We got a fascinating boots-on-the-ground report from a friend of ours traipsing about Hong Kong … and no, this isn’t about Hong Kong.

“My Big Short moment …” was the subject line.

“The Big Short” refers to Michael Lewis’ book and the recent movie of the same name, which both tell the tale of events leading to the 2008 financial crisis.

Our friend went to an “open house” for a pre-development condo tower. Prices STARTED at $700,000 USD for a 216 square foot condo. Crazy.

Non-Hong Kong residents pay an ADDITIONAL thirty-percent “speculation” tax. Ouch.

We’re guessing government is trying to discourage global hot money from bidding up properties and pricing out locals who need places to live.

Our friend reports these condos are only fetching $2,000 per month rent. Even with today’s low interest rates, those numbers make NO sense.

Nonetheless, our friend says bank financing is available … with 40% down.

Apparently, the banks aren’t completely insane.

However, he says the developer is offering much more attractive 30-year, 15% down, “teaser rate” financing. It starts at prime less 2% for years 1-3, then prime less 1% for years 4-5, and then prime plus 1% for years 6 forward.

Now, for those around pre-2008, these loans sound hauntingly like the infamous 2/28 loans which triggered the mortgage meltdown.

But it gets better.

Apparently, the demand for these tiny, grossly expensive condos is so high, the developer set up a lottery system for buyers.

A prospective buyer must pay $100,000 HKD to enter for the CHANCE to buy a unit. And there’s nearly THIRTY wannabe buyers for each unit!

Does all that sound just a tad overheated?

Of course, Hong Kong’s not the only place real estate values are out of control. Last week, we made mention of growing concerns about Canada’s housing boom.

Does this mean real estate investors should hibernate until things calm down?

We don’t think so. But we certainly aren’t suggesting anyone buy into over-heated markets or product types.

So what’s going on?

When an economy gets flooded with cheap money, prices get bid up because the ratio between money (technically currency) creation and product creation favors money.

More money chasing the same goods means prices rise.

But prices don’t rise everywhere on every item across the board. It depends on who gets the cheap money and what they do with it.

There’s a bazillion factors affecting how excess money gets into circulation. No one really knows for sure where it’s going to pop-up.

We call this “the squish factor.”

If you squeeze a water balloon that has enough elasticity, it will squish out between your fingers … somewhere. But you don’t always know where.

And if you push it back in one place, it pops out another. Again, you don’t always know where.

Speculators try to guess where it’s headed, and front-run it. They’re called the “hot money”. Their goal is to get in and out early, and let the late-to-arrive and late-to-leave crowd take the lumps.

And you never know where the next bubble will pop-up … or recede.

The reason bubbles recede is because there’s nothing REAL underneath them creating value.

So when the hot money leaves to front-run the next asset class, the air comes out of the current bubble … and it’s pricing recedes to the true value based on income.

The big short of it (sorry, we couldn’t help it) is … value is based on income.

Rents of only $2,000 per month can’t possibly justify a $700,000 value. All the excess value is from hot-money “air” … and the only exit is the greater fool or the poorhouse.

So what’s an investor to do?

First, let’s make a distinction between an “investor” and a “speculator”. The former focuses on cash-flow, while the latter focuses on capital gains without adding value.

“Investors” use currency to acquire assets which produce cash flows. Acquiring assets is the objective.

Conversely, “speculators” trade assets to acquire currency. Acquiring currency is their goal. Buy low, sell high, collect currency. Repeat. The cash flow comes from the sale of assets, not the holding of assets.

By those definitions, an “investor” would NEVER buy one of those Hong Kong condos. The numbers preclude it. They just don’t make sense.

But hot money speculators will … and apparently are. At the margin of the hot money is the dumb money. The dumb money gets in and out late … if they can get out at all.

We know. We’ve done it. It’s VERY tempting because the profit can be BIG and FAST. And when you win, it feels GREAT. But …

So, YES … it is possible to make HUGE gains getting in and out of a bubble asset. Be it stocks, bonds, commodities, currency or real estate.

It’s also possible to make a lot of money in a Ponzi scheme or at the craps table. But it’s not investing.

We’re NOT saying capital gains are bad. Far from it! We LOVE equity. But REAL equity comes from CASH FLOW and holds up MUCH stronger when the tide of hot money recedes.

So while speculators are drunk with cheap money in the bubble casinos … sober investors are poking around boring markets looking for cash-flows and value-add opportunities with multiple exit strategies.

The great news is cheap money spends just as well in the boring markets and product types, but there’s no hangover after a binge. Values up. Values down. Cash flows fairly steadily.

With all the weird happenings in the global financial markets, it’s more important than ever to stay sober and focused on finding real value … markets with sustainable drivers and nice boring cash flows.

The irony is that when the air comes out of the over-heated markets, some of the hot money will flow into those boring markets. Which is a fun ride for those already there.

Meanwhile, many of those markets aren’t over-crowded … yet.

Until next time … good investing!

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