On today’s episode we are talking about the laws of economics and how they apply to the world of investing. 

As real estate investors, we make choices about where to invest, when to invest, what us a class to invest in, and the positioning of the product in the marketplace. When you perform due diligence on a particular opportunity there are always three elements to look at in detail. 

  1. The team.
  2. The overall market 
  3. The specific deal. 

One of the realities of our modern world is that nothing ever stays the same. You’ll either be in a period of growth, or a period of decline. That is true of companies. That is true of cities. That is also true of individuals.

Often, the period of growth or decline can be self reinforcing. What I mean by that is growth attracts growth. decline attracts decline. During periods of decline, people tend to run the other way.

Whenever you have a self reinforcing function, it has the effect of accelerating. That is why you see companies experience financial difficulty slowly at first and then all of a sudden they’re in bankruptcy.

Cities can experience the same phenomenon.

Most cities are incorporated. It’s a special type of corporation that gets its power from the province or state in which it resides. Cities are not enshrined in the constitution. Municipal governments get their power usually from an act of the state or provincial legislature.

So why is all of this important?

The financial health of any municipality is determined by a number of complex factors. Most cities get the bulk of their revenue from property taxes. In an environment of rising property values, property taxes increase in proportion to the value of the property. As long as there is an influx of population, and an influx of jobs. We will tend to see rising prices for real estate and rising tax revenues

If people are leaving the market, and prices are falling then local government revenues will fall unless the city raises the tax rates. This is politically unpopular, and therefore politicians are reluctant to use that approach.

The other major variables are on the expenditure site. Cities spend most of their money maintaining the infrastructure of the city, paying local welfare checks, education, and funding other entitlement programs like pensions for those city workers who used to be in the police department, the fire department, or one of the numerous municipal bureaucracies.

It’s no secret that the number of people retiring has accelerated to an unprecedented level. We can expect about 10,000 baby boomers to be entering retirement across North America every day for the next 15 years. 

So what happens when a city can no longer afford to meet its pension obligations? At first they start to cut back on discretionary spending. Next they start to defer maintenance on critical infrastructure including roads, water, sewer, and public parks. Then they cut back on the number of teachers in the schools. We see class-size is increasing.

When that trick stop working the city has no choice but to declare bankruptcy. We have seen it in Detroit which owed $18.5B in debt. We have seen it in Stockton California. Even Jefferson county Alabama had to seek bankruptcy protection with 4 billion in debt. The 36 cities across the United States that have declared bankruptcy are just the tip of the iceberg.

So my question to you was a simple one. When you make an investment decision to invest in any municipality, are you taking a close look at that city’s upcoming pension liabilities? Are you paying attention to their ability to fund those liabilities?