Potato’s Third Law (of Finance)

September 18th, 2014 by Potato

Clarke’s third law:

Any sufficiently advanced technology is indistinguishable from magic.

Potato’s Third Law (of Finance):

Any sufficiently complicated analysis is indistinguishable from magic.

A few months ago, Brad Lamb posted this inane thing, suggesting that buying real estate in a highly leveraged way beat out investing in any kind of normal way because, with an average 5.5% return over 30 years and lots of leverage, you’d make scads and scads of money. Of course, that’s clearly a biased and overly simplistic analysis from a source that is, well, you get it. For instance, one important consideration in using massive amounts of leverage (95% in his example) is the cost to borrow. And if you look it up, over those same years the (simple) average mortgage rate was 9% — blowing the 5.5% appreciation out of the water.

Obviously there are lot more factors at play than just appreciation, but many people will have trouble following the red lady as these condo kings play their three-card Monte.

Similarly, Melissa Leong recently wrote about Sean Cooper‘s quest to save at an incredible rate and pay off his mortgage crazy early. While her article was very fair and level-headed, someone at the National Post decided to put this sensationalist caption to the preview: “Sean Cooper’s secret: He rents main floor of his house, while living in the basement and bikes and uses TTC instead of a car.” [emphasis mine]. While only part of the numbers are shown, if you work the math and make reasonable assumptions you get a fairly unsurprising result: he ends up paying about $800-1000/mo to live in the basement of his house. Which is what a basement apartment including utilities costs in that part of Toronto. Renting out the main floor of his house is no secret at all — the progress he’s making is solely due to the other insanely frugal and hard-working things he does, like biking everywhere and avoiding taxis or car ownership, working multiple jobs 7 days a week, and reusing everything to the maximum. The fact that he’s renting out part of his house is pretty much irrelevant to the story, but it looks like magic because it’s complicated and because for some reason being a landlord is high-status. Indeed, given the timeframes he’s been working under, he would have done much better doing all the hard working and frugal things he’s doing but plowing his money into index funds.

When there are a lot of factors in the analysis people just don’t want to deal with it. It all bleeds together and acts just like magic, so it becomes hard to critically assess what’s being presented. This happens a bit with a few topics in finance like investing, but it seems to be most prevalent — and most exploited — in real estate.

Take for example the terrible condo ads around Toronto that should be banned for what they try to get away with in the condos=magic department. Here’s a recent collection tweeted by Ben Rabidoux:

To pick one, the Thompson Residences in case you can’t read the image, it claims an 18.6% return on investment (such precision!) with no attempt to back it up (the fine text the asterisk leads you towards just says something about the parties not warranting or representing any of the figures). Another (Axiom) also claims 18.6% returns (they must have done some market research to show that this completely made-up number has some truthiness and feels more correct and gets people to buy than some other random number), this time on the unlevered condo. Of course they don’t provide the full details, just assuming that you’ll rent the place for $2355/mo (such precision — also that gets you a 3-bedroom detached house in many parts of Toronto, but sure, let’s just go along and assume a 1-bedroom downtown-ish is worth that because… George Brown?), and somehow make $685 in positive cashflow and $607 in principal repayment. So after interest (at just 3%) you’ll only have $227/mo for tax, maintenance, insurance, and condo fees (yes, that’s totally reasonable — oh wait, no maintenance fees for a year, of course that’s a representative calculation then). But then you take those phoney rent profits and add it to their phoney price gains ($58,993 — yes, also down to the dollar) and you know what you get? 17.8%. Not 18.6% like they say.

Clearly these ads are not targeted at the careful, numerate buyer — they can’t even be bothered to make their fake numbers internally consistent.

Where was I? Right, magic. Well, there’s clearly some smoke and mirrors going on in those ads.

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