The Story of a Synthetic Real Estate Agent in a Genius World

Last week, I had the very unique opportunity to meet an investment genius. It's definitely rare enough to be told here.
As you may know, I’ve no friend, the few potential candidates for a friendship ran away a while ago, usually after I talked to them about speculation, TLofT, blog, forum, gold, EURUSD, Britney’s new hairstyle, long-short strategies, etc. Gordon Gekko's famous quote "if you need a friend, get a dog" seems now to be updated: "if you need a friend, go on facebook" and as FB is blocked on our browsers at work... OK, all this is to explain why I often have lunch on my own...

Last week, during one of my lonely lunch at the restaurant, a couple sit at the table just next to me. Of course, I had nothing better to do than to listen to their discussion.
The guy told to his girlfriend: "You know, I purchased a while ago 2 flats, the price of the first one increased of around 40%, if I sell it now I can prepay the whole outstanding amount on the mortgage for the second one that will then be mine. This gave me an idea. I will come and see a banker with a business plan and will borrow enough money to purchase 10 flats and do the same, as their price will increase, that's a certainty, in 10 years I will be the proud owner of plenty of flats and immensely rich"
Wow what a genius! So smart that I'm sure no one has had this idea before him, the French say in such a case that the guy just invented the hot water. If the guy didn’t look like he was showing off with the girl I would have said something like:
“Have you ever heard about the subprime crisis? As after the 9-11 the Fed supported the credit expansion, decreasing dramatically the rates, there was a strong incentive for bankers to stuff guys like you with mortgages in order to allow them to be the proud owner of plenty of flats and immensely rich. The banks capacity to lend money was multiplied by the growing markets of Credit derivatives, notably the Asset-backed Securities (ABS, securitization of mortgages and other types of debts), the Credit Default Swaps (CDS) and the Collateralized Debt Obligations (CDO) that allow the transfer the credit risk on the borrowers to other market risk takers so the banks could net their current exposure and load some more (against fees). When all the genius like you got their mortgages, the banks seeking for new fees extended their credit policy broadly to the subprime borrowers. As the house prices increased, some of the genius had the good idea to cash out their equity, the difference between the value of the house and the amount to be reimbursed on the mortgage, to buy more houses (or a fancy car). The house price increase, all is here. While it increases, everything is perfect and we live in a wonderful world. It started decreasing end 06 and we know what happened, we’re still profoundly affected by this. Now back to your Business Plan, firstly let me tell you a thing, if I or anyone on earth, in particular my fellow traders here, had a certainty on a price move one day, we would be billionaire that day (or in jail for inside trading…): there’s no certainty on the markets otherwise there would be no market. Secondly, let me tell you about a guy, another genius, I know in London. The old chap manages for a living the 21 flats he has purchased at Canary Wharf, London’s financial centre where the UK headquarters of Citi, BofA, HSBC, Morgan Stanley, formerly Lehman, Credit Suisse,… are, plus a couple of them in the city (Goldman, UBS, Merrill,…). He got pretty easily the mortgages paid by the rents he receives from his tenants. I guess that the positions of his two sons, both senior executive at respectively Morgan Stanley and Lehman for a decade each helped, but also the fact that “historically the House Prices in London double every 5 moving years”. The old chap contacted me (Sauros real estate agency, I don’t why people tend to contact me when there’s a topic about their investments) at the end of last year after Lehman’s collapse, wondering if I knew people interested to rent one of the 3 flats he had available as the tenants, mostly bankers working at Canary Wharf, left suddenly. By the way, I learned that his sons left the banks in early 2008 and headed for a career in tourism… Another thing, your +40% profit is a paper one as on the residential real estate market, while it is not banked, it is not a profit: it’s a illiquid market where the price of your house is not the market price but close to the higher firm bid you have on it (when you have a bid).
By the way, sorry to interrupt but could you please pass me the salt?”

But as the girl was staring at him with eyes full of hearts, I just said: “Sorry to interrupt but could you please pass me the salt?” I probably missed the opportunity to make finally a friend as I’m sure I would have appeared as a kind of saviour to him and that he would be happy to go and lunch with me on a regular basis after this.

Actually, he raised two interesting points:

- Firstly, the point is about leverage. The leverage is the notional amount of assets you invest in compared to the actual money you invest. All the mortgage business is banks granting you leverage to invest and any trader knows theoutcome of a price action that goes against a highly leveraged position. I don’t say that the house price will decrease, I don’t know, I just say that most of people that acquire houses are speculating on the increase of the house prices with a high leverage (5 times assuming 20% of down payment) on a consequent part of their wealth and of their future income and most of the time without being aware of it. As a trader, would you go long (or short) the S&P 500 with a leverage of 5 on 30% of your future income for the next 20 years just because you have the convinction that it will increase (or decrease)? On the other side, for speculators, that could be seen as a major advantage of the real estate market: you are granted a leverage to speculate and this for size! It’s a bit difficult to imagine ourselves going to see the banker and borrow £500,000 over 20 years to trade S&P or to make it at poker while I believe that to the expert, trading or poker are a safer business than real estate to the non-expert most of us are. Basically my point is that real estate market can provide you a leverage you can’t get in another market. Wait… A leverage that can’t be got in another market? Well, actually I’ll need to talk to you about the financial spread betting which is a kind of futures market for individual, allowing investors to take exposures on various markets as would do any hedge fund of millions just with a few grants. If the futures, derivatives and other weapons of mass financial destructions are compared to the A-bomb, spread betting would be the financial machine gun of the individual investor. I’ll post something on it one day but it’s not today’s topic.

- Secondly, it raises the question of investment and trading on the real estate market. I tend to share the opinions of some Banks economists, notably the ones of Goldman seeing a “fake bottom” in this spring’s rally (see the slight peak on the Case-Shiller US National chart) arguing that the recent increase was due to temporary factors, mainly government stimulus programs and there’s uncertainty on what happens when the programs expire or wane (this said, one could say the very same with the rally on stock markets including Goldman’s share). The other thing is that the real estate market is much slower than the capital markets, with much more inertia, a trend can spend years to develop, so basically I think we can wait for a few more quarters before it grows again in a sustainable way.

I’m pretty bearish on the real estate market but I’m currently considering going … long for a long run play, particularly if we see another slump ("buy when everybody sells"). Frankly, nothing is decided at that stage and I'm still assessing the situation. How would I trade this? I might consider from next year onwards to apply the same pound-cost average technique I’ve used this year to go long equity. My guess was the crisis would last a while and that buying some equities every month, I would spend years to build a consequent stake and I would get some at the bottom. It looks like I was totally wrong on my guess and the length of the crisis (well we don’t know if it’s over…) but the thing is I managed to get as expected some stocks at the bottom and to benefit this year from the rally while building a stake. The same strategy applied to the real estate market could be a big winner particularly in the scenarii where inflation sets in on the long run. Alternatively I might do the very opposite and short while it decreases the current exposure I have. As you can see, it's pretty clear in my mind : I might go long or short or do nothing I don't know.

What would I trade to take an exposure to real estate? While I “own” a property I got with an infinite leverage (100% mortgaged, 0 down payment) and try to make a positive carry with it (I try to make sure the rents I receive more than compensate the mortgage I reimburse) and I’m under the process to purchase another one, this time with no leverage at all I’m paying cash, I’m generally pretty reluctant to purchase “real” properties. The one I first purchased appears to be a lifetime deal, a bargain I couldn’t miss, the one I’m purchasing now is more for family reasons while it has a great profit potential, but I’d prefer now to go longer in a “synthetic” way, though funds or futures or ETF, I’m assessing what’s available. Going “synthetic” rather than buying a “real” house will allow me to set up my pound cost average strategy, buying a few square meters synthetically every month, step by step, no need to worry about finding tenants, changing bulbs,… and if I urgently need cash, I can just sell a few square meters rather than the whole house. This last characteristic of the “real” real estate market explains why one can find very good bargains in the purchase of “real” houses: the owner needs cash urgently and needs to sell at ANY price, even if he/she has an outstanding profit... on paper.

A word on the Commercial Real estate market further to a chat I had a couple of days ago with Batman, the dark trader of Analyze Capital LLC. It looks like the whole market has been expecting a crash on the Commercial real estate market for a while, actually just after the subprime crisis. The situation on this market is bad, but we all know it for ages and to me on the one hand it has been broadly discounted, and on the other hand, I think that FED will make sure a crash won’t happen here using for instance the TALF program.

Finally to summarize, that was a lunch that led to many thoughts (not really easy to digest…). Today at lunch, the conversation next table was about the way divorced women should deal with the education of kids and I’m currently preparing my next post on this.