reduce its consumption of fuel.

NUCLEAR POWER NEEDED

As mentioned yesterday, millions of people in countries like Pakistan can now afford air conditioning. The result is competition for electricity between consumer needs and business needs. Many a developing nation is experiencing electricity brown outs. The reluctance of the world to invest in nuclear power generation has resulted in the building of an incredible number of coal fired electrical plants. I have forgotten the exact number but China starts something like 2 or 3 new coal fired electricity plants every week.

The treaty just reached between the USA and Russia is of great historical significance. It will open the flood gates to the construction of hundreds of nuclear power plants over the next 20 years. The problem is the amount of time it will take.

OTHER ENERGY PRODUCTION TAKES TIME TOO

Last night on Kudlow and Company, Senator Bernie Shaffer implied once again that solar power is the answer to our energy problem. This idea gained a lot of traction during the Jimmy Carter Presidency and billions of dollars were spent to subsidize roof top solar panels. Today, most of those panels have been thrown away and most of those roof tops have been repaired at considerable expense. Yes, eventually, solar might be the answer, however, the congress of the USA needs to stop the great harm they are doing to American industry and to the American people. By limiting drilling in America, the congress is indirectly responsible for the massive purchase of oil by Americans from foreign sources. By forcing Americans to put weak corn oil in gasoline tanks and by forcing us to pay farmers 51 cents per gallon for the junk, the congress has driven up the cost of food while padding the bank accounts of rich farmers and lobbyist and the campaign war chest of the members of congress. By fighting nuclear power at every step of the way, the congress has forced the building of dirty coal fired electrical plants in America and it has forced manufacturing plants to be built overseas. I suspect that in the last 20 years, the number of people who have died mining coal and breathing dirty air is more than a million!

On the republican side, Senators like John McCain have shown a willingness to go along with big corporate lobbyist in regard to cap and trade carbon systems. It is amazing that a Senator who likes to engage in "straight talk" is willing to go along with another big corporate, big lobby, big congressional spending boondoggle. If he truly believes that carbon dioxide production is a big problem, then he should offer a simple compromise of trading taxes on income for taxes on carbon. It does not take a degree in economics to understand that a tax on an item reduces the quantity of such items. We tax high incomes in the USA and get fewer people moving up the income ladder as a result. We could tax the production of carbon dioxide and get less carbon dioxide. The last thing America needs is net tax increase. Any new tax on carbon should be offset by a reduction on the tax on income.

Higher taxes on energy and lower taxes on income would give each citizen the incentive to find ways to reduce energy consumption. Some citizens would decide to "ride the bus", some would decide to insulate their homes, some would buy a smaller car and some would buy a hybrid car. Given the choice, consumers of gasoline would buy the pure stuff and let the farmers sell their corn to the hungry.

The tax on carbon would make solar energy, wind energy and nuclear energy more competitive and it would encourage utilities to burn only clean coal. Another incentive would be to pipe CO2 into greenhouses or algae farms.

HOUSES IN GOOD LOCATIONS

Under the tax plan mentioned above, houses in good locations would sell for a premium. Some years ago, a friend of mine gradually purchased a couple of blocks of homes in a slum on the edges of Washington DC. Before making his purchases, he studied the map of the metro and picked the logical location for the next station should the line be extended. Some would say he got lucky but I say he was smart. Some 20 years later, he bulldozed down the slum houses and sold the lots for hundreds of thousands of dollars each.

If you believe the price of gasoline is going to continue to rise, then you should believe in the value of a small home in a good location. The housing market works from the bottom up and prices are not a function of general inflation. I have seen it written many times that you want to own real estate during inflationary times. The reality is that house prices truly are a function of supply and demand, surprise, surprise, surprise. New home construction is approaching lows not seen for a very long time. The "doomster" news reports are about declining home prices and about the record number of houses that are sitting empty. The location, location, location comment about real estate is true because real estate is always a local market, even so, 22 states is a pretty big location. Michigan is one of the highly unionized states that is seeing a substantial decline in house prices. For an investor considering the purchase of a rental home in NC, the decline in Michigan is not a problem. Indeed, there are people who have moved out of Michigan, who are renting houses in NC even though their houses in Michigan are sitting empty. As usual, the best time to buy is when others are too afraid to buy.

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