All booms eventually go bust.
We all remember the stock market crash of 2000, and most of us remember the real estate crash after the implementation of the 1986 Tax Reform Act. Today, many people are anticipating another real estate crash.
Unfortunately, despite our understanding of booms and inevitable busts, it's always near the top of a boom that "dumb money" buys in. Currently, this has set the scene for a potential market bust of which few people are aware. I'll describe it today's column, and advise how best to prepare in my next column.
About a year ago, I wrote a Yahoo! Finance column warning readers that the real estate boom was over. How did I forecast the end of the boom? I got my hot tip from the cashier at my local Safeway supermarket.
While she was tallying the cost of my apples, broccoli, and steaks, she handed me her new real estate agent's card and invited me to call her for my next real estate investment. Moments later, I was home writing that column. As my rich dad used to say, "When dumb money chases smart money, the party's over." Needless to say, many real estate agents and investors wrote me nasty notes.
I'm not a hundred-percent certain where things are going today. Most economists are forecasting a strong economy, but economists worry me more than newly minted real estate agents. Most seem to be happy that inflation is in check; when I hear that inflation is in check, I begin to think about deflation, and as most of us know, deflation is much, much, worse than inflation.
An Inconvenient Truth
In the simplest terms, inflation occurs when there' too much money in the system. On the flip side, deflation occurs when there are too few dollars in circulation. When that happens, prices start to fall. For example, in inflationary times, prices of houses go up. In deflationary times, prices of houses come down. If prices of houses begin to drop too fast right now, it could be 1986 all over again.
I wrote a column in 2005 about how I love debt and my credit cards. The trouble is that most people do. Today, you can qualify for a loan to buy a house simply if you're alive and breathing.
The strong economy we've been experiencing for years has thus been built on dumb money -- in addition to smart money -- borrowing more and more. Even the U.S. government has had a field day borrowing money to do such things as fight a war and attempt to rebuild Iraq and Afghanistan rather than rebuild our country. And the inconvenient truth about debt is that it has to be paid back.
A Certain Ratio
For the next two years, I'm cautioning people to watch their ratios between good debt and bad debt, and keep liquid reserves such as cash, gold, or silver.
Good debt is debt that makes you rich. An example of good debt is the debt on the apartment houses I own. That debt is good only as long as there are tenants to pay my mortgages. If tenants stop paying their rent, my good debt turns into bad debt.
Most people don't have good debt -- all they have is bad debt. Bad debt is debt that makes you poorer. I count the mortgage on my home as bad debt, because I'm the one paying on it. Other forms of bad debt are car payments, credit card balances, or other consumer loans.
On our home, my wife, Kim, and I keep a 25 percent debt-to-equity ratio. In other words, our debt is 25 percent of the home's value. Unfortunately, many people have an 80 percent or higher debt-to-equity ratio. That means the debt on their home is 80 percent and their equity is only 20 percent.
On our investment properties, we carry a higher debt-to-equity ratio. To protect ourselves, we have cash reserves to cover the expenses of the properties. For example, in case all the tenants leave and no one is left to pay the mortgage and expenses, we have separate funds for each property, with enough liquidity -- i.e. cash, stocks, and bonds -- to carry the building for a year. Unfortunately, the dumb-money crowd has no reserve funds for their properties.
Where Deflation Does Its Damage
In a deflationary market, the value of your home can drop. If the value drops, the bank may call in your loan. Even if you've never missed a payment, and even if you're ahead on the payment schedule, the bank can call in your loan if they feel the value of the property is lower than the loan amount.
For example, say you buy a house for $100,000 and put 20 percent down and borrow $80,000. If the market deflates and the value of your home drops to $70,000 (because everyone else is selling their homes to get out of debt), the lender may ask you to pay the $80,000 you owe immediately.
If such deflation happens, cash will become king. There will be half-price sales on BMWs, expensive restaurants will close, and people will be out of work. And anybody who caters to people with dumb money will be in trouble. As I said before, deflation is much worse than inflation.
Smart Money, Bad Times
The good news is that during deflationary times, smart money reenters the market, so crashes are great for smart people with smart money. Instead of listening to the optimistic economists, then, you should eliminate bad debt and improve your debt-to-equity ratios on good debt.
Most important, study; if you want to be smart, you need to learn. I'll discuss what you should study in the second part of this column. For now, be aware that if deflation comes and there's a recession, it won't have much effect on the poor. Instead, it'll punish middle-class people who think they're rich because their houses and stocks have gone up in value.
I'll explain more in a couple of weeks.