When it comes to money, an absolute necessity is a really good “crap meter” because, by goodness, there is so much absolute nonsense said and written about money and investment.
The good news for me is that this provides an endless source of issues to write about, but the bad news is that many people seem to have some of the great money myths ingrained in their DNA.
One of my favourites is the oft-quoted “good property doubles in value every seven years”. This seems to be in the real estate agent’s training manual. But it has also penetrated the minds of many investors.
As with any good myth, there is always partial truth. Here the part truth is that at times property does double in seven years, but when it does, watch out, as we must be nearing the end of a boom. In our big east coast cities in particular, there is clear evidence that in some areas prices did indeed double from 2011 to 2017.
Here a well-developed crap meter is very handy. Let’s think about this idea that property doubles every seven years. To do this, property would need to grow at a bit over 10% a year.
A useful tool for all of us is “The Rule of 72”.
If some maniac tells you that an investment will double in value in a set number of years, just divide it into 72. So if property will double in value in seven years, divide 72 by seven and you get around 10%. Sure, it’s actually 10.285%, but 10% will do us just fine.
Now 10% may seem possible. As with any investment, in some years it happens. But our crap meter should be on high alert because common sense shows us the problem. In many cities, $1 million is a common price for a home.
Let’s apply the “double in seven years” idea. In seven years this house would be worth $2 million. That sounds possible. Seven years later it would be $4 million. That sounds unlikely. But in another seven years it would be $8 million.
And to my great amusement, as I love compound interest, if we jump forwards 21 years, our house is worth $64 million. Even better, 21 years later it is worth $512 million. Then you have to wait only seven more years for your house to be worth $1 billion.
And all of this happens in our lifetime.
Yep, $1 million doubling every seven years, takes 70 years to get there. So we can safely say that anyone offering us 10% a year, going on forever, is either unaware of basic maths, a fool or a crook. Take your pick.
Mind you, for investors and owners a property boom is a very pleasant experience. It also helps the broader economy, as even when people don’t sell they feel richer.
This increases consumer confidence and flows on to how we spend. The only losers are the first home buyers who saved diligently only to see prices go up more quickly than their savings.
But big jumps like this cannot be sustained. In the past a big jump in prices has been reversed by all sorts of economic events. Usually it has been a decent recession, such as the GFC of 2009.
Here, Australians were lucky as Chinese demand for our commodities exploded, saving us from recession.
But in many parts of the US property prices fell by over a third. At other times it has been very high interest rates, such as in 2000 when mortgage rates hit 18.75%. This time it is different. Interest rates are low but we have had low wages growth and the banks have turned down the lending tap, making finance harder to get.
Even in a tough property market, the property PR spin keeps on churning. I doubt we’ll hear the “double every seven years” line for a while, but I did read with interest a good result from an auction in Leichhardt, Sydney, on March 31.
I also like good news, so I was pleased for the vendors of a property that sold for $1,705,000, a healthy $105,000 above the reserve.
What interested me more was that they bought it new in June 1991 for $255,000. The excited vendors had sold for over six times what they had paid for it.
Stamp duty aside, renovations and selling costs, and just looking at the purchase and sale prices, how did they do on an annualised rate?
Well, despite buying at a very good time in the downturn of 1991 and seemingly getting a good sale price, they were well off 10% a year.
That would have given them a sale price of $3.6 million. But they did achieve, before any costs, an excellent return of a bit over 7% a year – this would have been some 4.5% better than inflation.
On a really good investment, history shows us that 3% to 5% above inflation, before tax and costs, is quite possible.
That is my long-term target on my money. But if anyone tells you about returns much higher than that, your crap meter should be on high alert.