A Roadmap For the Future

In our previous presentations, we admittedly watered down our thesis to make it as simple as possible. But we dont think this is fair, especially for our investors who are already on board. We want you to be able to delve deeper into our thought process and show you what distinguishes us from the bozos that can make the same real estate is cheap because of the return on investment argument. To be quite frank, this isnt a sophisticated argument, and surely not something that should engender your confidence. We are quite positive that we are seeing this crisis, and concurrent opportunity in real estate, in a way that not even hedge funds and private equity firms are. This presentation is admittedly going to be harder to follow, but were confident that those who can follow along will be 100% on board with our thesis. So here goes.

The Classic View of Real Estate

First of all, real estate is an asset unlike any other because it affects the masses in a way that stocks, commodities, and even bonds dont. The equity in a home is perceived as savings, which means rising home prices will lead to a rise in consumption. But the same dynamic that makes real estate such an engine of growth in a bull market makes it an engine of economic destruction during a bear market. The latter is what we face today.

Home Prices vs Consumption (1987-Present)

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Dont listen to real estate agents who only understand 3 and 4 year cycles: the big cyclical declines in real estate take decades to recover from. Yes decades. Classic indicators like cap rates, ROIs, etc. are immaterial in the current environment for a number of reasons. First of all, in large-scale real estate collapses, cap rates and ROI projections are favorable even as home prices continue to plummet. Your entire equity can be wiped out even with historically favorable cap rates, especially if you panic and mistime your sell. So lets leave ROI projections alone for a second and think this real estate investment through on a higher level.

The Real Estate Cycle

The real estate cycle is fractal in nature, but most real estate investors only understand the minor oscillations. Unfortunately, what we face today is one of the huge oscillations that occurs every couple of generations. The basic cycle is 60 years of generally rising prices followed by 20 years of generally falling prices. The data is a little incomplete for home prices in the U.S., and to understand the cycle you need to read historical texts, but it is a valid cycle. Heres a chart from 1900 to present that shows the general cycle.

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The good news we can extract from cyclical analysis is that the worst of the decline is probably over. But can we see a 10% drop from here nationally? Of course. In fact were expecting it.

Capital Flows: The Key to Understanding it All

People in the U.S. think from a domestic perspective, and this has been a flawed approach since we entered the floating exchange rate system. What people forget is that the value of currencies is no longer fixed, so this adds another variable to the equation. Large inflows and outflows of capital invariably affect our domestic economy, and this is critical to understand as we face a debt crisis of mammoth proportions. Stage 1 of the Debt Crisis The first stage of a debt crisis is a flight to quality. During the Great Depression, Europe was mired in a debt crisis similar to the one we are experiencing today. Because investors feared widespread defaults in Europe, capital flowed to the U.S. because it was the #1 creditor nation at the time. In a gold standard, current accounts are balanced by inflows or outflows of gold, so being the global creditor was a sign of health. This is why capital flocked to the U.S. Today, the U.S. is the #1 debtor nation, but capital is still flowing to the U.S. Why? Well the U.S. dollar is the reserve currency of the world and we have the deepest markets. For now, there is nowhere else to hide. The situation in the UK and Japan is arguably worse than ours, so there is no reason for capital to flow to any other currency. Stage 2 of the Debt Crisis Stage 2 of the debt crisis is a eureka moment for the entire world. This is when people realize that even the perceived safest country/currency (in this case the U.S.) is not safe at all. During the Great Depression, the U.S. economy stagnated for over a decade because capital inflows eventually turned into capital outflows. But dont conflate economic strength with asset strength. Capital during this stage fled sovereign debt and found its way into stocks and real estate. So paradoxically asset rose while we entered the 2nd stage of the Great Depression.

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Dow 1932-1937 (Stage 2 of Debt Crisis)

2012 (We are in Stage 1)

Credit is easing in part because banks have improved their balance sheets. But whats often lost in the shuffle is that the crisis in Europe is sending capital to America, and this capital eventually finds its way into the hands of consumers. Think of this as a temporary reprieve.

Consumer Credit Outstanding

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Foreign Net Direct Investment

Stage 1 is basically a flight to quality, which in the current environment means the dollar, U.S. Treasuries, and gold. Simple stuff. Stage 2 is where things get interesting.

The Reversal of Fortunes: Stage 2 of the Debt Crisis

Stage 2 of the debt crisis is when the U.S. will be deemed to be unsafe by investors because qualitatively it is no different from any other debt-ridden country. What this means in investing terms is a decline in the dollar, a sharp rise in Treasury yields, and a rally in in gold. Well see stage 2 sometime in the next 35 years. How Does this Relate to Real Estate? As of now, lower Treasury yields mean lower mortgage rates. Initially, capital inflows will boost real estate to an extent, but this rise will be counteracted somewhat by a stronger dollar. So nationally, only the most distressed markets should rise in the next 3-5 year cycle. NYC is in trouble, we cant belabor that point enough.

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30 Year Fixed Mortgage Rates

In stage 2, generally you see a flight out of anything government. In theory this includes real estate, but heres the problem: No one will be able to obtain a mortgage! If you thought 2008 was a credit crunch, wait until you see the credit environment in 2016. So after a temporary boost in real estate prices due to foreign capital inflows, there should be renewed weakness in real estate. And this cycle should last somewhere along the lines of 10 years. So it seems like were contradicting ourselves, huh? Well heres the paradox. Even though we probably arent buying real estate at the bottom, buying real estate now at historically low mortgage rates and at low prices is the best strategy for buying real estate when the bottom does hit. After all, whats your alternative, 10-year Treasuries yielding 1.5%? Lets get real here.

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But anyway, heres a standard leveraged deal.

Purchase Price: Down payment (20%): Mortgage:

$50,000 $10,000 $40,000

Income Gross Income (5% Vacancy Rate): $8,550 Expenses Annual Expenses Annual Mortgage Payment ROI Cash on cash return: Cash return:

$3,330 $2,432.09

$2,787.91 27.88%

Imagine now that you have $50,000 to invest, and you leverage this across 5 homes. Over 5 years your positive cash flow will be $69,697.75. Furthermore, your loan amortization will be $17,684.15. Now lets assume home prices fall 10%. Your equity will still be roughly $112,381.90. You have ownership of 5 homes, which are being paid off with your cash flow, and the ability to purchase a 6th home free and clear. Now lets assume you buy bonds because you want to be safe. Investing $50,000 for 5 years would give you a whopping $51,569.34. One home in 2012 is still one home 5 years later. Is it really wise to wait for the bottom in real estate?

Conclusion
Our strategy is to obtain fixed-rate mortgages to purchase real estate at fair prices because of the cash flow these properties throw off and NOT because we think this is the absolute bottom for the entire cycle. It is more accurate to say that 2012 will be the bottom in this countertrend cycle. With this accumulated cash flow, we will be one of the few people who can buy properties in a tight credit environment because we have cash. We will be buying at the bottom and at the start of a new upward cycle.

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This is the long-term perspective, and this is the strategy that will probably yield the greatest returns by far. A huge crisis awaits us. Believe us, the smart money is thinking in the terms we laid out above, and they are acting accordingly.

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