I'm not a fan of bank credit. I advice against it in my book because most people get burned by it. The typical borrower gets in late in a credit cycle. They end up paying too much for things, and if they're particularly unlucky, they get slammed with high interest rates and forced to sell at the worst possible moment.
This happened to many during the housing bust that took place between 2004 and 2014. At its peak, typical houses were priced at 10 kg of gold. At the bottom in 2014 the same houses went for 2 kg. There's a lot of misery hidden in those numbers. However, the person that bought a flat in our building for 2 kg back in 2014 can now sell that same flat for 4.4 kg. That's a profit of 2.4 kg based on 2 kg of capital put down up front.
In terms of Euros, the buyer in 2014 has done even better. The price has gone from €66,000 to €240,000.
If the €66,000 required to buy the flat were all borrowed from a bank at 4%, the cost to the buyer would be €21,000 over the eight year period. That translates to about 0.7 kg of gold in running costs. When we subtract this from the profit of 2.4 kg, we get a profit of 1.7 kg based on 0 kg of capital put up front.
Instead of a profit of 2.4 kg made on 2 kg, the buyer has a profit of 1.7 kg made from 0 kg. If the buyer borrowed 100% from the bank, 1.7 kg was made from nothing.
Buying real-estate with credit when prices are down and interest rates are low is clearly a winning strategy because money can be made from nothing. However, this combination is rare.
To see how things pan out when house prices are high, but interest rates remain low, we can use the house I sold in Norway in 2017 as an example. Measured in gold, the house went for 16 kg, and it now commands a price of 14 kg. It's down 2 kg. However, the buyer almost certainly used bank credit. We must therefore look at the prices measured in Norwegian Krone.
The house was sold for 4.7 mill NOK in 2017. It now commands a price of 7.2 mill NOK. If financed with credit at 5%, the buyer has paid 1.2 mill NOK over the 5 years since 2017. This translates to a cost of about 3 kg.
On the other hand, there's a profit in NOK to the buyer of 2.5 mill NOK. That translates to 4 kg. If the buyer used 100% credit, that buyer is now up 1 kg.
The use of credit makes it possible to make money even when prices in terms of gold are falling, provided the fall isn't too sharp, and the interest rates aren't too high. In the case of my house in Norway, the buyer has made 1 kg of profit from 0 kg of capital if the house was financed 100% from bank credit.
However, if the buyer in Norway paid with real savings rather than bank credit, that buyer is now down 2 kg, because the 16 kg paid is now 14 kg. But this same person enjoyed a bonus in that there was no interest bearing debt to carry over the five years. That's 3 kg of liquidity that the prudent saver could enjoy that the ones using bank credit had to forego in order to make a paper profit of 1 kg.
The prudent saver sees a paper loss of 2 kg at no cost. The bank credit speculator sees a paper gain of 4 kg at a cost of 3 kg over the same five year period.
Interestingly, if the prudent saver decided to put aside 3 kg in savings over the five years, corresponding to the 3 kg in costs incurred by the speculator. The net result would be a gain of 1 kg to the prudent saver. When everything is added up, the speculator is no better off than the prudent saver in absolute terms. The big difference lies in the fact that the speculator gets 1 kg from nothing, while the prudent saver put 16 kg up front for the same gain. But that advantage to the speculator comes at a price; namely risk.
Imagine now a drop in house prices in Norway down to 11 kg over the next five years, and that this corresponds to no change in nominal house prices and no change in interest rates. The speculator will in that case continue to pay interest rates corresponding to about 3 kg of gold while the prudent saver can add another 3 kg of gold to savings.
This scenario results in no change to the prudent saver's gold + real-estate holding. It remains at 17 kg when all added up. However, the speculator is now down from having a paper profit of 1 kg to a paper loss of 2 kg.
If this trend continues for another five years, the house will be at 8 kg. The prudent saver will have another 3 kg of gold, totalling 9 kg, which makes a total of 17 kg together with the house. The speculator, on the other hand, has a house worth 8 kg, at a cost of 9 kg over fifteen years.
Considering that none of this is particularly extreme, the prudent saver may end up being able to buy the speculator's house after fifteen years, using no credit. The speculator, on the other hand, will have spent 9 kg over the same period with only 4 kg of gold to show for it.
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