By Miles Clyne
I heard the following statement recently:
I think there is truth in these words. Most find the concept of slavery unthinkable, yet we willingly bind ourselves to years of debt.
The good side of debt is that it can be productive financially if the asset(s) you have leveraged appreciate at a rate that exceeds the cost of your borrowing on an after tax basis.
There are only two types of assets:
1. Those that have the potential to appreciate,
2. Those that have little to no potential to appreciate (i.e. disposable goods or stuff that simply wears out).
Much of our financial success will be determined by the assets we own that have the potential to appreciate, and also the timing of when we buy those assets.
The securities industry, where I make my home during the day, will very often tell you: “don’t try to time the market”, just buy, and preferably buy often. There is truth to this, but there is also blindness. Most investments are cyclical and at times too expensive and at other times they become inexpensive. Getting your timing better as to when to buy is a function of your commitment to understanding what you are buying, not succumbing to the lemming factor or impatience.
My other home is where I live by night and weekends. This is where virtually all of us have something in common, whether we rent or own. For many, a very large part of debt is what is owed on our home. If you have owned your home for any length of time, you are likely experiencing the positive effect of leverage. This is where the value of your home is appreciating faster than the cost of your debt.
The out of control real estate markets on the West Coast of BC and in Toronto should be making anyone considering or currently invested in these markets step back and assess the situation. The market has become irrational in these areas, to the point where there often isn’t time to even have a home inspection done.
In the investment industry, and this applies to real estate as it is an investment, buying without doing your homework, especially for the largest investment most of us make in our lifetime, should be unconscionable.
The bigger picture is that all is not right in the world. We see this in the prolonged low interest rate environment in many developed countries, ours included. Low interest rates have aided in driving up real estate prices. This in turn has made it an effective market for leverage to work, in the short-term at least. The correlation between interest rates and the price of real estate is real. The lower interest rates get, the higher real estate prices get.
Here are the guts of this equation that should not be ignored...
We are at historic low interest rates, and we are at historically high prices in real estate in the areas mentioned. What do you think happens next? There are three outcomes worthy of consideration: interest rates go lower and prices continue to rise, interest rates and prices stabilize, or interest rates rise and prices fall. The scenario you believe to be most likely should be a large factor in your decision on whether you buy or sell in these markets given the magnitude of leverage most will be using.
The Simple Reality?
The simple reality is that leverage is not a free ride. There has not been an investment asset class where investors have been able to apply leverage and have it succeed 100% of the time. If this were the case, we could just allocate all of our excess capital and/or borrow to infinity and just live off of the growth above the cost of leverage. Our economics are not built this way. History will exact its toll again on those that blindly go where they shouldn’t; it is just impossible to know when the music stops. Many will be burdened with debt that exceeds the value of the investment when this occurs. An old axiom keeps coming back to me at times like these: “Markets can remain irrational far longer than investors can remain solvent.”