Boom times: Peter Esho goes beyond the pandemic

The housing boom won’t last forever – buy what you can best afford today and watch the economy settle into its post-pandemic rhythm

Each year I spend time reading through Warren Buffett’s annual shareholder meeting to see what’s on his mind and where he sees risks in the global economy. I remember attending the meeting in 2007 – it’s a spectacle. Buffett is not only a great investor but a master businessman. He doesn’t consider himself a stock picker but instead as someone who invests in businesses. His 2021 meeting took place on May 1 and something very important stood out to me. The threat (or opportunity) of inflation.

“We are seeing substantial inflation,” Buffett said. “We are raising prices. People are raising prices to us, and it’s being accepted.”

He pointed to much higher steel costs impacting Berkshire’s housing and furniture businesses.

“People have money in their pocket, and they pay higher prices ... it’s almost a buying frenzy,” he said, noting that the US economy is “red hot.”

I believe inflation is the single biggest current threat to your wealth and quality of life. But it’s also an opportunity. While inflation hasn’t yet been a problem, it is about to absolutely explode.

Threats produce opportunities

John Rockefeller was the richest man in US history. However, what most people don’t know is that before he got into the oil business, he was in a partnership trading commodities, mainly agricultural products, from a warehouse in Cleveland, Ohio. His first big business break came right after the civil war when inflation sent the price of everyday goods skyrocketing.

The northern US states fared much better and reaped the rewards of inflation. Rockefeller and his partners saw their profits quadrupled in the first year after the war.

This reminds me very much of 2021. We’re seeing a boom period following the severe economic shock of Covid-19. The global economy is starting to react as though we have just come out of a large world war. In fact, the economic downturn we saw early last year was sharper than what we saw during World War II.

The recovery is in the early stages and some of the world’s wealthiest and most successful investors, like Buffett, are telling us that inflation is here. Doing nothing and staying in cash is the single biggest risk to your wealth and quality of life.

Inflation is a hidden tax that can quickly reduce your wealth if you aren’t ready for it. The price of goods goes up quickly and if you don’t have offsetting factors – such as more money and rising asset prices – you can fall behind quickly.

The best way to prepare for inflation is to have sources of income that rise with it. Salespeople generally earn a commission on the goods and services they sell. They’ll do even better if they earn their commission on the value of assets they buy and sell. For example, a 2% real estate commission is relatively inflation safe. If the value of a house goes from $1 million to $2 million, the sales commission rises in proportion from $20,000 to $40,000.

This applies not just to real estate, but many other assets or business services. It’s probably a good time to sharpen your sales skills if you’re in the workforce. By comparison, high-service jobs, ripe for disruption, will be hardest hit. If you cast your eye over the last time we saw high inflation, it was jobs in the manufacturing industry that took a tumble.

Western countries have little manufacturing remaining as a proportion of their economy. So “lazy services” will be the first thing people stop paying for when inflation becomes rampant. If you’re a dentist, optometrist or architect, then things could get tough if you start losing your pricing power to cheaper alternatives.

Start planning and investing

You need to start thinking about the ramifications for your primary sources of income if we do see the price of assets and goods start to rise. Supermarkets like Woolworths will be okay because most people will just end up paying whatever price is dictated. Government workers should in theory be protected by unions and bargaining positions, but there could be a lag and ceiling on income gains.

Having investments that generate income is important. Real estate is the most obvious inflation-hedged asset and rental income from residential real estate is relatively stable, so rising inflation should translate into higher rents. Dividend-paying stocks like Woolworths are also a good idea.

Other benefits from property rises

You’d have to be living under a rock to not notice the big rise in real estate prices across major metropolitan cities. We’re seeing similar movements in the UK, Canada and the US as economies return to some level of normal life again.

It’s not just major metropolitan cities, either. Research from property data company CoreLogic in May showed monthly prices in regional areas jumped 13% compared with a 6.4% gain in capital cities.

CoreLogic analysed the 25 biggest non-capital city markets and gave Richmond-Tweed in NSW the top gong for gains across both houses and units, with 21.9% and 15.5% annual growth respectively.

It’s not just houses themselves rising in value. Timber prices have also been booming. As at the time of writing, lumber futures in the US market have broken a record,

surging beyond $US1700 per thousand board feet for the first time, a meteoric rise for a commodity that was sitting below $US400 this time last year.

Many have been asking me: how long can these rises continue and are recent gains sustainable?

It’s all about interest rates

If you want to know the future of real estate prices, keep a close eye on interest rates. Most people think of bricks and mortar, but, really, when we buy and sell real estate, we are trading for dollars and these dollars are dependent on what happens to interest rates.

Real estate prices are rising because governments want them to rise. They encouraged central banks to cut rates to unbelievable levels last year.

So far, it’s working. The UK and Australia announced huge government stimulus for housing projects, such as home building grants and stamp duty discounts. This is all intentional.

When house prices rise, so do many other things in the economy. Housing has a big push factor. Workers demand more money from their bosses, these bosses start to put up their prices and so on.

Low interest rates have one purpose – to push up asset prices. Real estate is the largest asset class in the world.

What we learnt from the 2008 US housing collapse is that when markets are left alone, without government controls, they can blow up spectacularly. The sustainability of this boom will come down to close monitoring of the banking system and checks to ensure things don’t move up too quickly.

We’re likely to see interest rates remain low for some time, but there will be close monitoring on the levels of debt ordinary investors can take out.

For example, most banks have a hard debt/income ratio of seven, which means the maximum amount of debt a borrower earning $100,000 can take on is $700,000. The higher the income, the more debt.

As house prices rise, debt/income ratios will probably remain the same. This means some price points will be more sustainable than others. As an investor, stick to markets where the median price of the suburb/area is similar to the debt/income ratio of seven (for example, a $700,000 median price where salaries are $100,000).

Houses will soon become unaffordable in many major cities. Apartments will be next to move because of low rates and hard rules on debt/income ratios.

There will be income growth, too. Don’t discount the ability of a $100,000 annual salary to become $140,000$160,000 within three or four years as the pandemic winds down and economic activity picks up.

I know what you’re thinking ... wage growth is nonexistent and most economists are expecting low growth in the coming years. That’s true, but the job market is improving faster than expected. The forecasts could change quickly and I wouldn’t hang my hat on wages remaining low forever. At some point, things will quickly shift. The government secretly wants wage growth because it brings with it higher taxation, which is needed to pay off record debt.

A $50,000 salary rise can add $350,000 (using our seven multiple) to the borrowing capacity of a home buyer. All of a sudden, they can go from borrowing $700,000 to $1.05 million if the debt/income ratio remains at seven.

Small changes, big difference

The most important thing in real estate investing is stepping away from your own limiting thoughts and acknowledging the big picture. Investors make money based on the future and changes in future expectations. It’s about how tomorrow will change, not yesterday.

Things can sometimes look crazy at face value, but there is often a good explanation. The cost of money has never been this cheap in modern history and the level of government support during 2020 is unprecedented.

There are consequences to creating cheap money and that often includes higher house prices. But with that also comes a new reality: more income, more tax revenue and a reset in what we think is expensive or cheap.

Residential real estate, supported by good fundamentals and backed by solid rental income, is always a good investment option. Buy the best quality real estate you can afford.

Start small, think big and keep growing.

A $50,000 salary rise can add $350,000 to the borrowing capacity of a home buyer