May 31, 2011
Santiago, Chile

As I told Sovereign Man: Confidential subscribers on our monthly teleconference yesterday afternoon, I’ve been focused over the last several months on sniffing out the best deals in Chilean farmland for our planned resilient community. We’re definitely close.

My base in Chile is here in beautiful Santiago, however, and I wanted to take some time today and tell you about the real estate market in the city.

First, you should know that Santiago is a truly fantastic city. In terms of weather, you can hardly beat it:  bright, blue sunny skies and a temperate, Mediterranean climate where it hardly rains. And yet, you’re no more than an hour or two from both world-class ski resorts, as well as the beach. (note: the city does have a problem with smog which is worst in the winter time)

Another 'dreary' winter day in Santiago, taken from my balcony in El Golf at about 11:50am this morning. High temperature today: 73F.

Furthermore, Santiago is just a nice, clean, modern, first world city… something like Madrid meets Chicago. It’s a pedestrian-friendly city with great mass transit and a privatized highway system. There are parks everywhere among the sprawling towers, and you see locals everywhere enjoying a coffee in the city’s numerous cafes and eateries.

(as an aside, Santiago has something you won’t find in too many other places in the world… a concept called ‘cafe con piernas’ or coffee with legs. Think of it as a combination of Starbucks and Hooters…)

Most of all, this place is civilized; Santiago is devoid of the sort of destitute squalor you would expect of a Latin American capital. Obviously some parts of town are nicer than others, but overall I find it every bit as nice as Europe or North America with every amenity you could ever want or need, and all at a pretty nice cost of living discount.

Compared to what I’ve seen elsewhere around the world, real estate in Chile (and Santiago in general) is a relative bargain. Bear in mind, I think about real estate in terms of square meters, which for our metric challenged readers is 10.76 square feet… so a 1,500 square foot 3-bedroom home is about 140 square meters.

My unequivocal, universal standard for ‘cheap’ residential real estate in big cities is $1,000 per square meter. It’s really hard to find this anymore in the world. Ecuador comes to mind– there are a number of good quality properties in Cuenca and Quito for $1,000 per square meter.

I’ve also seen a number of existing condos in Medellin, Colombia for this price, as well as parts of the Yucatan peninsula in Mexico (such as Merida).

In parts of Santiago, it’s possible to find some bargain properties for $1,000 per square meter. In the area around Parque Forestal near in the center of town and the Bellas Artes district, you can find some lovely older properties for between $1,000 to $1,200 per square meter.

The construction quality is excellent– these buildings are solid concrete, built to last… and they’re huge too. You can find many apartments in excess of 300 square meters (3,225 square feet) with a beautiful view overlooking the area’s numerous parks.

The neighborhood is undergoing a gentrification process and is becoming popular now with young professionals, the art crowd, and Santiago’s rapidly growing gay community… the triumvirate of a promising real estate market.

It’s also a protected, historic area, so the chances of a new eyesore going in anytime soon are slim.

Property taxes are a joke; owners might pay $40 to $100 per year in taxes on a reasonably-sized apartment, while rents command a 6% yield at present. I expect the rental yield to increase over the years, along with property values, as supply is constrained and demand is increasing.

In other parts of Santiago– the upmarket areas of Vitacura, Las Condes, La Dehesa, or Providencia, property prices can run between $2,000 to $3,000 per square meter. This is much more expensive than downtown, but it’s still quite reasonable to what I’ve seen elsewhere in the world, including in Argentina and Uruguay.

Even in Asia, which has some of the cheapest cost of living on the planet, it can be hard to find good quality construction for less than $2,000 per square meter. In Bangkok, many upmarket properties sell for in excess of $5,000 per square meter, no doubt a bubble fueled by cheap credit and Chairman Bernanke’s exported monetary inflation.

Santiago has been much less prone to such speculative bubbles; the central bank here has taken rather steps to both hike interest rates and allow the peso to appreciate. In the face of coordinated currency devaluation and exchange rate games in just about every other country on the planet, these are undoubtedly bold moves.

The peso is now near its 10-year high against the dollar, and the central bank’s benchmark interest rate is 5%. In the Greek-induced financial system meltdown part II that I expect to occur over the next 2-years, Chile will consequently emerge as one of the safe havens (i.e. least scathed countries) because of the responsibility it is taking now.

Years ago, in my early 20s, I had my first taste of investment success.  I wish I could dazzle you with a great story about a goldmine in the jungle or negotiating land rights with warlords… Unfortunately, no. All that would come later.

Rather, my first deal was a set of very plain brick apartments on the wrong side of the railroad tracks.  They weren’t very sexy, but I was able to pick them up for pennies on the dollar… and it was a hell of a learning experience.

Over the next several months and years, my property investments grew, until eventually I became a ‘known player’ in my local real estate market.  Bankers and developers even started calling me to ask advice or offer deals.

My success was based on developing and sticking to a system for valuing real estate transactions based on three methods– comparative market value, “replacement cost,” and income.

I actually use these same three approaches today to value companies as I run around the world in search of exciting business and investment opportunities.

Of the three approaches, the most important one to me was the income valuation… to me, an investment property was literally worthless if it didn’t cash flow enough to cover the debt service– I would have been better off stashing my money under the mattress.

Consider the residential investment property market.  The formula is quite simple: landlord owns property, landlord leases property to tenant, tenant pays landlord, landlord covers all expenses from the rent and pockets the rest.

A landlord’s key operating expenses are property management service, maintenance, taxes/dues, insurance, and any utilities paid.  On top of this the landlord must service any mortgage debt.

If the rental income exceeds the operating and interest expenses, the property is cash flow positive, and the landlord is happy.

If the expenses exceed the rent, however, then the landlord has a problem and must feed the property. Naturally, a landlord can only afford to do this for so long before s/he runs out of money.

This is a similar situation to many start-up businesses that are unprofitable for the first several years of operation; obviously the owners expect the business to eventually turn a profit so that they can recoup their initial investment.

Businesses, however, often have exponential revenue growth potential that can make up for early losses. Investment properties do not; a landlord can only increase rents at a low, linear rate.

Thus, an investment property must have some mechanism for the owners to turn a profit, especially if the property is cash flow negative.  Most landlords expect that the appreciation in the property’s value will bridge this cash flow gap.

For example, if a property fetches $20,000 in rent annually, yet costs $35,000 in annual expenses and interest, an investor would have to be crazy to buy this property… unless, of course, s/he believed that the property would appreciate by at least $15,000 annually.

This price appreciation, in theory, would cover the cash flow shortfall.  But it is based entirely on expectation.

When property markets are in a bubble, the cash flow gap of investment property is enormous, i.e. rents are miniscule compared to the cost of maintaining the property and servicing the debt. This is because buyers have an expectation that properties will increase in value, and the increase will more than make up for the negative cash flow.

You’ve seen it happen– real estate agents, TV infomercials, etc. all urge buyers to run out and make their real estate millions.  People begin to make irrational financial decisions based solely on the expectation that property values would increase, and increase big.

Even the banks believed it– they wrote trillions of dollars of no-doc, zero-down loans based solely on the premise that the US real estate would increase substantially in value, cash flow be damned.  We all know what happened next.

In the long-run, the natural, steady state of a real estate market should be cash flow neutral; cash flow positive properties will be bid up by investors, and prices of cash flow negative properties will fall from lack of demand.

This is exactly what is happening in the United States, as well as many other world property markets right now.  Eventually, once the negative cash flow gap had become too wide, the bubble burst.

NCREIF chart of property returns

The formula starts with RENT– annual rent must cover debt service and operating expenses in order for a property to break even; and in order to find a tenant who is able to pay, rents must be affordable. Affordability, as we know, is directly proportional to the health of the economy.

This is one of the key metrics that I use to evaluate property markets around the world. In the United States, I still see many local markets where rental yields do not support property prices.  Consequently, I believe that US housing prices still have room to fall.

With this is in mind, I will start reporting on rental yields of local property markets as I travel to give you a better idea of which countries present the best real estate investment opportunities.

We have a really intelligent group here.

All the comments from yesterday, plus the dozens of private emails I received, underscore one of the big reasons why I do this in the first place– to build a community for like-minded, sharp, successful people who are lions instead of sheep… bold winners who think outside the box and take action instead of find excuses.

The comments were spot-on, even the one about the massage parlor (you know who you are).  Everyone appropriately captured the challenges that will befall Panama over the coming years.

To be clear, no place is perfect. The United States has enormous fiscal, monetary, and social challenges ahead of it, and a long tradition of serially incompetent politicians who make things worse.  Notwithstanding America’s woes, most of Western Europe is in an even leakier boat.  I will be reporting more on this in the coming weeks.

Panama undeniably has its own problems. It has been under US influence since its infancy and continues to be awash with US government sponsored spooks, thugs, and bureaucrats.  Years ago when I first started traveling there, the US Customs and DEA thugs in Miami used to stand on the jet bridge and randomly search passengers for drugs. Today they search people for ‘monetary instruments.’
Resource constraints are also problematic– blackouts are not uncommon and there are surprisingly some parts of the country that have run into water problems; these growing pains, however, are typical of a small country experiencing such a rapid influx of development and foreign residents.

Some people view the corruption as a major detriment; I think every government is corrupt– the Panamanians just haven’t mastered it like US politicians.

Also, as in most developing countries, there is a chasm between the rich and the poor; one of the key indicators that I look for in emerging markets is the growth of a strong middle class.  This is happening in China as we speak, and it is starting to happen in Panama, though certainly to a different standard than we are accustomed to.

I agree with many of you that, if there is an Achilles Heel in Panama’s economic future, it is its currency; Panama has been dollarized ever since JP Morgan engineered revolution and independence from Colombia in 1903. While this provided stability and credibility for the last century, the dollar is now a liability for Panama.

The US government’s runaway fiscal and monetary policies, coupled with centralized influence of the banking sector, are a recipe for future inflation.  This will adversely affect Panama and Panamanians as the country has never once in its history issued its own currency.

Martinelli is not remotely interested in rocking the boat by trying to issue a new currency; most Panamanians have no idea that the dollar is in trouble… hell, most Americans have no idea that the dollar is in trouble. Raising a stink about the dollar in Panama will likely land him political purgatory– it’s simply too much risk for him.

Fortunately, while the dollar will be a future problem for Panama, it does not have to be a problem for you.

It is critical to first move money out of the dollar and into precious metals and other currencies– this will combat the future effects of inflation.  Panama (and the US) will be cheap countries for those of us who are not holding dollars.

I also expect the free market to take over and create its own solution, even if the government does not issue a new currency. This practice is common in many countries across Eastern Europe, Africa, and Latin America with a history of unstable currencies– big ticket items like cars and houses are bought and sold in a foreign currency.

For example, real estate in Croatia and Latvia is frequently priced in euro; I expect the same would happen in Panama.

Consequently, Panamanian property is probably a smart buy right now for anyone who is thinking about expatriating there; prices are depressed and there is even foreclosure inventory to choose from.  In the event of significant dollar instability, the real estate market will likely start pricing in euro, yen, or renminbi to compensate, so property value will be maintained.

I’m off to Europe and will be transiting through New York City tomorrow.  Make sure you look for my Friday missive (from JFK airport…) as I will be discussing what I learned about the banks in Panama.