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Smoke and MirrorsOlly Newland's Column, September 2008
The Reserve Bank of NZ lowered the official cash rate by 0.5% and that's good.
It will not solve the credit crunch. We are caught in the slipstream of world events and, short of discovering huge oil deposits in the middle of Wellington Harbour, we will continue to be buffeted by the collapses and bail-outs that we have seen and read about -- locally and offshore. As I write this, several big US financial institutions have collapsed or are on the point of collapse (Lehman Brothers, Merrill Lynch, AIG just the latest) in a string of events that, collectively, are unprecedented since the depression of 1929. There will be more to come, you can be sure of that. All this was doubtless caused by the smoke and mirrors created by whiz kids with their new forms of financial instruments (derivatives of mortgage pools, Consolidated Debt Obligations etc) that nobody really understood... least of all them. Even more astonishing, the pillars of the banking world (Barclays, Chase, UBS, et al) bought them hook line and sinker.
As I have alluded to previously, the financial world has become a vast gambling den, dominated by those who delight in creating complex deals, rather than simply investing and getting fair profits in return. If there is one thing to learn out of this credit crunch carnage it is this: 'Keep it simple' Write that on your office wall and remind yourself of it every day. On the local front, the coming General Election will tend to fudge matters as many eyes will be on the polls and the results. The Ancient Romans used the same trick to appease the masses with 'bread and circuses'. It is my view that we are entering a quieter phase right now -- but it may only be temporary. Early next year, well after the election hype has died down, the new government will have to face the realties of the marketplace -- and it won't be easy.
Political considerations
Labour governments generally spend like crazy to keep the workers happy and hang the consequences. This then flows into the pockets of investors until we finally get a 'Big Bang' (such as now) and things all get terribly messy. Then the party is over and we all go home with hangovers. Next, National has to come in and clean up the mess and in doing so often has to dish out unpalatable medicine -- we all don't like it, but we have to take it because we know it's good for us. This has been the pattern in the past, and will in my view likely be the pattern again.
The Finance Company Fiasco
I predicted this scenario in my book The Day the Bubble Bursts but even I am staggered at the ferocity and the speed of events as they continue to unfold. Flowing directly from these financial fiascos is the evaporation of billions of dollars of purchasing power, either lost for good or locked away for the duration. The lifeblood of the property and development industry has been choked off with the unfortunate flow-on effects of job losses, soaring mortgagee sales, and record bankruptcies and receiverships. As the facts are revealed and the lax practices of some of the financial cowboys exposed, one can't help but wonder how it was possible that with all the expertise available to them, they could have got it so wrong. I have seen all this before. This nightmare takes years to work through the system. It will be many more years before we can enjoy the sort of boom we've all benefitted from in the recent past. We will be lucky if the market just hovers above flat-line for the foreseeable future.
Skulduggery
In some cases it worked like this: (in very simple terms) Dodgy Finance Co would issue a prospectus and raise $100M from Mum and Dad investors. 'First Ranking Fully Secured Debenture Stock' these investments were pompously labelled. (More like 'First Ranking Rubbish Secured Against Thin Air', I would say.) Dodgy Finance Co would make a deal with the Bent Developers Co to launder the $100Million in such a way as to make it appear as being a good deal all round. Bent Developers wanted (say) $70Million to buy some bare tussock land by a weed-choked lake and to erect 1,000 shonky houses to on-sell to dummies for a huge profit in three, four or five years time. Dodgy Finance would say 'Here is the $70Million you want, but you must sign up to pay us back $100Million -- being capitalised interest, our fees, and a share of your profits.' Bent Developers would duly agree and, Hey Presto!, Dodgy Finance could claim it had made a instant $30Million profit! Then Dodgy Finance Co could take $20million out in cash and pay it to the promoters of the debentures (the directors often enough) while the remaining $10Million would put aside to pay the investors 'interest' so as to keep them quiet until the next dollop of investment money came in.
So no real profit was made at all. The whole scheme came unstuck, of course, when the market for shonky homes located by weed-choked lakes dried up and stopped selling to the gullible public. An implosion can happen just as quickly as an explosion. Hence we have the current finance company debacle and the flow-on or knock-on effects. These will reverberate for years to come. But wait! It could get worse.
Moratoria
If they manage it, then I will be the first to cheer. Really. We property investors need imaginative finance companies, rather than po-faced trading bank managers, to assist us with the more risky, unconventional deals (but not crazy, off the planet ideas). We need their help to fund the deals which can make investing so much more challenging and rewarding. I have to say that to date the few finance companies that have struggled to their feet again, have come up with some pretty bizarre schemes. Some of the proposed arrangements, simply put, swap an investor's deposit for shares or some other security which will take a lifetime to collect in full -- if ever. Better than nothing I suppose (in some cases, barely) but they're really akin to burning the furniture to keep the house warm. However, we must remain vigilant. Back in the aftermath of the Crash of '87 (and the late 70s as well) when similar collapses occurred, one of the schemes tried was simply an attempt to rort the investors with smoke and mirrors. For example I was caught up in a scheme in the late 80s where ABC Finance (not their real name) which was about to go into receivership, tried to get out of the strife by claiming to inject a large amount of money out of the pockets of the directors and so recapitalise the company anew.
Now you would say, 'That's great!' What the directors came up with was a deal where they, the directors, would give to ABC Finance a huge lump of bare land which they had had valued by a (friendly) valuer at $300Million but which 'only' had a $200Million mortgage over it. 'Look' they cried. 'Here is our capital injection. There is an equity of $100Million which we are giving away to help the company onto its feet again.' Needless to say, raspberries all round was the response. I just escaped from that mess by the skin of my teeth and soon after ABC Finance went under, as it richly deserved. (They still owe me $13 million plus interest but aren't answering calls.) Keep an eye out. It wouldn't surprise me if this idea was tried again.
The Knock-on effect
I sincerely hope they are right -- but my logic tells me that it will take longer than that.
Based on my experiences of the past, I believe it will take several years for the property market to come right. My advice to investors is to take any profits they may have now and cash them in -- or be prepared to hang on for five years, maybe even ten years. History teaches us that the market always does come right and in five or ten years from now, we will look back and laugh at the prices of property now as compared with the prices then.
I recall back in the late 70s making headlines and being paraded on TV because I predicted that houses would one day sell for a million dollars or more. This was when you could buy a nice 3 bedroom house for under $100,000.
The trouble is, we have to survive in the meantime in the market we live in -- and that fact has been lost on many, especially the developers who were bedazzled by the big numbers and not the facts.
What was the developer Dave Henderson of the Big Hole in Queenstown thinking with his stalled 500 house development? At this moment there are scores of other developers who have bet against the market, or gotten their timing very wrong -- subdividing and building around lakes near country towns or on thinly populated sea shores in the pious but deluded hope that the market will absorb everything -- no matter how big. I predict many more developers will go under in the months ahead as the market crumbles. Existing or potential buyers simply can't get the cash anymore. You cannot get blood out of a stone and no matter what, people who may have signed up to buy that romantic lakeside section (or that nice new townhouse) a few years ago, will be forced to walk away from their contracts because they simply have no choice! Up and down the country, tens of thousands of people are facing severe financial stress (ruin in some cases) because of finance company failures, developers' failures, business failures or just simply the credit crunch. This could take years to flow through the system so it could be years before the market recovers.
The only quick way out, as I see it, is to endure another round of hyper-inflation (also known as 'the speculator's friend') as this make people spend rather than save. After all, it is well known that rampant consumerism greatly helps the economy. Nevertheless, if you have cash or can borrow, and you have faith in your abilities, then there is a killing to be made in selected parts of the market today. Those who read The Day the Bubble Bursts will recall that I wrote a chapter on the coming 'tidal wave' of cheap and shoddy apartments. I said that they would end up being sold for fifty cents in the dollar. This has come to pass just as I predicted, and if I had the time and inclination there is one area of the market that I would be investing in right now. I would be buying up cheap, oversold apartments in the city centres -- those that aren't rubbish, of course. This market has had its correction early, and the prudent buyer could do very well indeed by trawling through the ruins with an eye to the future. In time we will all look back at today's depressed prices and wish we had bought truck-loads of them. One further caution: Buy only freehold apartments -- NOT those on leasehold land -- and with at least one dedicated car park each. Likewise, nice standard three bedroom family homes on full sites in leafy suburbs will be all the rage as more and more people end up in shoe boxes on the 25th floor.
Leasehold v Freehold
Now he can have taste of the medicine he has dished out so cruelly to so many innocents. But there is another lesson here: Never, ever buy residential property on leasehold land. It may be cheaper to get your foot in the door, but as I have explained in talk after talk and seminar after seminar, every year that ticks by on that ground lease brings the next rent review closer and closer. A new generation of investor is learning that while you fight to hold the value up (and even increase it), the ground lease pushes the value down until it becomes virtually unsaleable. Stick to freehold and never be tempted.
Conclusion
Having seen these false dawns before, and having been bitten hard by them, I tend to remain skeptical -- but hoping that this time I will be mistaken, and we really are turning the corner.
My advice: Remain cautious for the time being. Get out and look for bargains, by all means as I said last month. If the market really is improving, it is better to be a day too late than a day too early.
Olly Newland
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