Real Estate

Consider the current economic environment where interest rates have recently been slowly increasing and may continue to do so in the foreseeable future. They may go down but it's unlikely. Now imagine borrowing £1,000 at 10% to buy a bond selling at a premium yielding 9% hoping that the 1% you are losing in interest payments will be offset by appreciation of the bond price in subsequent years due to what you hope will be lower future interest rates. Keep in mind that as interest rates go up, bond prices go down in order to create a higher yield to match the interest rate. Would you do it?

This is just a made up scenario that to me seems both speculative and risky. I don't think that any rational and well advised retail investor would ever do something like this. The risk reward ratio would just not be worth it. However, in my opinion this route is similar to the one which many property investors here in the UK have decided to take.

I recently heard about someone who has taken out an interest only mortgage on an "investment" property where the monthly rental income falls £25 per month short of the monthly mortgage repayments. And this is not including any capital expenditures. Not only is there is a highly leveraged position, some the bank's interest charges out of this person's own pocket just to keep the investment alive under the false premise that property prices will continue rising forever. Keep in mind there is an interest only mortgage which is not amortising the loan. As I’m told, because there is a leveraged position in the investment, any price appreciation will magnify any gains on the initial investment but I think there are two things being missed:

1. Leverage cuts both ways. Borrowing five times the deposit will see a 10% rise in the market price return a 50% return on the investment. On the flip side, a 10% drop in the investment will give a 50% drop in the investment.
   
2. Vitally, she is not receiving any productive economic benefit from this "investment". Instead she sees the speculative appreciation in the property price. Isn’t this the same as hoping to gain from trading commodities? Read more here
   

It's true that rent inflation will see the £25 monthly deficit disappear within a couple of years however this may take longer than anticipated if interest rates continue to increase. Moreover, if interest rates do continue to rise then that puts pressure on market price appreciation- the entire point of this investment.

There is nothing wrong with real estate as an investment as the old adage "safe as houses" still holds true in my opinion. However this style of "investment" is incredibly sensitive to any market down turn. The strange thing is that my colleague feels perfectly comfortable with the situation. I wonder what the feeling will be if, heaven forbid, the market slowed and declined enough to see her "investment" fall into a negative equity situation. What if prices were to stagnate for 10 years? What if there was forced sale? If one can afford to ride out any market storms then they will be OK in the long run but whether they will be wealthier for it I can not say. Without amortising the loan there is an even greater risk of seeing negative equity in the purchase.

I want to finish this post by citing one interesting comment made by Warren Buffet which went along the lines of "one of the characteristics of a price bubble is that investors start to invest in assets based on price appreciation alone and forget about the income generated by the asset". I think that pretty much sums it up.