In my letter 5 months ago, I discussed the “Black Swan Theory” whereby a surprise event shocks the system and later is inappropriately rationalized after the fact with the benefit of hindsight.  It seems in my investment career of 23 years, the recessions have gotten worse and the government intervention has been more pronounced.  A nasty downturn will indeed come but the timing and cause of the Swan’s seemingly sudden arrival awaits us which is why I’m always looking for ways to mitigate these future shocks.

That said, I am on the lookout for that diamond in the rough property to buy.  The prices keep going up (pushing capitalization rates down) as are the rents as the economy feels like it continues to gain strength.  As I talk with fellow investors, I have started hearing some of those old refrains, “there is a new paradigm” and amazingly “I don’t think this cycle will end.”  One of my favorite Warren Buffettisms is “be fearful when others are greedy and greedy when others are fearful.”  To be sure, this is a time to be cautious.

While official CPI inflation is quite low, the price of a candy bar just went up 8%.  Rents in Southern California, Atlanta, Austin and Berlin (the markets we still have properties) are also enjoying upward pressure.

The Hershey Bar Test: Do you remember what a Hershey Bar cost you when you were a kid?  Do you believe the price will continue to rise over the long term?

 

Similarly, there is a push in a number of states and cities to raise minimum wage.  In California, minimum wage last rose on January 1, 2008 to $8.00 per hour.  On July 1^st of this year, it went to $9.00 and on January 1, 2016, it will move to $10.00.  I believe that this will raise prices and inflation.

A sign in the window of a pizza restaurant in La Palma (Orange County), California

 

While it feels much like 2005 when I was a seller of US real estate and was investing my greenbacks in buying opportunities in China and Germany, I am a domestic buyer today.  Certainly the Central Bank policy has been a punishment to savers (a bank bailout on the backs of their depositors) and that policy continues to steal buying power from all of us today.  So why buy now when I screamed that the sky was falling in 2005?  At that time I believed there would be a housing bust which would gut the economy and our overleveraged tenants would not be able to afford our rents.

The economy today faces different challenges and I think we are more likely to see inflation in our rents which will translate into a higher valuation.  I also think currency preservation by buying hard assets which yield (i.e. rental real estate) is advisable in 2014 and the foreseeable future.  The wildcard is a steep rise in interest rates but as a hedge, I am being cautious with either the loan to value, the term of the loan or both.  This approach should allow enough of a cushion for staying power for when that downturn does come.

In specific markets, I believe like a Hershey bar, there will be long term demand for rental real estate and investment makes sense.  As there is plenty of greed out there, some healthy fear in structuring the purchase is advisable.

 

Kyle Kazan

Chief Economist

Contrarianomics

www.contrarianomics.com