Don’t Predict

January 18, 2016
by Noriyuki Morimoto

Human abilities have their limits. We may be able to make a rational assessment of probabilities, but we cannot tell what is going to happen in the future. Investments are activities that are carried out under such an awareness: activities based on decisive predictions qualify as speculation.

Predictions usually do not become true. We are all surprised when they do, because they are made with the assumption that they will not. Investments become speculation when based on the prediction that a price will surely rise, so the question is: what do investments without predictions look like?

Take real estate for example. The rise in real estate prices do not cause rents to rise. It is the other way round: rents rise, which push up real estate prices. Therefore, the basis of rational investment decisions should be the rent. Betting on the rise of real estate prices is speculation. If you analyze rents to find the price of a property and acquire that value, what you are doing is investment.

The investment value of a property can be objectively measured as the current value of future net rent revenues, based on the current rent level, management costs, and occupancy rate. Nobody invests, or should invest in, anything whose value cannot be calculated objectively. Measuring an asset’s value is the very first step of making investment decisions and the most basic thing of all.

Then there is the risk of losses, but you can use insurance to prepare compensation for physical losses such as collapse or fire. The most important risk factor here is the occupancy rate: if it goes down and is unlikely to recover in the near term, you have to cut down the rent, which reduces the total rent revenue even if the occupancy rate is maintained. This is what it means to make losses.

At the time of investment, such risks are recognized and accepted through an overall evaluation of the property’s location, size, purpose of use, and the composition of tenants. Moreover, when investing through professional asset managers, it is important to assess whether the manager is fairly capable of avoiding the erosion of value, by applying appropriate tenant policies and investment plans for repair/renewal.

If you predict future rents to rise when assessing the value of a property, there will be no ceiling on the assessment. Investment values should be measured using a conservative approach, requiring that the property is worth investing even if rents stay at the current level, and assuming that even if there is a certain drop in the rents, the drop in value is within an acceptable level.

If you predict rents to rise, it will be easy to approve the act of acquiring land ahead of the market. But investments will be degraded to land speculation. It is basically very rare to make losses through real estate investments. Losses are always the result of falling into speculation. This is why I say: don’t predict.