Saturday, May 26, 2012

Financial Risk at an Opportune Moment

Here we are, 2012, and mortgage interest rates are at a low we'll probably never see again, 3.5% on thirty years. They're comparable to inflation.  Neither index has anywhere to go but up, especially given our nation's financial foolishness of borrowing, spending, tax-raising, and can-kicking.

Combine low mortgage rates with property prices still shocked and locked from 2008, and a financial risk-taker probably sees this as the prime opportunity to make money off of borrowed money in the romanticized market of real estate.  Land.  They aren't making any more of it. 

Here's the playbook:
  • Sign on long term for as much as you can handle to purchase assets whose market price can only go up (or can they?) 
  • The funny thing about (fixed) mortgage interest rates- they're fixed for the term of the loan, and the term of the loans are long. 1982 was thirty years ago. Mortgage interest rates were 13-14%. The Clash released Combat Rock. 
  • Should I Stay or Should I Go?
  • Lock in your costs at today's ridiculously low rates and be a baron down the road.  If your bet is right, you'll be sitting pretty.

What could go wrong?

Ask those who were flipping houses during the 2000-2007 real-estate bubble.  The game was to buy on short term financing, refurb (or not- sometimes the houses appreciated regardless) and flip.  Double down on the next few properties.  Lather, rinse repeat.  And then the bubble burst, leaving the risk-takers with interest-only-balloon and other unique short term loans and properties they couldn't move.  What to do?  It's no fun to declare bankruptcy mid-life and start all over.
Debt is funny.

When financing investments it is a risk, a bet that you can beat the cost of financing with your return.  Debt is a time machine getting you what you want now at a fixed additional cost and, well, indebtedness (and opportunity cost) for the future.  Your cash-flow is committed until the investment matures, for better or worse.  What are you risking?  Debt on a dead investment.  If you can't pay that, you're risking savings, retirement money (you do know that you're responsible for your own retirement, don't you?), bankruptcy.

It seems quaint to look back a mere five years (when interest rates were a relatively astronomical 7%) and consider that we defined and justified (let's be honest- rationalized) our homes as investments.  My, how times change.  Today we look at the same loan as what it truly is- a debt to be paid to acquire an asset many are upside-down on and will be for a while.  Despite fortunate refinancing and aggressive principal pay-down, we're still hoping for market prices to float us back to sea.

Does your neighborhood look like this?

Cash (dare we call it capital?), however, is an interesting investment instrument in comparison to a financed investment.
  • You can make a wiser call on your investment because, man, you feel the pain of spending that money and will be more cautious than when spending time-machine money.
  • If things go wrong, you can weather the storm or, worst case, cut bait at a loss.
  • Your cash-flow is not affected; other sources of income (other investments, your wages and earnings, savings) continue to carry you in tough times.
  • The assets you purchase with cash are yours.  They are a positive on your balance sheet.
And so here we are.  The cost of the bet is 3.5% per annum.  Indicators are that we're bottomed out, yet the risk is still the same. One thing can go right.  Many things can go wrong.  Are you willing to get caught with financed investments?

Rush was also busy in 1982, and had this to say about the Subdivisions we find ourselves living in today:

Some will sell their dreams for small desires
Or lose the race to rats
Get caught in ticking traps
And start to dream of somewhere
To relax their restless flight
Somewhere out of a memory of lighted streets on quiet nights...

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