Leverage and loss avoidance (thoughts on some recent Property Academy Podcast episodes)

Sonnie Bailey

24 January 2023

I am ambivalent about The Property Academy Podcast, hosted by Andrew Nicol and Ed McKnight. I listen to an episode every now and then, and sometimes I learn a bit. Andrew and Ed seem like personable, clever guys, and I would probably like them if I met them in person.

But sometimes I listen to the show, and I really don’t like what I hear. I often disagree with them, especially when it comes to bigger-picture stuff. On most days I put it down to having different presuppositions about the world. On my less charitable days, I also put it down to having different incentives. If I had all the time and energy in the world, I’d have responded to quite a few episodes.

They published two episodes in the past week that I listened to, and I REALLY didn’t like them. They are:

  • Episode 1226 (20/1/23): Leverage – The Concept All Property Investors Need To Know (Love Letter to Leverage); and
  • Episode 1227 (21/1/23): From Fear to Confidence: Overcoming Loss Avoidance in Property Investing

In relation to leverage (episode 1226), they talk about all the benefits of leverage, without paying any significant attention to the risks of leverage. They then encourage listeners to share this particular episode with people who are thinking about investing in property.

In episode 1227 they talk about “loss avoidance” and explain how this is an “emotional” problem rather than a “logical” one. They then look at historical data and make big statements like “there are no losses over a 5-year period if you bought in Auckland” and “you can roll a 1, 2, 3, 4, 5, or 6, any time you’re going to win”. It’s not really clear what data they are using to draw their conclusions from – my presumption is that they are basing this on median property prices, and aren’t factoring in anything that isn’t captured by this metric – such as transaction costs, significant maintenance or renovation costs, nor any top-ups to rental income that the owner might need to make in order to cover costs such as mortgage payments between when the time of buying and selling.

Episode 1226 (20/1/23): Leverage – The Concept All Property Investors Need To Know (Love Letter to Leverage)

 Let’s start at the end. Ed concludes the episode by saying:

“If you have a friend who is just starting to get into property, or if there was someone you were talking to over the holiday break who was thinking about property, just starting to get into it, then I want you to share this episode with them because the concept of leverage is the most fundamental benefit of investment property. So whip out your phone and share that with someone who needs to hear this.”

I’ll say it outright: I think it’s irresponsible to introduce someone new to investing by talking about borrowing against your assets to invest, without pointing out the risks associated with doing so.

The risks

Early in the episode, Andrew says: 

“This is the reason why many people invest in property. Because what are they putting into the transaction? Yep, they’re going to take some risks because they’ve gotta borrow money against assets they already own or about to buy, but often the only money that investors are putting in, especially in times where interest rates are a bit high is cash flow to top up the investment property.”

This is true, but you can’t understate the fact that you are putting your existing assets at risk. If you’re securing lending against your home, you are putting equity in your home at risk. 

Will this come into play for most people? No. It might be a low-probability event. But it’s also a very-high-consequence event.

Hypotheticals

Ed shares a simple hypothetical of paying $200 per week into shares versus using leverage to invest in a $1 million property that requires a top-up of $200 per week. He is generous with shares, assuming a 10% return, and less generous with property (relatively speaking), assuming a 5% capital gain. In this hypothetical, you end up with $11,000 in shares and additional equity of $50,000 in the property at the end of a year.

Admittedly, he acknowledges: “Of course that [$50,000 isn’t] liquid… And is it a bit more complicated than that? Of course it’s a bit more complicated than that. That’s why we’re over 1,200 episodes deep in this podcast. You can explore it elsewhere.” But this is the only instance where he qualifies this. And he doesn’t give any breadcrumbs to episodes that might be relevant.

For reference, I ran some similar hypotheticals. Except I got Excel to create 200 scenarios. And instead of assuming a specific return in each case, I got Excel to generate a “random” return for $10,000 of shares and $1 million of property anchored to a mean of 5% and standard deviation of 10% (for Excel geeks: NORM.INV(RAND(),[mean],[standard deviation]).

This is a sample of what I got:

As you can see, the property scenario generates way better returns – most of the time. If the vertical axes were the same, the difference would be even more pronounced. It’s tempting to think that property is the way to go.

But there are scenarios where the “returns” are very negative. And you need to consider whether you can stomach this. Because it’s a real possibility.

Because you are magnifying your outcomes with leverage, you need to be a lot more careful about the assumptions you’re making.

To illustrate this, below are 200 hypothetical scenarios based on some slightly different assumptions.

“Random” returns based on a mean return of 5% and standard deviation of 10%:

Or mean of 2% and standard deviation of 10%:

Caveats abound!!! For instance, I haven’t given serious thought to what a “reasonable” standard deviation would be. More importantly, I’ve generated these scenarios using an assumption that changes in property prices are normally distributed (which they aren’t). This concept of thinking about the assumptions and thinking more probabilistically about potential outcomes will hopefully be the subject of another article or three at some point in the future.

A poem to Leverage, that fickle mistress

At the end of the episode, Ed shares a love poem to leverage. Here is my attempt at a more balanced love poem (aided by ChatGPT):

Fickle mistress, Leverage, how you tease

With promises of power, wealth and ease

But handle you with care, or you’ll bring woe

For in your arms, both victory and defeat can grow

 You multiply our efforts, make them grand

But one false move, and all may come undone

With you, success is always close at hand

But you may be a lover, but not always a friend.

 Alternatively, I’ll quote the unofficial poet laureate of finance, Warren Buffett:

“If you don’t have leverage, you don’t get in trouble. That’s the only way a smart person can go broke, basically. And I’ve always said, ‘If you’re smart, you don’t need it; and if you’re dumb, you shouldn’t be using it. 

Episode 1227 (21/1/23): From Fear to Confidence: Overcoming Loss Avoidance in Property Investing

In this episode, Ed and Andrew talk about the concept of “loss avoidance”. I believe they’re referring to “loss aversion”, a concept first identified by Amos Tversky and Daniel Kahneman. The basic idea is that people tend to be more sensitive to a loss than an equivalent gain.

There are times where loss aversion can result in people acting illogically or irrationally. There are lots of examples where you can ask someone if they will pick one of two options that are substantively identical, but they will respond differently depending on the wording of the option and whether it emphasises the gain or the loss.

However, like most heuristics, we have evolved to be loss averse because it’s adaptive.

Ed uses the example of being able to take a coin flip, where with one side you double your salary and with the other half, you halve your salary. When pushed, he says he wouldn’t take the bet:

“Logically, you probably should, because if you look at the expected value you’d say well, you’re going to be up, but also, am I willing to live with a 50% paycut. The answer is no.”

I agree with his reasoning, but I’d argue that taking the flip is not the logical thing to do. The thing to think about isn’t the financial expected return. You need to translate it into utility. There are diminishing returns to income and wealth. For most people, doubling your income isn’t twice as good as halving your income is bad.

One exception to this is you actually are personally ambivalent about income and wealth. For example, if you are financially comfortable and you are likely to meet your lifestyle needs and assist your loved ones in the way you want, your focus might be on maximising your financial outcomes for the benefit of causes you care about. In this case, the utilities are likely to be more closely mapped to how much you can contribute to these causes financially, in which case it might be more logical to focus on financial expected returns – just don’t go full Sam Bankman-Fried!

And of course, everyone is different in terms of their sensitivity to these things. The concept is related to how everyone has a different appetite when it comes to investing.

Investing in property as a “weighted coin”

Andrew says:

“Investing in property over the long-term is like a weighted coin. Apart from the weighting is very heavy, you’re probably very unlikely to lose money if you’re investing over the long-term. But there are losses that are potential in real estate. You can lose money. But there’s also a lot of money to be made. Way more money to be made then there are losses.”

To me, the weightings are key. As I mentioned earlier, if you’re using leverage, you need to be more sensitive to the assumptions you’re making.

There is a logical reason why the first investment property is scariest

Andrew says:

“The first [investment property] is the scariest. I get that. The first is always the most scary for people. And it’s not that they don’t want to invest in property. But it’s the loss avoidance in their mind playing tricks on them. And that stops them taking the first step. And you can’t get to property number five if you don’t buy property number one.”

Later Ed explains:

“When is loss avoidance a big issue? I think number one, when you’re at the start of your investing career. Because those property investors that have quite a few in their portfolio, the risks to them don’t seem as big any more because they’ve been there, they’ve done that, they’ve seen the property go down in value, they’ve seen it increase in value, and think oh well, that’s just part of it.”

There is some truth to what they’re saying. But I don’t think “loss avoidance” is playing tricks on new property investors. And although I think experience plays a part in people feeling more comfortable with investing over time, a huge factor relates to wealth – and diminishing utility relating to wealth.

When someone is thinking about their first property, it’s likely that the downside is more significant – as a proportion of their wealth and actual life outcomes. Once you get to property five, my expectation is that you have a bit of equity built up in your portfolio. For most people, losing $100,000 when you have $500,000 is worse than $1 million when you already have $5 million. Yes, losing $1 million is worse than losing $100,000 in absolute terms. But most people would much prefer to be worth $4 million than $400,000, even after a 10% drop in wealth. With $4 million, most people are financially set, and losses won’t hurt as much.

Median property prices as a proxy for making or losing money on property?

Ed says:

“I’ve run the numbers over the last 30 years in property in NZ, for which we’ve got data, and said, well if you bought property in any month over the last 30 years, what is the likelihood that in a year’s time you’d have made money, and what is the likelihood that you would have lost money? So you take any month, a year later, did it go up in value, did it decrease in value? Across the country, 86% of the time you would have made money over the next year. You would have lost money, or the value of that property, would have gone down, 14% of the time.”

To illustrate:

“Imagine a dice… If you roll 1 to 5, you make money, if you roll 6 you lose money. Now, actually, the odds of property are slightly better than that” (the chance of getting a 6 is 17% versus 14%).

He includes a few caveats:

“… these numbers that I’m giving you are historic, it doesn’t mean it’s going to be the same in the future, but it starts to put things into perspective.”

“[the figures are] historic, might not happen in the future, we don’t know what the future always holds”.

He also notes that “the regions operate differently than the country overall”. He then cuts the data for 5 year time frames – ie, if you’d bought a property in any month in any particular region, and whether that property had gained in value in 5 years’ time from that month.

Based on Ed’s analysis, property prices increased after 5 years this percentage of the time:

  • In Auckland: 100% of the time (in every instance)
  • Christchurch: 96%
  • Wellington: 95%
  • Hamilton: 86%
  • Dunedin: 80%.

In relation to Auckland, Andrew says:

“So you can roll a 1, 2, 3, 4, 5, or 6, any time you’re going to win. Isn’t that amazing.”

Hmmmm.

I’m willing to bet that in the last 30 years there are people in Auckland who have purchased property, sold it five years later, and lost money.

What’s important to note is that this analysis appears to be based on property prices only, and presumably median property prices.

What about factoring in:

  • Transaction costs incurred when buying and selling the properties?
  • Money an owner might use “top up” the property on a month-to-month basis? For instance, if they rented the property out, but rental income wasn’t enough to cover rates, insurance, and maintenance?
  • The cost of renovations that some owners will have made? People often spend tens or hundreds of thousands of dollars on upgrading properties. All this data would show is an increase in the value of a given property, not the costs associated with making it more valuable.

My understanding is that none of these factors are in any large data set.

Ed says:

“The numbers we’re talking about here in terms of losing money 4% of the time, making money 96% of the time [in Auckland, over 5 year periods], that’s historic, might not happen in the future, we don’t know what the future always holds, but if you were to look back and say if I had invested at any point in time, no matter what was happening in the market, how many people would have made money, how many people would have lost, these are the numbers. And I think, thinking about framing up, well what is the likelihood of loss or historical likelihood of loss does help to put this into perspective. And even being aware of , am I so scared of losing that I’m not going to let myself get into the position where I could win, and create that better life? I think understanding that concept is really powerful for you guys.”

I’ve added emphasis because I think this is what most people who casually listen to this episode will take away from it. However, I think this reading of the data is misleading and makes investing in property appear to be less risky than it actually is.

A couple of other comments:

  • When it comes to investing, almost everyone wants to think they invest for the long-run. In fact, this is one of the better features of illiquid assets like real estate, because it encourages people to stick to a long-term investment strategy (compared to, say, savings accounts or shares, which can be liquidated fairly quickly, inexpensively, and with very little hassle). However, we all live in the present. And sometimes the short-run impinges on our long-term plans. People lose jobs. They get sick. They separate. They incur unexpected costs. When these things happen they have to recalibrate their plans.
  • I am wary about relying on using data from the last 30 years. Have you seen the Case-Shiller Index relating to US property prices? The last 20 to 30 years appear to have been anomalous, and I can’t help but wonder if this is true for New Zealand. This goes back to my comments about being very careful about your assumptions, especially when leverage is involved. What assumptions are reasonable? I don’t know. But based on what I’ve heard in these podcasts and others, I’m less optimistic than Ed and Andrew.


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