Ken McElroy | Profiting From Expected Volatility

One of the greatest sports quotes was by hockey legend Wayne Gretzky, who said, “a good hockey player plays where the puck is . . . and a great hockey player plays where the puck is going to be.”

Great performers across all lines spend most of their time focusing on the future by using information from the past or present. Anticipating what is going to happen in the future is far more challenging and rewarding, and using these proven techniques to better understand the future will maximize your success.

Successful people lead their lives by practicing different habits.

Arguably, one of the greatest minds in recent history and a master of understanding the future was R. Buckminster (Bucky) Fuller, who lived from 1895 to 1983. Bucky was renowned for his comprehensive perspective on the world’s problems. For more than five decades, he developed pioneering solutions that reflected his commitment to the potential of innovative design.

One of Bucky’s famous sayings is, “Nature is trying very hard to make us succeed, but nature does not depend on us.” He published more than thirty books on a variety of subjects, many of which were based upon generalized principles. He believed that if you study and understand the generalized principles, you can better estimate and predict certain outcomes.

One of the main drivers of innovation involves analysis of market trends and predictions of what the trends will be in the future. If you want effective problem solving, you’re better off with principles rather than philosophy. Philosophies can be strangely seductive. Philosophies are opinions; principles are general laws or truths.

Jim Cramer, the famous stock guy said, “There are tons of people who are late to trends by nature and adopt a trend after it’s no longer in fashion. They exist in mutual funds. They exist in clothes. They exist in cars. They exist in lifestyles.”

Trends exist in real estate, too. These trends create cycles.

When you say “real estate,” most people immediately think “my house,” and U.S. households have experienced substantial deflation in housing prices in the last several years. A home is also a consumer purchase — one that ties into the buyer’s self-image, hopes, aspirations and sense of community. It’s a deeply personal thing. So it’s no surprise that the ongoing troubles in the housing market are tainting investors’ views of real estate in general.

But the fact is that the dynamics of the residential market are fundamentally different from those on the commercial side. Are you a speculator or an investor? Not all people in real estate are investors. It is critical for people to determine whether they are investors or speculators. The difference is simple: an investor looks at real estate as a business, while speculators view themselves as playing with expensive short-term holdings, with no intrinsic value. The professional investor understands that real estate assets are long-lived, and that their cash flows are somewhat predictable. The speculator invests for capital gains by trying to “time” the market.

With real estate’s relatively predictable cash flow, I believe it’s still a sensible way to invest for the long term. If anything, the current economic situation has reaffirmed just how sensible it is.

The continuing troubles in the residential market are making many individuals wary of real estate, to be sure. But those folks are ignoring the very clear distinction between residential and commercial markets. If my assessment is correct, and the commercial market is just beginning an extended period of recovery, I believe it will be the kind of opportunity that real estate investors see only once or twice in a generation.

It’s easy to look back now and be reflective of the aftermath of the current recession and the real estate bubble. Bubbles characterize all asset markets. A bubble is an irrational over-investment in one particular sector or economy. But what is particularly interesting about the property market is that its cycles, its bubbles and depressions are (unlike the stock market) so smoothly predictable.

Property markets actually move very slowly, giving the observant investor plenty of time to buy and to sell. When my partner, Ross McCallister, and I began to see unfavorable market trends, we simply backed off of our investing and let the market take its normal course. Once the “fallout” happened, we started to buy again. It sounds simple and it seems that everyone should have done this, but why didn’t they?

As Mark Twain quoted, “Whenever you find yourself on the side of the majority, it is time to pause and reflect.”

Malcolm Gladwell’s book, “The Tipping Point,” examines how cultural, social and economic factors converge to create trends in consumer behavior. The masses fall into what is known as the “herd mentality,” and the truth means little when a powerful herd effect is already in place. The term herd mentality describes how people are influenced by their peers to adopt certain undisciplined behaviors, follow trends, and/or purchase items. Individuals in a group can act together without planned direction. Many people spend a lot of time analyzing and trying to predict the next investment cycle, trying to “buy low and sell high.” It doesn’t take a sophisticated investor to understand that selling something higher than you bought it for creates a profit.

On the contrary, most successful people lead their lives practicing different habits that are much more disciplined. Professional investors can make money when the market is going up or down. This is the primary way many sophisticated investors survived the current recession. You can make much more investing when the market is down.

It is important to understand how a cycle works, but it is much more important to understand why it is going up or going down. Trends create cycles. If you can figure out why a trend is beginning or coming to an end, you can be wildly successful with your investing.

Having a firm grip on the trends relating to population, the economy, public opinion, changes in family structures and changes in public consumer behavior are essential for effective strategic planning. Demographics like “live births” and “age” are roadmaps to the future if you study them.

Reviewing the current demographic, economic and sociological trends does not allow us to completely predict the future, but it does allow us to predict a variety of potential futures. Knowing what can be possible in the future allows us to make decisions in the present that guide us to one of the possible futures. To invest wisely, investors have to become adept at both local and global trend analysis.

One thing I can predict with absolute confidence is that government chiefs, and even most economists, will not learn the right lessons. New money creates price inflation. There should be no argument over this fact. History will repeat itself, as it always has.

Meanwhile, with pending inflation, it’s likely that replacement costs will keep going up, and owning real estate with fixed rate debt during inflationary periods can be a great “inflation hedge.”

Demographic trends create real estate supply and demand. New cycles begin because demand is on the upswing, and at the same time, early in the cycle, new supply is relatively low because there’s so little new construction. The good news for sophisticated investors is that supply and demand as it pertains to real estate is slow moving.

A recent report from the Urban Land Institute titled “Housing in America” offers two key predictions for the decade ahead: Home appreciation will slow considerably, to about one percent to two percent annually; and the current U.S. homeownership rate, now at 67 percent (a decline from the record high of 69 percent at the height of the housing boom), will fall further, to about 62 percent.

The report also cites four major U.S. demographic trends that will have a major impact on housing. These “trends” will impact existing supply and demand, creating new cycles.

  • Aging baby boomers (55 to 64 years old) – They’re 74 million strong, and for the next 20 years, this demographic will continue to have a significant impact on housing. Although they are nearing retirement age, many will keep working out of necessity or by choice. Some will be forced to stay in their suburban homes until values recover. Those who are able to move will not choose traditional retirement locations or senior housing, opting instead for more mixed-age living environments that cater to their active lifestyles.
  • Younger baby boomers (46 to 54 years old) – Now in or entering their prime earning years, this group will also face a tough time selling suburban homes, hampering the ability of these boomers to move. Because the recession has left many younger boomers with flat incomes and less home equity, their ability to purchase second homes will be greatly diminished, curbing prospects in general for the second home market.
  • Generation Y – This tech-savvy generation has a population of about 86 million, more than the baby boomers. Gen Yers place high value on community; on places (either virtual or actual) to gather and share information, ideas and opinions. As they enter the housing market, they will be far less interested in homeownership than their parents were when they were young adults. The recession has tempered the interest of Gen Yers in buying their own homes and they will be renters by necessity or choice for years ahead. Despite having small incomes, Gen Y will gravitate toward walkable, close-in communities, choosing isolated housing on outer edges only as a last resort because it is the most affordable. Green, “net zero” homes powered exclusively by alternative energy will have strong appeal to this group.
  • Immigrants – Already 40 million strong, the total population of legal and illegal immigrants in the United States has an even greater impact when the children and grandchildren are included as a factor. The tendency of immigrants to cluster, and to live in multi-generational households, suggests that they would prefer larger homes if they could afford them, and if the homes were in neighborhoods with a strong sense of community.
  • All of these groups have some characteristics that reflect a desire to live in more pedestrian-friendly, transit-oriented, mixed-use environments that de-emphasize auto dependency, whether the location is urban or suburban. According to the report, economic and land constraints make it impossible for urban infill development to accommodate all of the housing demand represented by all demographic groups.

The trends and the ensuing cycles are long, enabling the professional investor to make sound and rational decisions. All of these things take time; real estate is largely predictable.

Most people believe that risk equals return. I believe that work equals return. The more work you put into your investments, the higher your return should be. Instead of running for the exits during times of market stress, the smart investor greets downturns as opportunities to find great investments.

About The Author

Ken McElroy

Ken McElroy is the co-partner of MC Companies in Scottsdale, Ariz. He is the author of the best-selling books, The ABC's of Real Estate Investing, The Advanced Guide to Real Estate Investing, and The ABC's of Property Management. McElroy is also a contributor for The Real Book of Real Estate by Robert Kioysaki, and The Midas Touch by Donald Trump and Robert Kiyosaki. McElroy's fourth book, The Sleeping Giant, is dedicated to the new class of entrepreneurs who are emerging in today's economy. For editorial consideration please contact [email protected](dot)com.

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