Episode #324 of The Creating Wealth Show showcases an interesting interview by Jason Hartman of George Gilder, author of Knowledge and Power: The Information Theory of Capitalism. But before Gilder holds forth on a topic which should be of interest to all of us, Jason invites frequent co-host Michael aboard for a discussion of why hedge funds nearly always stink up the joint when it comes to real estate investing.

The Hedge Fund Role in the Housing Market

Jason and Michael use a recent interview by John Burns to kick off the hedge fund topic. It’s not surprising that hedge fund managers find it almost impossible not to jump into real estate when market prices are low, but there are a few reasons they simply aren’t very good at it. Numero uno among these reasons is that they are not real estate experts. That in and of itself is reason enough for hedge fund clients to get nervous when the managers start talking about diving into real estate.

The Multiple Dimensions of Real Estate Investing

Going beyond the simple fact that hedge fund managers are rarely real estate investing experts, consider also that they (and almost every other type of investor) are programmed to think of any asset in a single dimension. And that single dimension is usually appreciation. In other words, you buy a property at one price, hold it for a while and sell it at another – hopefully higher – price. Outside of the few remaining dividend-paying stocks, this is how almost every form of investing works: stocks, bonds, mutual funds, precious metal.

But it is the multiple avenues of profitability that have consistently generated wealth for investors like Jason Hartman over the decades. Jason puts it thusly: appreciation is just the icing on the cake. It’s nice if you can get it but is not necessary to win at the real estate investing game. To rely on nothing more than appreciation for profit leads hedge funds to buy up large tracts of properties in high risk areas like California. As Jason has taught for years, you need to pay close attention to the RV ratio of any income property you buy, even more than other popular metrics like cap rate.

If hedge funds seem a little reckless in their buying, it’s likely because the managers are not using their own money. They feel like they can swing for the fences. There will be strikeouts along the way and maybe a home run or two. Trust us, that’s not the way you should go about building your own income property portfolio.

Why California is Still a Bad Bet and the RV Ratio Matters

Let’s get right into the guts of this. One of Jason’s favorite screening metrics when it comes to selecting an appropriate investment property is the Rent to Value (RV) ratio. It’s easy to calculate. Divide the purchase price by how much you could rent it out for and you’ve got it. For example, say you’re looking to buy a $500,000 house and you know comparable properties in the area rent for $2,500 per month. The result is .005 which isn’t enough! Jason Hartman’s minimum RV is 1.0. Go below that and you’re asking for trouble. There’s a good chance monthly cash flow from the tenant will not sustain mortgage payments and associated landlord costs. As a review, here are a few of the other ways you earn money with a real estate investment:

* cash flow
* principal reduction
* tax benefits
* appreciation

A thorough understanding of ALL the ways a single property can generate money for an investor makes it clear why appreciation is not of much concern to a disciplined investor. Just think, you could hold a rental property that never gained a dime in value for ten years but still come out smelling like money while raking in $1,000 of rent every month. When you consider that the tenant’s rent should cover the mortgage payment, it’s like you come out at the end having put very little into the property yourself. You used the bank’s money to finance 80% of the purchase, then paid off that loan using rent money. At the end, the property is yours completely!

Introducing George Gilder

Mr. Gilder is an American investor, writer, economist, techno-utopian advocate, and co-founder of the Discovery Institute. His 1981 international bestseller Wealth and Poverty advanced a practical and moral case for supply-side economics and capitalism during the early months of the Reagan Administration and made him President Reagan’s most quoted living author. In 2013 he published Knowledge and Power: The Information Theory of Capitalism and How It is Revolutionizing Our World, which reformulated economics in terms of the information theory of Alan Turing and Claude Shannon.

Entrepreneurs Sow the Seeds of Creative Destruction

According to Gilder and the concepts of Information Theory, creative entrepreneurs are, by their very nature, a disruptive force in the economy. They come up with new ideas that challenge the status quo and constantly push against the communal comfort zone. But this is a good thing! It’s when government regulations get in the way and stifle the entrepreneurial class that our national economy tends to wallow in unproductivity. Information Theory explains exactly how this works and lobbies to loosen the chains that fetter capitalism.

Mr. Gilder likens the perfect system to a low entropy carrier, where government interferes to the absolute least extent, and high entropy endeavors – like creative entrepreurs – are allowed to operate in almost total freedom. When you ponder our modern day ultra-intrusive government, you start to see why we are stuck in a cycle of stagnancy.

The Good News

Though Gilder’s assessment of America seems to be kind of a downer, he claims it is actually positive; since the economy is based on knowledge, it can change as fast a people change their minds. For many more thoughts from the great man himself, visit George Gilder’s website at www.Discovery.org(Image: Flickr | stevendepolo)

More from Jason Hartman:

A Rigged Game: Wall Street vs Main Street
What China’s Militarism Means for the World

The Jason Hartman Team

Real estate is the best investment