Churchouse Letter
May 2013                   by Peter Churchouse

If You are Young, This May be the Best Opportunity You will See in Your Lifetime

Central banks are destroying cash based retirement nest eggs but encouraging you to hold real estate hard assets. Oblige them!

Inside This Issue:
Central Banks in many Western countries WANT real estate prices to rise. They will succeed. This is possibly the best opportunity in your lifetime to secure your longer term financial future in these hard assets. Grab it with both hands!
Japan’s policy of deliberately weakening the Yen has the potential to underpin local real estate markets. Real estate stocks have soared in both local and US$ terms. We maintain and closely monitor positions but are mindful of currency impacts.
Governments routinely “cook the books” on inflation statistics. Dr. Tim Morgan explains how.

A good friend recently confided over dinner that he wished he had acquired more real estate during his working life. My friend is far from poor, having built one of Asia’s most successful businesses of its type, which he sold at a particularly good point in the market. He is extremely bright, worldly, investment savvy, conservatively minded,and sold his business to pursue other investment, academic and philanthropic pursuits.

His point about owning less real estate than he would ideally like right now is more about the income potential of real estate than it is about capital growth prospects. I am sure many other reasonably well off people at the tail end of their careers harbour similar thoughts.Central bank policies around the world are destroying the savings and futures of people like him who are in, or closing in on retirement.Both middle class families as well as those in the upper end of the asset/wealth spectrum are hitting a wall of low interest rates and the potentially devastating impacts that is going to have on their retirement nest eggs. The conservative thrift, businessman, and family that saved hard for retirement and trusted their money to the apparent safety of bank deposits, money market accounts and bonds is now seeing the income generating potential of those hard won savings eroded to near zero.

Inflation while still low, even if we remotely believe the “cooked”inflation books of most western governments (see below), is still moving ahead at rates well above the levels of interest rates that investors are seeing in deposits, and bond yields. Dividend yields are also typically below inflation.

And inflation is going to head in only one direction – upwards, and at potentially devastating rates that could put large numbers of savers into the poorhouse.

Real estate has traditionally proved a reasonably reliable hedge against inflation over the long term, both in terms of asset value and income generation.

This is putting middle class families into a real bind as their savings and pension nest eggs are increasingly unlikely to be able to provide the monthly income needed to maintain even a modest lifestyle in retirement in the future. I suspect my friend is far from alone in regretting not having a sufficiently large steady stream of rental income flowing into his coffers alongside the dwindling flows from other investments.

I have long held the view, and banged the drum at various times, of the merits of younger families buying into modest amounts of real estate to hold for long term value creation (see most recently our July 2012 edition of the AHA Report). Most importantly, I suggest holding rental real estate as an inflation adjusted source of cash flow into one’s later years. Yes, the preservation and growth of asset value is very important, but perhaps even more so is the ability of halfway decent real estate to spin off increasing rental income over the long term.

"The insidious nature of a runaway inflation is that it bankrupts the middle class... so the poor stay poor, the middle class.. the people that have had some fiscal rectitude, the doctors, the lawyers, the civil servants that have saved their money and put it in the bank, those are the people that get wiped out…. the wealthy that are levered with productive assets do the best."

  - Kyle Bass

“Position for eventual inflation: the end stage of a supernova credit explosion is likely to produce more inflation than growth, and more chances of inflation as opposed to deflation. In bonds, buy inflation protection via TIPS; shorten maturities and durations; don’t fight central banks – anticipate them by buying what they buy first…”

  - Bill Gross

And there is only one way that inflation and interest rates will go in the medium term— UP!

For sure your bank deposits are far from inflation protected, and neither are most bonds. Real estate, over the longer term does tend to modestly outpace inflation in most countries. And that makes a certain amount of sense. Most countries historically managed to produce REAL economic growth of around 2% - 3%. In today’s world of say 2.5% inflation, that suggests historic NOMINAL economic growth of 4.5% - 5.5%. It is perfectly logical for the value of assets such as real estate to grow more or less in line with nominal GDP growth. Of course there may be any number of economic and demographic conditions that alter this relationship, creating cycles in prices, rentals, supply, demand, affordability, but over time the relationship does tend to revert to pattern.

A $1 million nest egg in the 1980’s would need to be about $2.1 million today to have kept pace with inflation….

Another way of looking at it: housing cost (either rental or mortgage) is one of the single biggest monthly expenditures that most households make. Housing cost is one of the factors that makes up the inflation numbers. Therefore housing cost can be a major component and driver of the overall inflation rate. Owning some of this asset offers some asset value and income protection for savers.

How The Fed is Crippling the Middle Class.

Imagine that you had retired in the mid 1980's with a very fortunate nest egg of US$1 million. Throughout the 1980's the average yield on 2 year US government bonds was 10.11%. Parking and rolling your cash in such bonds and would have produced a very livable annual income stream of US$101,100. (see Fig. 1)

Fast forward 10 years, and (adjusting for inflation) you retire with US$1,424,287 in the bank, you lend your money to Uncle Sam and with an the average yield in the 1990's of around 5.8%, your annual income stream would have been around US$82,000. So far so good.

As recently as 2006-07, your retirement nest egg of US$1.938mn (ie. Inflation adjusted US$1mn mid 1980’s equivalent) would still have yielded about 4.59%, giving you just under US$89,000 a year.

Today, courtesy of Mr. Bernanke your nest egg of US$2.137 million invested in the same government bonds would produce an annual income of less than US$5,000.

BUT your $2.1 million would produce income of less than $5,000 per year if invested in 2 year government bonds… ...versus… ...about $101,000 per year for the $1 million invested in the mid 1980’s!
I cannot make the point enough to younger people at an early stage of their life, to consider firstly owning a home of their own, for all the obvious reasons. For myself, I did not convince myself of this as early as I should have, but did see the error of my ways. Next is to make that step into an investment property that is going to provide a growing stream of rental income over time....

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