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Top drawer - The art market

604 words
18 December 2004
The Economist
ECN
373
English
(c) The Economist Newspaper Limited, London 2004. All rights reserved

The art market

A stunning price—and this time, for something old

IT IS said that people buy contemporary art when they are confident about the future and old art when they are not. Maybe a few worries are setting in. On December 9th, a piece of furniture known as the Badminton Cabinet—made, in pietra dura, ebony and ormolu, in 1720-32 by the Medici workshops for the third Duke of Beaufort—was sold at Christie's in London for £19m ($36.7m), a record for a non-pictorial work. The auctioneers had hoped to match the £8.6m paid by the previous owner in 1990.

The cabinet is the latest of a number of older works going for record prices. However, in recent years, contemporary art has made all the running. Last month saw record auction sales of contemporary art in New York. Research by the Art Sales Index shows that over the past four years the shares of contemporary and modern art in auction-market turnover have risen, while those of Old Masters and 19th-century works have declined. That said, Daniele Liberanome of Gabrius, a company that tracks art prices, considers Old Masters undervalued based on their performance since 1990.

Conventional wisdom has it that older art holds its value, while contemporary stuff is for risk-lovers. William Goetzmann, a professor at Yale, estimates that during the last art-market slump, which set in after 1990, Impressionist and contemporary works fell by most (51% and 40% respectively), while Old Masters suffered least (down by 16%). Yet despite the bumps, contemporary works have been rewarding for those who are prepared to hang on: according to Jianping Mei and Michael Moses, professors at New York University, since 1970 the returns on contemporary art have far outstripped those on Old Masters and 19th-century paintings.

Since the late 1980s, more sophisticated analysis of the art market and a growing interest in alternative investments have spurred the creation of several new investment funds focused on art. At a recent conference organised by one of these, the Fine Art Fund, Rachel Campbell of Maastricht University pointed out the low correlation between returns on art and on those other investments. Given that it usually pays to diversify, that is a good argument for investing in art, whatever your taste. The Fine Art Fund, which began buying this April (and has 36% of its money in cash), advises that investors spread their art allocation fairly evenly between Impressionists, Old Masters, modern art and contemporary works.

Contemporary art, in particular, has served rich investors well in the past few years. Prices stayed buoyant when stockmarkets slumped. Nevertheless, one recent academic study has found a correlation with another asset class: during the last world art boom, in the late 1980s, prices were closely tied to property values, specifically Japanese land prices. After 1990, art and property slumped together. Now property prices in several countries are once again at giddy heights.

Investing in art will always be a risky business. Works of art are by definition heterogeneous; holding periods vary; the market is illiquid; art yields no income, producing only capital gain or loss; transaction costs are high. As for contemporary art in particular, it is a sobering thought that, according to Mr Moses, each year an average of only two artists emerge whose work increases in value over time. All this speaks against a big commitment to speculating in art; better, maybe, simply to buy what you like, if you can: treat your money, in other words, not as invested but as consumed.

Document EC00000020041217e0ci0003l

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PERSONAL JOURNAL --- Canvassing the Art Market --- Old Masters and New Money: Getting a Realistic Perspective On Indexes That Track Prices

By Eric Uhlfelder Special to The Wall Street Journal
1,538 words
6 August 2004
The Wall Street Journal Europe
P1
English
(Copyright (c) 2004, Dow Jones & Company, Inc.)

PICASSO'S "Garcon a la Pipe" made the headlines when it sold for the equivalent of 86.5 million euros at Sotheby's New York this past spring, setting a record for the most-expensive painting sold at auction. But as an investment, a lesser-known drawing by the Spanish master, "Tete de Femme," was an even bigger gainer.

According to Michael Moses, finance professor at New York University's Stern School of Business -- and co-manager of an index that tracks repeat sales at New York auctions -- the drawing had fetched $26,400 (21,900 euros) at a November 1998 Christie's auction. Five-and-a-half years later, the piece resold at Sotheby's for $164,800. That's an annualized gain of 39%, during a period when the S&P 500 ended up about where it started. ("Garcon," hadn't sold since 1950, when it brought $30,000 -- meaning an annualized gain of just over 16%, and an illustration of the magic of compounding.)

While most art investments aren't going to perform like "Tete de Femme," especially over the short term, advisers and investors are recognizing more and more that art is a legitimate asset class that can improve returns. Over the 50 years through mid-2004, the broad Mei-Moses All Art Index appreciated at an annualized pace of 12.1%. That's half a percentage point higher than the return of S&P 500, dividends included, and 5.6 percentage points greater than 10-year U.S. Treasury bonds. And the art index had a low correlation with both -- 0.17 with the S&P 500 and -0.12 with Treasurys -- supporting the idea that art diversifies a stock and bond portfolio.

Art as pure investment may be catching on. Investors still can't buy an art index fund the way they can a stock index fund, but the London-based Fine Art Fund did recently become the first professionally managed pool of assets designed explicitly to profit from the appreciation of art. It's not for everybody -- minimum investment is $250,000 (with annual expenses of 2%). Designed to last 10 years and managed by a network of fine-arts specialists, the fund will spend its first three years investing exclusively in European and American canvases: 30% old masters, 30% impressionists, 20% modernists, and 20% contemporary. After that it will be permitted to sell paintings at anytime, and investors will be permitted to privately sell their shares, which they aren't allowed to do during the first three years. The fund will be marked to market -- that is, the value of the portfolio will be estimated -- every year to help assess share value and potential tax consequences. Management expects returns over the life of the fund to average between 10% and 12%, before expenses.

Additional art funds are being planned by Fernwood Art Investments, a specialty firm established by Merrill Lynch veteran Bruce Taub that has offices in Boston, New York and Miami. Mr. Taub, the chairman and CEO, is currently capitalizing one fund that's focused on master painters and another that's looking to exploit special opportunities. And Peter Hastings Falk's Connecticut-based art-management firm is currently setting up an American Art Investment Fund.

While the fund approach makes sense for establishing significant, professionally managed positions in important works of art, how can individual investors who don't have several hundred thousand dollars to pony up make a go of it? How can you evaluate a piece of art for its investment potential?

There's no shortage of figures -- a number of firms track art sales one way or another, maintaining databases that generate charts reassuringly reminiscent of those that follow, say, the stock market. But investors should understand their limitations. For instance, the oft-cited Mei-Moses index gives a broad, long-scale view of the market but isn't really an investment tool. The underlying data aren't available, making it difficult to know what segments of the art market and which artists in particular have been driving returns and which have been dogs.

And with all the indexes there are issues of methodology and accuracy. After surveying the sales of 4,200 French impressionist paintings, David Kusin, who manages a Dallas economic-research firm for institutions that focuses on art and antiques, reported finding material errors in one-third of all reported transactions, involving final sales prices, date of work, or anticipated pre-sale prices.

Still, the art databases are a good starting point, especially for new investors. Mei-Moses aside, providers do break down their numbers by individual artists, specific works, and major periods. In addition, a number of these Internet-based firms -- such as the Milan-based Gabrius Art Index and Lyon-based Artprice -- offer trend analysis, commentary and interactive usage, permitting investors to customize searches and identify promising opportunities. Most offer inexpensive temporary access for sampling or to accommodate the occasional user; price for a subscription ranges from $199 a year for Artprice to as much as $2,500 a year for access to Gabrius's entire database and analytics.

Mr. Hastings Falk likes ArtNet, Art Sales Index and Artprice. "These three databases," he says, "respectively provide images, the most comprehensive sales data covering all major mediums, and the most extensive provenance and price histories available on line."

Though most databases were formed between 1968 and 1987, they've generally backfilled historical data from before their founding, permitting analysis of longer-term trends. Nearly all collect and aggregate their information directly from auction house catalogs because the information is public and verifiable. The number of houses tracked by each index, however, varies widely. Gabrius tracks 53 of the most important while Artprice taps into 3,000, including many smaller and more obscure houses.

Specialists at each firm determine the range of artists and periods covered, which like the number of auction houses varies considerably. Art Market Research tracks 6,000 artists, Artprice more than 300,000. Most firms track sales in the major mediums -- paintings, works on paper, sculpture and photography -- which enables more than half the firms to create broad and highly refined indexes. Art Market Research, for instance, maintains 500, including the broad-based Art 100, Old Masters 100, and Contemporary Art 100. Gabrius aggregates performance of Old Master, 19th-century, 20th-century pre-War, and 20th-century post-War paintings. Frequency of update ranges from daily to quarterly.

Fernwood's Mr. Taub says the statistics underlying the databases take him only so far in evaluating a work of art. He requires more analysis, including "assessment of liquidity, correlation with traditional asset classes, risk-return profiles and hedging strength of a particular artist or movement, and identifying particular mediums of an individual artist or historical period that may outperform." Before making a transaction, Fernwood considers a piece of art the old-fashioned way, examining its provenance, or ownership history, its quality and rarity, and the frequency with which it comes to market.

Mr. Kusin agrees that if mined properly, indexes' raw data used in concert with specific benchmarks can be useful in assessing investment opportunities. You could, for example, compare the performance of 17th-century Dutch old master landscapes with AA-rated corporate bonds. But the broad strokes that general indexes may paint about the value of investing in art "are meaningless -- a thin visual description that will not help you decide when to buy or sell, because such trends fail to penetrate the dynamics and layers of the market."

As for comparing indexes between firms, that too can be of dubious value because of differences in methodology. Some indexes include art that fails to sell at auction, recording it at 75% of the low pre-auction estimate. Mr. Kusin favors the use of these so-called buy-in figures, saying they're essential for assessing downside risk. While concurring that buy-in figures are useful, William Goetzmann, a professor at Yale School of Management and co-creator of the Gabrius index, warns that such figures could at times be substantially off the mark, contributing to inaccurate risk assessment.

And some databases -- Artprice and Art Market Research, for example -- combine all sales of an artist or a historical period to determine averages and trends, while others -- such as Gabrius -- rely on repeat sales of given works. Mr. Hasting Falk believes it's essential to use both techniques to compile a comprehensive view "because not enough pieces are sold more than once." But it does make for apples-and-oranges comparisons.

For all their imperfections, art indexes make available data that would otherwise be virtually impossible to assemble, and facilitate greater interest in art as investment. And as demand for greater and more accurate analytics grows, so likely will the quality of the research that these indexes provide.

(See related article: "Private Bankers Bid to Play a Role in Building Your Collection; We Check Out Their Advisory Services and Tag Along at an Auction" -- WSJE August 6, 2004)

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Arbitragem: risco e oportunidade

959 words
14 July 2004
Valor Econômico
Portuguese
Copyright (c) 2004 Valor Econômico S.A. Todos os direitos reservados. É proibida a reprodução do conteúdo deste artigo em qualquer meio de comunicação, eletrônico ou impresso, sem autorização escrita do Valor Econômico S.A.. Para maiores informações entre em contato com nosso Departamento Comercial (+55-11-3767-1277) ou Redação (+55-11-3767-1151). http://www.valoronline.com.br

Discutiremos neste texto as operações de arbitragem e suas peculiaridades. A arbitragem é uma operação na qual o gestor identifica dois ativos com fluxo de caixa idênticos, porém com preços que, por alguma razão, não refletem a similaridade de fundamentos. O gestor, então, compra o ativo mais barato e vende o mais caro, apostando que o preço dos ativos irá convergir. A arbitragem com risco - mais comum na prática - é aquela na qual se identifica ativos com fluxo de caixa similar (e não necessariamente idênticos) e preços que não refletem a similaridade de fundamentos. O gestor monta sua posição apostando na convergência de preços. Operações de arbitragem também são conhecidas como "long/short".

O texto "The Limits of Arbitrage", escrito por Andrei Shleifer e Robert Vishny, professores de Harvard e Chicago respectivamente, é um dos principais sobre o tema. A visão convencional acadêmica (vide mercados eficientes) é de que oportunidades de arbitragem são escassas e rapidamente exploradas por um grande número de pequenos investidores. A grande contribuição dos autores foi fazer uma modelagem diferente: em vez de um grande número de pequenos investidores, no modelo de Shleifer & Vishny, as operações de arbitragem são feitas por um pequeno grupo de investidores profissionais altamente especializados com capacidade para montar posições grandes com recursos de terceiros.

O conceito central do artigo é de que operações de arbitragem podem ser relativamente complexas de modo que, apesar de o gestor saber perfeitamente o racional de suas operações, o mesmo não se pode dizer de seus clientes. Além disso, existe um nível razoável de volatilidade nos papéis arbitrados - que pode levar uma posição teoricamente vencedora no longo prazo a sofrer bastante no curto prazo. Como o investidor não tem o mesmo grau de informação do gestor, sua avaliação das "habilidades" do gestor acaba se baseando fundamentalmente em performance passada. É o que os autores denominaram PBA - Performance Based Arbitrage. E é exatamente aí que está o "pulo do gato" no modelo de Shleifer & Vishny: boas operações que sofrem volatilidade de curto prazo podem levar os investidores a resgatar dinheiro de fundos "long/short" forçando o gestor a reduzir suas posições e contribuindo para afastar ainda mais os ativos arbitrados de seus preços justos.

Outro texto interessante sobre o assunto, intitulado "Pairs Trading: Performance of a Relative Value Arbitrage Rule", foi escrito por três integrantes da Yale School of Management: Evan Gatev, William Goetzmann e K. Rouwenhorst. No artigo, os autores testaram uma estratégia de investimento denominada "pairs trading" com dados diários de 1962 a 1997, para ações do mercado americano. A estratégia consiste em identificar ativos com alta correlação histórica e aproveitar oportunidades em que seus preços se distanciem para comprar o mais barato e vender o mais caro. Os autores escolheram trabalhar com um horizonte de seis meses (ou seja, a cada seis meses as posições montadas durante o período que não funcionaram eram desfeitas com prejuízo) e com um gatilho para a montagem de posições de dois desvios padrões históricos.

Os autores encontraram um retorno anualizado médio de 12% para a estratégia, utilizando os 20 pares mais correlacionados do mercado. Ajustando pelos "spreads" (diferença) de compra e de venda, o resultado cai para cerca de 8%, ainda bastante relevante. Dos vinte pares mais correlacionados, 82% são compostos por papéis de "utilities" - composto por concessionárias de serviço público. Além de ser responsável pela grande parte das operações, o setor de "utilities" é disparado o mais rentável, com um retorno anualizado médio de 10,6% frente 4,9% para transportes, 7,6% para o setor financeiro e 5,5% para o setor industrial. E mais: além de ter o melhor retorno, o segmento de "utilities" ainda possui um desvio padrão menor que seus concorrentes.

Outro ponto relevante é que o retorno dos 20 pares de ativos mais correlacionados tem uma exposição positiva que, embora pequena, é estatisticamente significativa a fatores como tamanho e preço sobre valor patrimonial. Em outras palavras, o gestor muitas vezes está arbitrando empresas menores e mais baratas contra similares maiores e mais caras. As operações possuem uma volatilidade que não pode ser desprezada: na média 16% das operações apresentam retornos negativos em seis meses e o retorno mínimo para o portfólio em seis meses foi de aproximadamente uma queda de 10%! Ou seja, o gestor realmente tem de ter uma boa dose de cuidado para encarar esse tipo de estratégia.

Ao contrário da visão convencional de mercados eficientes, a presença de fundos especializados para explorar esse tipo de estratégia não parece ser suficiente para esgotar completamente as oportunidades disponíveis. Como foi bem colocado por Shleifer & Vishny, movimentos de zeragem de posição de fundos especializados por conta das oscilações aleatórias de curto prazo no preço das ações podem contribuir para deixar as arbitragens ainda mais interessantes.

No Brasil, nossa experiência corrobora a visão de Gatev, Goetzmann & Rouwenhorst de que o setor de "utilities" é bastante interessante de se arbitrar, principalmente tendo-se em conta o momento de consolidação que estamos vivenciando no setor de telefonia. Os custos de aluguel de ações, que ficam em torno de 5% a 6% ao ano, são consideravelmente menos atrativos que nos Estados Unidos, o que limita um pouco o número de operações possíveis. As oportunidades de arbitragem no mercado, porém, são muito interessantes. Nossa confusão societária resultante das diferentes classes de ações (ordinárias, preferenciais, etc) e das muitas holdings e operadoras presentes no mercado acabam gerando um ambiente de muitas oportunidades.

Acreditamos que o setor, ainda bastante incipiente, tem tudo pra se desenvolver bastante no país e se tornar uma classe realmente importante para o investidor que procura retornos atrativos em bolsa, mas não necessariamente está disposto a ficar comprado o tempo todo.

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Basel and the brush - Modern art

929 words
26 June 2004
The Economist
ECN
371
English
(c) The Economist Newspaper Limited, London 2004. All rights reserved

The Basel Art Fair, arbiter of contemporary taste

The arbiter of contemporary taste

FOR most of the year, the sleepy Swiss city of Basel sees nothing more exciting than a steady stream of central bankers on their way to the Bank for International Settlements. Except in early June, that is, when the place is invaded by a very unsteady flood of contemporary-art collectors rushing to the six-day Basel Art Fair. When the gates open on the first day, Nike-clad collectors literally sprint through the doors in pursuit of work by prized young artists. Some have been known to steal dealers' passes in order to sneak in early and get the pick of work that is newer and, in many cases, weirder than anyone else's.

By lunchtime on the first day, the VIP lounge is a scrum of hugely wealthy adrenaline jostling for food, puffing cigars and flashing digital images of art stored on Palm Pilots. According to a London dealer, David Juda, whose gallery was in at the founding of the fair, there has been a huge increase in interest in contemporary art since it began in 1970. “Today, people are more aware of what is happening in art and in museums,” he says. “They have more disposable income and they feel more at ease coming into a gallery than they would have, say, 30 years ago.” The fair is so successful that it is now held twice a year—once in Basel and once at Miami Beach (in December). This year 10,000 collectors flocked to the opening day, and over 50,000 attended during the week.

The draw is quality: Basel is the most strictly vetted modern-art fair in the world. A committee of international dealers selects each of the 270 galleries that attend on the basis of the quality and variety of their art. Stands are inspected daily, and dealers are encouraged to bring their best to Basel. It is possible to buy a Picasso or, if you're lucky, this century's Picasso. And that is part of the thrill: “It's like horse-racing,” says Mr Juda, “people only remember the bets that come in.”

Fancy a flutter on Finnbogi?

The fair is arranged on two floors: on the ground floor are the blue-chip art dealers such as Acquavella, Berggruen, Beyeler and Krugier. Upstairs are the more lively contemporary galleries where prices start at around euro5,000 ($6,000), but can be as high as the £450,000 ($824,000) paid for Jake and Dinos Chapman's sculpture of a copulating couple. Down the road from the main fair is the “Liste”, where even trendier young galleries show work by emerging artists. Here collectors pounce as if they're in a bargain basement, sometimes snapping up entire stands at once.

Some collectors come to Basel with their personal curator to advise them. Others—such as Francesca von Habsburg—rely on their instincts. This year Ms von Habsburg paid euro35,000 for a “sound installation” by an almost unknown Icelandic artist called Finnbogi Petursson because she loved the work: “It makes sound visible,” she says. The room-sized piece will go to Ms von Habsburg's new Vienna-based art foundation, dedicated to showing 21st-century art. Scion of a family famous for collecting old masters, Ms von Habsburg took a punt on Mr Petursson's work knowing that the Reykjavik gallery exhibiting it had launched the career of another Icelandic artist, Olafur Eliasson, who is now a star in the contemporary-art world.

Most collectors start by decorating their own houses. Frank Cohen, a Manchester millionaire, bought his first painting to furnish his home 30 years ago. But his interest has spiralled so much that next year he is opening a museum of contemporary art in Manchester to house his vast collection. An Argentine pharmaceuticals tycoon, Juan Verges, and his wife have been coming to Basel for eight years and have amassed such an immense collection of large-scale installations that they have restored a factory in Buenos Aires to exhibit them all. For Mr Verges, as for most collectors, buying new art allows him to get to know artists and to watch the creative process at first hand.

But not all buyers are wide-eyed enthusiasts with little concern for the future value of their purchases. Joao Reindeiro, president of Banco Privado Portugues, believes that contemporary art is a good investment. He sees it as a “risky asset class”, but one that has earned returns of 10-12% per annum over the past 17 years.

Collectors who want to keep an eye on the value of their art can turn to the Gabrius Index for help. Set up by William Goetzmann, a professor of finance at the Yale School of Management, it charts changes in the price of art that has been auctioned more than once. Mr Goetzmann says that contemporary art is like a “high beta” stock: one that rises and falls faster than others.

Last year, the sub-index of abstract contemporary art prices rose by 97%, a rate not seen since 1991. Does this presage a bubble similar to that of the late 1980s, when prices doubled almost every six months? Not yet, says Mr Goetzmann: “We are seeing the first flush of enthusiasm rather than a boom.” The sober-minded at Basel (a minority) noted that at the end of 2002 the abstract-art index stood at almost exactly the same level as a decade earlier.

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Personal Business: Real Estate

Your Home By the Numbers; Some basic tools can help you calculate how good an investment your house is.

By Peter Coy With Ann Therese Palmer in Chicago and Michael Eidam in Atlanta
2,744 words
14 June 2004
BusinessWeek
88
Volume 3887
English
(c) 2004 McGraw-Hill, Inc.

A house is most Americans' most valuable asset, and lately it has been the best-performing. In some ways, though, it's the least understood component of the average investment portfolio. Financial advice on homeownership consists mainly of real estate agents' truisms: Buy the most house you can afford.... The housingse market never crashes.... Houses are better to own than stocks and bonds because they're tangible. These sales slogans are a poor substitute for serious analysis of an asset that's critical to your financial future. To evaluate housing as part of your portfolio, set aside your affection for home, sweet home. Shake off the delusion that the recent leaps and bounds in home prices in many markets are sure to continue. Instead, look at the property you own -- or want to buy -- with the same cold detachment as you would 1,000 shares of IBM.

Employ basic concepts of investing: total return, risk reduction, transaction costs, liquidity, forced savings, leverage, market depth, tax treatment, and net present value. Few people are that rational about houses. ``People buy with their gut, and then they bring out their wallet,'' says Julie Garton-Good, an author of books on real estate. And when they do toss around investment terminology, it's usually because they have dollar signs in their eyes. ``A tendency to view housing as an investment is a defining characteristic of a 'housing bubble,''' economists Robert Shiller of Yale University and Karl Case of Wellesley College wrote in a Brookings Institution paper last year.

A good green-eyeshade analysis of housing might well lead you to the conclusion that house prices in some of the hottest markets -- from New York and Washington to San Francisco, Los Angeles, and San Diego -- are dangerously high. The warning signs are abundant: Prices have climbed much faster than incomes, interest rates appear to be rising from historic lows, and homeownership rates are already at record highs.

But regardless of whether the market you live in is frothy or flat, the purpose of this article is to show how tools of financial analysis developed by economists and top investors can help you make better decisions about the place you call home.

A good starting point is total return. Like the return on a stock, the return on a house has two parts. First, there's the ``dividend.'' That's the annual cash flow you get from the property. The dividend from a house is not a check payable to you. It's the money you save each year by not having to pay rent to a landlord to live there, minus annual homeowner expenses such as utilities, insurance, and upkeep. This dividend is roughly 6% or 7% a year before property or income taxes, according to Wellesley's Case.

PALTRY GAINS

THE OTHER PART OF your return is the capital gain or loss, which you get when you sell the house for more (or less) than you paid for it. From 1975 through 2003, house prices rose at a compound rate of 5.8% a year, according to data from the Office of Federal Housing Enterprise Oversight. Put the dividend and the capital gain together, and you get a highly respectable annual pretax return from housing of about 12%. That compares with the 13% annual pretax return from stocks over the same period, including both dividends and capital gains, according to Ibbotson Associates. For ease of comparison, these calculations assume that both the house and the stocks are bought with cash. In reality most houses are bought with borrowed money. After taxes, housing beat stocks over the period for high-income people whose stock returns were heavily taxed.

There is one important difference between the return on houses and the return on stocks: Although many people have gotten rich recently from housing, nationally, over the whole period, capital gains accounted for just 5.8 percentage points of housing's total return, vs. 9.4 percentage points of stocks' total return. Housing's capital gains look even smaller when inflation is stripped out (chart). From 1975 through 1995, the annual rate of appreciation after inflation for a typical single-family house was just 0.4%. Extending the period through 2003 gets you up to only a 1.3% annual rate. And even these modest figures overstate the annual capital gains by about half a percentage point because the price increases are partly the result of money spent by homeowners on renovations, according to OFHEO economists.

If history since 1975 repeats itself, boomers who aren't already sitting on a pile of housing wealth had better sock away lots of money in their 401(k)s, because they won't be able to count much on future gains from rising home prices. On the other hand, Gen-Xers who are still renting might actually be able to afford a house some day, because prices won't keep growing forever faster than the rate of inflation or the rate of income growth.

There's a subtler implication here as well. Many people make big sacrifices to buy the most expensive house they can afford, figuring that the bigger the house, the bigger the gain that it will someday produce. But that could be a mistake: History suggests that future after-inflation gains for most house sellers are likely to be modest.

So if you really like big houses, buy one. But if you hate dusting empty bedrooms and using intercoms to communicate with your children, purchase a smaller house -- and don't worry that you're missing out on big profits. Buying a smaller house will leave you with more money for things that will make your house more enjoyable. ``People end up being house-poor,'' says Susan Hirshman, financial planning strategist with JPMorgan Fleming Asset Management. ``You walk into a beautiful house and there's no furniture.''

RENT HEDGE

SMART INVESTORS also use houses as a means of risk reduction. Since homeownership protects you from having to pay rent, in effect it's a hedge against future rent increases. So the longer you plan to remain in one place, the more logical it is for you to buy rather than rent. A house can also stabilize an investment portfolio because the housing market's ups and downs aren't closely correlated with those of stocks and bonds. The trouble is that many people, especially young families just starting out, have the bulk of their wealth tied up in housing. Marjorie Flavin, an economist at the University of California at San Diego, advises that people whose assets are skewed toward housing should offset the high risk inherent in their housing investment by tilting the rest of their portfolio toward bonds and away from riskier stocks.

One of the best ways to improve your returns from housing is to minimize transaction costs, which are much higher for houses than for other assets. To sell $500,000 of stocks costs approximately $350 in brokerage commissions. In contrast, to sell a $500,000 house might cost more like $40,000 in fees, estimates Mike Sklarz, chief valuation officer for Fidelity National Financial, a real estate services company based in Jacksonville, Fla. Add to that sum the cost in money, time, and aggravation of preparing the property for sale and moving. Because transaction expenses are so high, it makes sense to move infrequently -- just as you save money on brokerage fees by not churning your account.

Many people underestimate the value of liquidity in housing until they need a lot of money in a hurry. Fortunately, the liquidity of housing has improved in recent years with the spread of rapid refinancing as well as home-equity loans and lines of credit. Most useful of all are home-equity lines of credit, which cost you nothing until you need to tap them in an emergency. If you don't already have one, get one.

Ironically, though, the ease of borrowing against equity takes away what was always one of homeownership's greatest advantages: forced savings. While people must still make principal payments every month, they can -- and do -- offset the equity accumulation by simultaneously borrowing.

Houses are money machines in good times because they're bought with enormous leverage. Assuming a downpayment of 5%, a one-year increase of 10% in a house's price gives you a 200% return on equity. That extreme degree of leverage would be fine if the truism about houses being a stable investment were correct. But that's only true of the national average. Prices are more volatile by region -- and more volatile still on a house-by-house basis. In a 1993 study, Yale School of Management economist William Goetzmann found that there was a one-third chance that the price of any given house in San Francisco would increase or decline 12.7% vs. the long-term trend in the course of just one year. The fluctuations were only slightly smaller for other cities.

Although leverage can be abused, there's nothing dangerous about a zero downpayment, per se, as long as you save the money you would have spent on the downpayment or put it back into the property. For example, Eric Kliem, 30, a loan agent, and his wife, Erin, 31, a high school teacher, put nothing down last year when they bought a $385,000 townhouse in Huntington Beach, Calif. They had money for a downpayment but chose to use it instead for renovations after the purchase. That raised the townhouse's value and gave them equity.

The mistake many people make is in thinking that the more leverage they're allowed to take on, the more they can afford to pay for a house. That's getting things backward. The prudent move is to figure out first how much you can afford to spend on a house, taking into account your income and other variables, then choose the balance between loan and downpayment. ``What you're qualified for and what you can afford are two different cases,'' says Paula Nichols, a Coldwell Banker broker on Chicago's North Side.

CLEVELAND'S VIRTUES

OF COURSE, IT'S HARD to stick to vows of prudence when faced with the exorbitant prices of houses in today's hottest markets. BusinessWeek's Luxury Housing Affordability Index (table) shows that while houses at the top end of the market are still easily affordable to upper-income households in places like Cleveland, St. Louis, and Atlanta, they're scarily high relative to top incomes in such cities as San Francisco, Washington, Los Angeles, and San Diego, where construction falls short of demand. Worried about getting suckered by buying at the top in one of those markets? Then settle for a smaller house, or rent and wait for a downturn -- or take another look at the virtues of Cleveland.

People who are buying houses in the top tier of the market are at the greatest risk of overpaying. That's because market depth is poor -- in other words, there are few transactions, so small fluctuations in supply and demand can cause big swings in prices. Don't assume the price that you're quoted is anywhere near what the market will bear. For example, Palladium Construction in Lake Forest, Ill., recently raised the asking price for a luxury house in the Chicago suburb of Highland Park to $8 million, even though it had been on the market at $6 million since 2000 with no takers.

Tax treatment is what decisively tips the balance toward homeownership for many families: Mortgage-interest payments are deductible. Also, there's no tax on the dividend of housing -- that is, the shelter value it provides you. And the first $250,000 in capital gains from a sale for an individual, or $500,000 for a couple, is tax-free if the house sold is a primary residence and the owner has lived in it for two of the previous five years. There's no limit on how often you can take this tax break. Plus, the 2003 tax law lowered taxes on capital gains over the limit to a modest 15%, from 20%. ``This is making housing a more attractive asset than it used to be,'' says Jonathan Noonan, chief investment strategist at Boston money manager Appleton Partners.

One family that has taken full advantage of the tax-law changes is Edmond and Jennifer Sahm and their two children, who in March closed on a new, $620,000 four-bedroom house in Carlsbad, Calif. Sahm, a certified public accountant, always buys newly built homes because, he says, builders sell them at a discount of 10% to 20% to existing homes. The Sahms have bought and sold two residences in the past five years, earning handsome capital gains both times, and have already contracted for another one for $1.1 million. A tip from Edmond Sahm: To get into new developments, ``get on the builder priority lists.''

THE BEST TOOL

WHILE ALL THE TOOLS mentioned above are useful, if you had to pick one technique for evaluating a house, it would be net present value. That's the value in today's dollars of the house's stream of cash flows. The negative cash flows each year are the mortgage payments, property taxes, utilities, and maintenance. The positive cash flows are savings generated by income-tax deductions and -- the big element -- avoided rent. The flows are netted out for each year, and discounted by the going interest rate. Typically, the longer you plan to stay in a house, the bigger the net present value will be.

You don't need an MBA to figure all this out. A program for calculating a house's net present value, which can be tried for free, is available at www.smithfinancialplace.com, created by Pomona College economists Gary and Margaret Smith. Reassuringly, the calculator produces answers that accord with common sense. For example, it shows that how much you pay for a house is a crucial factor in whether its net present value to you is positive or negative. (The message: Beware of bubbles and don't overpay.)

Wrestling with difficult questions such as a house's net present value isn't fun. But you owe it to yourself to make the smartest possible decisions about your biggest investment.

Bargains...and Bubbles?

The BusinessWeek Luxury Housing Affordability Index shows big differences between the largest metro areas.
METRO LUXURY AFFORDABILITY
AREA HOME INDEX
Cleveland $250,500 244
St. Louis 274,000 241
Columbus 269,000 236
Atlanta 312,000 235
Detroit 296,673 229
Philadelphia 320,000 227
Orlando 285,000 208
Tampa/St. Pete 272,000 208
Nashville 305,406 204
Charlotte 325,000 195
Denver 394,000 175
Chicago 435,000 165
Las Vegas 358,500 154
New Orleans 368,000 152
Sacramento 437,000 146
Baltimore 485,000 140
Riverside/
San Bernardino 406,000 139
Boston 679,250 130
Miami 450,000 124
San Jose 941,500 116
New York 650,000 110
San Francisco 1,195,000 94
Washington 940,000 93
Los Angeles 737,000 89
San Diego 765,000 89
HOW WE CREATED THE INDEX
The usual affordability index tells whether a midmarket house is within the budget of a middle-class family. BusinessWeek's index, based on house-price data from Fidelity National Financial, looks at the top 10% of house prices and incomes. An index value of 100 means that given prevailing mortgage rates, a family earning just enough to be in the top 10% of incomes in a metro area should be able to afford a house that's barely in the top 10% of prices. The higher the index, the more affordable the market. Metro areas listed are the biggest ones for which reliable data exist.
* Fourth quarter 2003
Data: Fidelity National Financial Inc., Housing & Urban Development Dept.

illustration | Illustration: Chart: HOUSING PRICES: THE LONG VIEW | illustration | Illustration: Chart: Location, Location, Location CHART BY RAY VELLA | photograph | Photograph: FLIPPING HOMES The Sahms bought and sold two in five years PHOTOGRAPH BY ROBERT BURROUGHS | photograph | Photograph: GIMME SHELTER Prices rise more slowly where there's lots of building PHOTOGRAPH BY ATIM BOYLE/GETTY IMAGES

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BUSINESS

Carried away? Burst of interest in IPO could lead some astray

Tom Abate
Chronicle Staff Writer
1,221 words
29 April 2004
The San Francisco Chronicle
FINAL
C1
English
Copyright (c) 2004 Bell & Howell Information and Learning Company. All rights reserved.

Pssst. Have you heard that Google might be going public?

Fed by leaks from bankers "close to the deal" and repeated in countless media reports, Internet search engine Google Inc.'s expected IPO resembles, some market watchers fear, the sort of over- hyped stock stories that ignited the technology bubble of the late 1990s.

The worry is that however solid Google is as a business, a frenzy for its stock could drive its share price into the stratosphere. And that could make some people forget the lessons they learned when tech stocks crashed a few years ago and the excesses of Internet mania were purged from the marketplace.

"People do work themselves into enthusiasm for certain investments," said Yale University economist Robert Shiller, author of "Irrational Exuberance," published in 2000, just as the dot-com bubble was beginning to deflate.

Googlemania could hit a decisive point today, the deadline for the privately held search engine firm to reveal its finances, according to Securities and Exchange Commission rules. They say Google has so many internal shareholders -- financial backers and employees with stock options -- that it must have the financial transparency of a public firm.

Anticipation of this event has fueled speculation that Google's management will decide that because the company must bare its bottom line, it will go all the way and file an initial public offering to sell stock on Wall Street.

To be sure, not all market watchers agree that we are about to enter a dangerous new era of tech fever.

A successful Google IPO could simply return the market to health, allowing strong companies to raise the capital they need. And Google, they point out, is one of the most successful businesses on the Web.

If Google files an IPO, Yale finance Professor William Goetzmann said it is likely to open the window for other public offerings, to use the Silicon Valley slang.

"I think it would be wonderful if this IPO for Google went smoothly and reinvigorated the public equity markets," he said. "I don't see that as a problem of a fever or excess. I see the last few years of shutting down the equity markets as the panic."

Richard Peterson, who tracks public offerings for the Thomson Financial news service in New York, said IPO activity all but ceased after the dot-com collapse.

For most of the 1990s, Wall Street averaged 100 IPOs per quarter, he said. During the last two years, that fell to fewer than 100 IPOs per year. Peterson said there have been 46 IPOs so far in 2004, a sign that capital markets are beginning to regain their appetite for risky new offerings.

Tim Loughran, a University of Notre Dame finance professor who has studied IPOs going back more than 20 years, said the prospect of a Google offering is generating the same sort of excitement -- and for the same reasons -- as Apple Computer's 1980 IPO or the 1995 premiere of Netscape.

"These companies encapsulate the American dream of a couple of people sitting around, having a great idea, getting some success and going public," Loughran said.

Google certainly has all the attributes of a modern rags-to- riches myth. Founded by Stanford graduate students Sergey Brin and Larry Page, Google elbowed its way onto the computer desktop by dint of its sheer usefulness. It is expected to reveal today that it has become a revenue powerhouse in its last six years as a private firm.

At this point, it's difficult to gauge how much visions of a blowout IPO have seized the imaginations of Main Street investors. There are plenty anecdotes of individual investors clamoring for shares. But for all of Google's attributes, not the least of which is its awesome name recognition, media fascination with the company may be running ahead of investor appetite.

Sondra Harris, spokeswoman for Charles Schwab, said that, given all the speculation, she called several of the brokerage firm's regional offices to gauge interest in the possible offering.

"It varied from little to some," Harris said, adding, "The frenzy is being fueled more by the media coverage than interest on the part of individual investors."

Bill Brady helps run hedge funds for Presidio Management, a San Francisco institutional investor likely to get first crack at any Google shares.

"It's an exciting company, and it's creating a lot of excitement in the investment community," said Brady. But as a practical matter, because he doesn't know whether it's going public or how many shares Presidio would be offered if it did, he hasn't put a lot of time into weighing its merits.

The intensity of media coverage in advance of actual details doesn't surprise Shiller, who dedicated a chapter of "Irrational Exuberance" to the connection between the press and financial euphoria.

"I don't think there were any bubbles until there were newspapers," said Shiller, whose research went back to the Dutch tulip bulb craze of the 1630s.

"Holland was the first nation to have a free press," said Shiller, who said media reports spread enthusiasm the way sneezes spread germs.

Other economists believe markets are generally rational and pooh- pooh the notion that, when it comes to financial hype, the media is the biggest culprit.

"Everybody's interested in Google because it's a big company that we all know about," said John Cochrane, a professor at the University of Chicago's business school. "I have not seen evidence that the media by themselves can ignite the sort of frenzy that would not otherwise occur."

Ironically, stories about Google are sharing the news pages with articles about former Silicon Valley investment banker Frank Quattrone, who is being retried for alleged excesses during the IPO boom of the dot-com era.

But should Google go public, the volume of the coverage could make otherwise sober investors ignore fundamentals, said UCLA Professor Avanidhar Subrahmanyam, who studies investor psychology.

"I'm not saying Google's IPO wouldn't be successful, but the publicity feeds the frenzy, and the danger is that people get carried away," he said.

Loughran, of Notre Dame, said if and when Google does go public, small investors should not try to get in on the first day, but wait and see. "Microsoft was a big winner," he said. "But its IPO was in 1986, and the stock took years to take off."

But whether whipped up by media coverage or not, even smart people are excited by Google. "I got medical advice in a few minutes that would have taken me a week of visits to doctors' offices to get," said Arno Penzias, a Nobel Prize-winning Bell Labs scientist who is now a venture capitalist in San Francisco. ------------------ ------------------------------------------------

NOT MANY VENTURED, SOME GAINED A LOT

The number of initial public offerings in 2003 was the lowest in years, but several companies that did go public had significant gains.

Initial public offerings

99 510

00 373

01 108

02 97

03 88

04 46 (year to date)Sources: Thomson Financial, Bloomberg Financial MarketsChronicle Graphic

E-mail Tom Abate at tabate@sfchronicle.com.

Caption: Dan Hubig / The Chronicle; Photo: GRAPHIC, CHART: SEE END OF TEXT

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Factiva

Dow Jones & Reuters

BUSINESS

Carried away? / Burst of interest in IPO could lead some astray