Published 12 January 2007
I liked the intro: “Of all the â€˜investments’ one might make at this time, one of the best may be to be prepared for a breakdown of the economy as we know it. This is not necessarily a prediction – any more than having fire or flood insurance is a prediction that you will have a fire or flood.”
It was the opening to a feature on the contrarian Daily Reckoning website, The ultimate contrarian investment for 2007. I read the piece then went to the New economics website of the author, Nathan Lewis, wanting to find more about him.
There, I discovered 2 articles Mr Lewis wrote in 2006 on valuing real estate which, despite being for an American audience, seem as apt here.
In his March 2006 article, How to value real estate, Mr Lewis began: “A person can go through life and never buy either a stock or a bond. Given the level of investing knowledge of the typical nonspecialist, that might be a good strategy. However, everyone has to live somewhere, and virtually everyone thinks about buying a house at some point. For most people, it is their biggest financial undertaking. Yet, after 2 decades of consumer finance magazines like Kiplinger’s or Smart Money, most people know more about stock & bond valuation than they know about real estate valuation.”
In some detail, but easy enough for a layman to understand, Mr Lewis proceeds through a valuation exercise, with comparisons to share returns along the way.
Then he discovered that, “apparently some economist types have recently come up with a â€˜new’ way of valuing real estate, based on discounted cashflows. This justifies property values much higher than the sort of methods we used a few weeks ago, which are the methods smart investors have used for decades.” So he wrote his second property valuation piece.
What caught his eye was the New York Times story on a March 2006 paper by 2 Californian academics, Margaret & Gary Smith, of Pomona College, Bubble, bubble, where’s the housing bubble? for the Brookings Panel on Economic Activity.
In the abstract they wrote: “Housing-bubble discussions generally rely on indirect barometers such as rapidly increasing prices, unrealistic expectations of future price increases & rising ratios of housing price indexes to household income indexes. These indirect measures cannot answer the key question of whether housing prices are justified by the anticipated cashflow. We show how to estimate the fundamental value of a house and use unique rent & price data for matched single-family homes in 10 metropolitan areas to illustrate this approach.
“These data indicate that the current housing bubble is not, in fact, a bubble in most of these cities in that, under a variety of plausible assumptions, buying a house at current market prices still appears to be an attractive long-term investment. Our results also demonstrate the flaw in models that gauge bubbles by comparing movements in housing price indexes to movements in other indexes or to values predicted by regression models.”
Mr Lewis wrote: “Whenever assets are highly priced, whatever they may be, there will inevitably appear elaborate & sensible-seeming justifications for the present pricing. Remember Dow 36,000? It appears to me that the authors of the paper just wanted a handy justification to buy their â€˜dream house’ in California, despite the fact that the market is overpriced.
“To summarise, the authors argue that rental income tends to rise over time, while the coupon on bonds remains stable. Thus, even if rental yields are lower than mortgages on the same property today, that lack of cashflow today would be made up some time in the future as rents rise at their average annual pace of 3% or so. Similarly, it may â€˜make sense’ to buy today even if the monthly cash cost of owning a property is greater than equivalent rent, because the monthly cash costs would be stable while rents could rise.
“Actually, that’s true – and it explains one major reason why homeownership (& investment-property ownership) tend to be good long-term investments. The problem, of course, with pricing property on that basis is that such pricing eliminates the advantage!”
Mr Lewis then went through a 30-year discounted cashflow model â€“ and the ensuing problems.
The Smiths are both longstanding academics with high-profile careers â€“ Mrs Smith was an intern for Senator John Kerry in 1988 and went on to Yale & Harvard before teaching at Pomona, and Mr Smith has published a long list of papers
But detail about their critic has proved more elusive. The Daily Reckoning said Mr Lewis was formerly the chief international economist of a firm that provides investment advice to institutional investors and is now part of the investing team at an asset-management company. He’s written for numerous publications and appeared on various financial programmes around the world, and on his own website he writes about economics & other matters, usually posting new material at the weekend. His website says nothing about him â€“ and my check on the Lewis archive website, Nibiruresearch, led me to the search for planet X (or Niburu as the ancient Sumerians apparently called it).
Websites: New World Economics
9 April 2006, Valuing real estate version 2
19 March 2006, How to value real estate
March 2006 Brookings paper, Bubble, bubble, where’s the housing bubble?
Attribution: Websites, story written by Bob Dey for this website.