Is successful real estate investment like judging a beauty contest?

Successful real estate investing involves analyzing cashflow and obtaining a return on investment independent of resale value.

OCHN-rating-10Imagine you lived in a place where real estate was the only viable market where you could invest money. Further imagine that properties in this real estate market that had no expenses and no income. If this were your world, how would you go about selecting which property to invest in?

In such a market, you only make money if someone is willing to pay you more in the future than you paid today. Since the investment offers no other metric for returns, speculation on future values is all you have to work with. What criterion would you use to select your properties? If you’re looking for a beautiful real estate investment, be sure to check out Option Achat.

Most people would look at short-term changes in price and extrapolate it infinitely into the future. This buying behavior becomes self-fueling, and investing with this strategy is the basis of all financial bubbles. In other words, it’s pretty foolish.

Behavioral Finance Theory

The more savvy speculators realize in such circumstances the way to make money long term is to solve the beauty contest dilemma.

Keynesian beauty contest

John Maynard Keynes wrote a book called The General Theory of Employment, Interest and Money. In the book he compared stock markets to beauty contests. During the early 1900s, the London newspaper would print 100 photos of beautiful women. Contestants were asked to pick the six women they found the most beautiful, and everyone who picked the most popular woman would win a

If someone really wanted to win the prize, they didn’t seek to pick out the woman they found most attractive. To win, the contestant had to select the woman everyone else thought would be most attractive. To be a true master, one had to go even further. Keynes put it this way:

“It is not a case of choosing those [faces] that, to the best of one’s judgment, are really the prettiest, nor even those that average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practice the fourth, fifth and higher degrees.” (Keynes, General Theory of Employment, Interest and Money, 1936).

This is how a purely speculative real estate market would work. The successful speculator would identify those properties with the characteristics more desirable to everyone else playing the game.

Where Prices Start at $115 Million: Bel Air’s Trophy Home Boom

In Los Angeles, price tags for ultra high-end homes—many of them speculatively built—are topping the $100 million mark. Is the big ticket just a gimmick?

The only thing missing: a crowd of buyers who can afford to live in them. The Park Bel Air, the 11-acre development currently under construction, has asking prices that start at $115 million—and go up to $150 million with upgrades and custom furnishings.

“There are probably only about 3,000 people [in the world] who can afford this,” says Barry Watts, the Los Angeles-based president of Domvs London, the Park Bel Air’s developer. The buyer “needs to be a billionaire.”

That’s a thin buyer pool!Hollywood_HELOCs

In Los Angeles, the latest trophy homes—many of them speculatively built—may top the $100 million mark. Sales at eye-popping prices have been fueled partly by wealthy international buyers who traditionally shopped for second homes in places like New York, London or Monaco, but have lately turned their sights on Los Angeles.

Why would anyone build spec homes for a buyer pool of less than 3,000 people in the whole world?

They’re playing the beauty contest game.

China’s beauty contest

You may have noticed from my hypothetical example the parallel to the reality in China today. Chinese have few viable investment alternatives, far fewer than we have here in the US. Their stock market is volatile because hordes of unsophisticated investors buy anything that rises and sell anything that falls. Many average citizens prefer the tangible simplicity of real estate investing.

Most real estate in China has no cashflow. Rent is very low relative to the cost, and many speculators don’t bother renting the properties out. China’s ghost cities are well documented.

Ponzi_wineThe real estate bubble in China is truly epic by any Western standard of value including price-to-rent or price-to-income, the two best measures of real estate value. What sustains China’s bubble is an ongoing willingness of Chinese banks to fund the beauty contest disguising the Ponzi scheme.

The rules of speculation that work in China are very different than what works here in the United States. Here, real estate is taxed heavily and expenses are high. The rent varies considerably by location and house price, and the path to success in the United States is to ignore the beauty contest and focus on cashflow.

(See: Contrarian investing in cashflow real estate a strategy for success)

Exporting the madness

Like the California equity locusts of the housing bubble that inflated house prices in second-home communities across the Western United States, the Chinese equity locusts are inflating house prices in those foreign markets Chinese speculators deem beautiful. Since their markets don’t move on cashflow, it’s not an investment style many of them understand, so instead, they seek out trophy properties here in the US with prices that make no sense by any valuation metric.

They exporting their beauty contest.


So Much For Your China Housing Bubble

Kenneth Rapoza, November 2, 2015

When will they get it right? Maybe if they keep getting booked on CNBC or writing for Bloomberg View about the pending implosion of China’s housing market it will, at long last and by some twist of fate, come to pass.

Or not. …

China’s housing market, unlike the bubble market in the U.S., depends on a growing urban migrant community, rising incomes, and cash-rich investors who are required to put down at least 20% or more on a property. By contrast, the U.S. housing bubble started from sub-prime lending and its derivatives market, whereas investment banks were trading junk mortgages like they were stocks. The Chinese does not have a large mortgage backed securities market that could take down large investment houses, nor does it have a sub-prime lending market. It is hard to find news of Chinese home owners being foreclosed upon by lenders. In short, the bubble in China is nothing like the bubble in the U.S. and Europe.

cashflow_positiveHe’s right. In many ways the housing bubble in China is nothing like the US. The main difference isn’t in the factors he outlines above. The main difference is that China’s real estate isn’t anchored in tangible cashflow. There is nothing backing the loans on Chinese real estate other than the promise of the borrower to repay. There is no underlying cashflow that serves as a basis for value.

Here in the United States, if house prices fall below cashflow values, investors come in and buy the properties because they can rent them for more than the cost of ownership and obtain a predictable return on their money. In other words, there’s a legitimate financial reason for prices to find support at certain levels. Not so in China.

In China, they built $500,000 houses in areas where the local population lives in shanties on $3,180 a year. If these markets were revalued by Western standards based on cashflow, the results would be devastating. Measure our bubble and multiply the problem by 12, and you start to understand what’s been going on in China over the last two decades.

A 90% reduction in prices is necessary just to bring priced down to where they were as inflated as our bubble was during 2006. Cut that in half again, and a 95% decline in Chinese house prices is a very realistic scenario.


Perhaps the Chinese can continue playing the beauty contest game forever.

Perhaps cashflow isn’t the basis of real estate value.

Perhaps the flow of Chinese cash will sustain house prices in trophy neighborhoods in Coastal California.

Perhaps everything I believe about real estate value is wrong.

Or perhaps not.

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