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Is Irish Property a Good Investment?

Defining Investment

Warren Buffett, the world’s most successful investor, referencing his inspiration Benjamin Graham, would define the act of investment as follows:

So an investor must take the time to study the investment and be satisfied that the likelihood of a loss of capital is remote. There are two key rules to investing. These are:

1. Never Lose Your Capital
2. Never Forget Rule Number 1

Once one is satisfied that capital will be preserved, the prospect of a reasonable return should be highly likely. One man’s “reasonable return” is another man’s mediocre one but that is another day’s work.

A speculator, by contrast, generally pursues the greater fool theory ie that (s)he is going to buy now with the intention of selling on to a greater fool at some future point. A speculator looks less to the underlying economics of the investment but more to the likelihood of being able to “flip” the asset in due course. We saw this at scale in Ireland during the property boom when people paid illogical amounts of money for property on the basis that the market was going up. There was almost no price too high as whatever was paid, it would have gone up next year. There is nothing wrong with speculating so long as one realises that one is engaging in it and limits it to a very small part of their net worth ie no more than 5%. For the purpose of this article, we are going to assume that the reader is an investor ie willing to do their homework, interested chiefly with the preservation of capital and looking for a reasonable return over the long run ie we are not looking to buy off the plans with a view to flipping to a greater fool in 6 months time. We are going to look to the underlying economics of the asset being considered for investment ie property.

Opportunity Cost

Charlie Munger, the vice-chairman of Berkshire Hathaway speaks a lot about the concept of opportunity cost. By this he means that whenever they are making investments, they are assessing the universe of opportunities open to them and looking to find the very best. Berkshire is a large holder of Coca Cola for example so whenever they look at buying into a new company, or buying it outright, they ask “why don’t we just buy more Coke?” The theory is that the opportunity cost of investing in the new company is that they forego buying more Coke shares. So as potential property investors, we are asking ourselves, what alternative asset classes are available to us?

Stocks, Bonds, Commodities, Asset Managers

Stocks

Benjamin Graham advises investors to classify themselves at the start of their investing career as either passive or enterprising investors. The former do not claim to possess any above average aptitude for investing and even if they did, they simply don’t have the time to do the necessary study in order to meet the criterion of an “investor” as mentioned above.

For example, you may think that Ryanair may be a worthwhile purchase on the basis that they will ultimately solve their industrial relations issues and once they do, their dominant position as Europe’s lowest cost carrier will remain and so profits, and the share price will grow. This may well be a viable theory but in order for you to invest in Ryanair (not speculate), you would need to, at the very minimum, read their annual reports for the past three years. Your research would need to be supplemented by doing the same for the main competitors such as Aer Lingus and EasyJet. Ryanair’s annual report for 2018 runs to over 200 pages and is available here: In order to form an intelligent view of Ryanair’s (or any other company) prospects, the annual report would need to be read by someone with at least a fundamental knowledge of business and accounting. Without this grounding, it will be difficult to interpret the numbers in the reports and make an informed view.

Once you have done this, Warren Buffett advises that you need to estimate the free cash-flows that the company will produce for shareholders between now and “judgement day”. This is the skill of a good investor ie to predict with a degree of accuracy what future cash-flows will look like. Once that is done, the investor needs to choose an appropriate discount rate with which to discount future cash-flows back to today’s value. This can be thought of as the rate of return that you expect from the investment over the years. The higher the discount rate used, the lower the present value will be. Buffett recommends using the rate on offer from long term treasury bills ie the rate available by lending to the American government as this is the risk free return - you will want a return higher than this of course; this is merely to bring cash-flows back to today’s value.

Once the stream of future cash-flows have been discounted back to present value, this gives the investor what (s)he believes the company is worth. This number is then divided by the outstanding shares in the company to get the estimated intrinsic value (the true value) per share. Some adjustments would need to be made if the company has any share option schemes in place as these will have the impact of issuing more shares and diluting the holding of the remaining shareholders. Once this is done, the investor should, according to Buffett as inspired by Graham, look for a margin of safety. By this he means that no one gets rich buying shares that (s)he believes are worth €2 for €1.95. The margin of safety is to protect investors against inevitable inaccuracies in predicting cash-flows so many years in the future. If an investor calculates that the intrinsic value of a company to be €1/share and they are trading at €.5, then this would certainly be a worthy investment. The theory goes that markets can often be inefficient in the short term (Buffett scorns efficient market theory) but that over the long run, they move toward being efficient ie they realise the true value of the company and the shares rise to reflect this. In the short run, a market can be a voting machine but in the long run, it is a weighing machine, is how he puts it.

So if you have strong business acumen and are willing to do the work, then you can certainly consider the purchase of marketable securities as a viable form of investment. The vast majority of non-professional investors however either lack the business training, acumen, temperament (to stay calm and buy more in down markets for example) and/or time to realistically fulfill the criteria of investment as outlined by Graham.

Graham however does distinguish between enterprising and passive investors. The former are willing to do the hard work and have a belief that their expertise will give them an edge over the market. Very, very few people succeed in this so if someone is going to attempt it, they should be aware that the odds are stacked against them. We will speak about how a non-enterprising (passive) investor can however invest in the stock market below.

Asset Managers

If one doesn’t have the time to be enterprising oneself, a logical conclusion is to engage a money manager to manage your funds on your behalf. So while you don’t have the time and/or aptitude to invest in stocks, you feel confident that you can identify a trustworthy, professional, intelligent manager who can behave as an enterprising investor on your behalf, for a fee of course. An extreme example of this would be to invest in a hedge fund or private equity fund - these are typically only available to high net worth individuals however for regulatory reasons ie to protect small time investors from investing in something they are ill-equipped to understand. Buffett, for the record is highly critical of the “2 and 20” fee structure of these funds. This means they charge 2% of AUM (assets under management) and take 20% of the profit. So no matter what happens, they take their 2% off the top every year. So they need to make a 2% return just to get back to breakeven for their investors. As they profit from the upside and don’t hurt on the downside, one could argue this creates an incentive to attract as much AUM as possible, rather than deliver returns. Money managers would retort that their ability to attract funds is tightly correlated to performance which is incentive enough. Buffett argues that the trading activities of hedge funds mitigates against returns in the long run for several reasons. First of all, the frictional costs of moving out of one position into another (tax, brokerage fees) have to be netted against returns but perhaps the main reason is that trading in and out of stocks means that the investor never really sees himself/herself as an owner in the business. Stocks are seen as vehicles to get into and out of depending on market conditions. Buffett operates entirely differently and subscribes wholeheartedly to the idea that investors need to think like owners. When he invests in a company, he sees himself as becoming part owner in that business and he intends to stay there for the long run. He will exit under certain circumstances (labour trouble, no potential of returning to profit) but for the most part, he invests for the very long haul. This changes the perspective of the investor and leads to better decision-making.

Buffett famously made a bet with a fund manager Protégé Partners that the S&P 500 would outperform a selection funds handpicked by Protégé. For more, see this article . Buffett makes the point that he can think of no other industry where the engagement of professionals can actually add negative value. If your pipes block, a plumber will add value; if your car breaks down, a mechanic will help but if you have funds to invest, you are probably better off doing a DIY job instead of paying a money manager as you’re likely to do better yourself over the long term. By “DIY” he does not mean to invest as an enterprising investor but rather to do so as a passive one in a basket of high quality companies (a low cost index fund). Buffett makes the point that because so much money is under the management of professional money managers, they necessarily will deliver returns, on aggregate, of whatever the market returns as they are such a large part of the market. This is what gave him his conviction to make his bet which he duly won.

However, if the money managers merely deliver market returns, after fees, their investors will do worse than the market. A cynic might say that the only people who get rich out of professional money management are the managers. The industry would rightly retort that some managers do consistently outperform the market. Picking the winners is extremely difficult however. Bill Ackman is a good example of a money manager who followed up incredible successes with crushing losses - consistent returns elude the vast majority of managers. It is worth pointing out also that there are funds with far more reasonable fees than “2 and 20” and some investors do outperform the market even on a net of fees basis.

The vast majority of potential property investors don’t have the time and/or acumen to be enterprising investors in the stock market. Delegating the task to a professional manager is fraught with difficulty as the likelihood of that manager outperforming the market on a net of fees basis is low. So Buffett’s strong advice for investors in this position is to gradually buy into a low cost index fund over a period of time – this ensures industry and time diversification. Incidentally, if the market did crash, he would counsel to increase buying at that point as during crashes, stocks are on sale.

Using the tool here: https://dqydj.com/sp-500-return-calculator/ you can see what your returns would have been had you simply bought a low-cost index fund of the S&P 500 with and without dividends reinvested. Returns will vary depending on when an investor enters and exits the market. If we take however, for example, an investor entering in October 1990 and exiting in October 2018, his/her return without reinvesting dividends would be 8.35% and if dividends had have been reinvested, the return would have been as high as 10.5%. Finding a money manager to deliver these types of returns, net of fees, over a long period would have been challenging indeed. So a long term investor should certainly consider buying an index fund and just sitting on it, reinvesting dividends in the same fund if possible. Remember that this period included the dotcom collapse of the early 2000’s as well as the market disintegration in 2008. However, if an investor had held his/her nerve and kept reinvesting the dividends throughout these periods of panic, they would have had strong returns in the long run.

Tool Courtesy of: https://dqydj.com/sp-500-return-calculator/

Bonds & Commodities

Many investors will flee to gold as a store of value during uncertain times. Buffett strongly disagrees with this as gold is a non-productive asset that gets dug out of the ground in one part of the world, made into bars and then put into vaults under the ground in another part of the world. An investor in gold owns a lump of metal sitting in a vault somewhere doing nothing. He would rather own a trading company producing profits or a property producing rent. The average investor really is not going to even consider bonds or commodities as these are fields for specialist, professionals and as such we are going to avoid them.

Property

Remember that to be an investor, according to Graham, we need to have done our homework and having done it, we need to be assured of the preservation of capital and a satisfactory return in the long run. We also need to be cognisant of opportunity cost ie by investing in property, we are foregoing an investment in another asset so we need to be sure it is the best option for us. As above, by buying an Index fund of the S&P 500, we can expect over the long run to make in the region of 8% and more if we reinvest the dividends. When thinking about property, the building itself can be thought of as the shares and the rent can be thought of as the dividends. So the investor’s return on property is made up of capital appreciation in the property plus the rent received.

Preservation of Capital

The chief risk to the preservation of capital when investing in housing is a property price crash. The below graph from the CSO shows average, national, second-hand house prices going back as far 1975 up to the end of 2016.

Graph: CSO.ie

If we draw a line from end 2016 horizontally back to the point where prices were at 2016 levels, we get back to early 2009 (as the market was sinking from its highs) and again in late 2003, as the prices were building to their peak in 2008. Anyone who bought, roughly speaking, and this is obviously property dependent, between 2004 and early 2008 is yet to see the market rise back to the levels that they paid ie as much as 12 years later, they would have suffered a destruction of capital invested.

In the normal course of events, prices would ultimately recover to pre-crash level just as the S&P recovered slowly after the dotcom and subprime collapses.

Alas, one key structural regulatory change has occurred that mitigates against the market recovering to 2008 levels in the short term at least. This is the Central Bank’s limit of 3.5 times salary cap on borrowings. While no such cap existed in 2008, purchasers borrowed well in excess of these levels and drove prices up. Now the Central Bank is protecting buyers from themselves and preventing them from borrowing as much as they did back in 2008 and this is keeping the handbrake on house price inflation. There is no doubt that prices would be higher in the absence of this restriction. Those who bought between 2004 and 2008 have not preserved their capital as their properties are worth less than what they paid for them.

However, when we look over a longer period, as we did with the S&P, and assume that an investor bought into the Irish property market in 1990 and held until end 2016, the average house price at the start of the period was approximately €60,000 and at the end was approximately €290,000. This implies a CAGR (compound annual growth rate) rate of 6.25%. This excludes the rent (dividends). Assuming the property generated a net rental yield of 6% (yield after paying management company and maintenance costs) throughout the period, that would push the return into double digits over the period. So on this analysis, the return would seem comparable with the S&P, if not slightly superior. Again, returns would be dependent on sitting out the bad times as exiting the market during a downturn would obviously lead to terrible results. Many who couldn’t keep up mortgage repayments during the latest recession had their properties repossessed thereby crystallizing their losses. Had they been allowed to sit it out, much of those paper losses would have been recovered in time.

So despite Ireland suffering the greatest collapse in property prices the country has ever seen, an investor who held the asset for the long run would still have seen not only preservation of capital but a respectable 6% annual growth rate, excluding rent. When rent is added back in, the returns look attractive if not spectacular. On this analysis, property in Ireland would seem like an attractive option for a prudent investor who intends to hold for the long run.

One caveat to add here though is that the RPZ restrictions which prevent a landlord from increasing the rent beyond 4% per annum will have implications for investors. For example, if a property’s value increases by 6% in a year, the rental increases will not be able to keep pace as they are limited at 4% thereby depressing the effective yield being achieved. It is important that landlords are diligent in raising rents the full 4% per annum in order to maximise their returns - many accidental landlords shirk this task due to having good tenants in place. For every year that this is not done, the further behind market rates the rent falls; remember that this 4% restriction goes with the property and so a new would-be investor will be constrained by it and if it is below market levels, it will reduce the property’s value.