Wednesday, March 21, 2012

A Home as an "Investment"

Benjamin Graham qualifies the difference between an investor and a speculator: An investment operation is one which, upon thorough analysis promises safety of principal and an adequate return. Operations not meeting these requirements are speculative.” The difference between these two concepts only makes sense in retrospect.

An investment depends nearly entirely on the acquired price. By not paying too much for a given asset one obtains a sense of security that the original principal balance will not be eroded, known as a “margin of safety.” Investors believe that over the long-run security prices reflect fundamental developments involving the underlying business/asset.

Speculation, on the other hand, is a belief that future demand will be higher (or supply lower) than today’s, commanding a higher price in the future. Speculation is a belief that one can predict the behavior of others. Speculation offers the prospect of instant gratification.

There are reasons to believe that a home is an investment, despite the recent legacy of too many people being burned as a result of speculation. Though both an investor and a speculator can believe that their acquired price is lower than the sale target, it is the investor (not the speculator) that can prove why their value-point makes sense. The speculator will, instead, merely claim that tomorrow’s environment will be better than today’s. Paradoxically, a buyer and seller can simultaneously believe that they are entering/exiting an “investment” at the optimal moment.

Further criticism is that tangible assets cannot have an implied fundamental value, because assets only have value for their productive use. “Gold bugs” argue that the price of gold is an inverse indicator of an eroding dollar (fear sentiment), while opponents will argue that one cannot infer, cannot assert that this is reason at all! This logic would follow that rental-yield potential (cap rate) of property is the only rational way of valuing a property, and can qualify as an ‘investment.’ This is how Warren Buffett articulated his investment thesis of homes.  

Similarly, homes are often called a barometer, a type of proxy for a local economy. The only trouble with that statement: are homes a leading or a lagging indicator?