Importance of Property

Next: Legalising Property

Its time to shift again to a different vertical or domain - property and money

TL;DR The concept of property is central to how our modern world works. In emerging markets old and bureaucratic property laws make it practically impossible to have legal title to property. It may take decades to work through the system and get ownership officially recorded and cost more than people can afford. Without legal title people cannot get loans, insurance nor officially connect their property to municipal infrastructure.

Modified Miethäuser Model is one approach to solve the issue.

Schrödinger’s Property

Financial industries are the last industry vertical we look at. The next series of posts are loosely on that.

Concept of property is at the center of financial systems in a way that most people are not aware. Property is not any physical asset in the real world like it is usually thought of, but an abstract concept protected by a fleet of laws. Laws that govern how it is used and how disputes are handled. Property laws enable individuals and private companies to take loans and make investments. They lower the risk of other companies who provide services. Property is a basis for governments to collect taxes. Property stabilises the society in many ways. To understand its importance, let’s compare property in emerging and developed markets.

Much of the property of the world is not protected by the law. This especially in emerging markets where overwhelming majority of it is so called extralegal property. They are real, valuable assets that lack however the protection of law. Farmers’ fields not recorded in public land registers, large quantities of buildings and small companies in informal settlements etc.

This fact that it has no protection by law from the official society places holders of such property at enormous disadvantage. They cannot raise loans and invest. This drags the whole economy down and is one of the primary reasons for slow development.

The reason why much if not most of the world’s property is extralegal is due to legal practices that make it practically impossible for people in emerging markets to own it officially.  For example, in Hernando de Soto’s book ‘The Mystery of Capital” there are numerous examples of how difficult the bureaucratic processes are to acquire legally property around the world. As examples from that book at the time of its writing to legally own a home in Peru had 5 stages where the first alone had 207 steps and in the Philippines the process to formalise informal urban property took 13-25 years.

In some countries the official registry offices are so back logged that property just changes hands without anyone bothering to notice the official record keepers.

So rather than use the non-functional, official method, most people use innovative alternative methods. They might for example form an association and buy a piece of land that is then illegally split into smaller lots and sold separately or just build illegally to government owner land. Such assets are still protected locally by informal agreements inside the community. Neighbours accept each other’s ownership. These informal agreements are often recorded in paper format in self-organised dispute resolution organisations. But the fact that they are local and informal prevents effectively the benefits of proper property system.

Let’s dig deeper into these two models.

As mentioned, property and asset are not the same thing. Asset is a physical thing – like a lot of land, factory or an apartment. Property is a virtual thing – a collection of common agreement protected by law telling how a particular property class works: what is possible to do with it and what operations are illegal and not valid. Each property class has detailed legal framework regulating it in order to protect investors, suppliers and property owners.

And there is a bewildering amount of property classes such as real estate including residential, commercial and industrial building and structures with differentiated laws about them. Intellectual property includes patents, trademarks, copyrights etc. And laws govern the ownership, sale and rights and obligations of parties. Financial assets including stocks, bonds, and other securities represent ownerships and debts. Natural resources like land (lots), minerals, water, forests with laws about use and personal ownerships like cars etc. And last but not least public properties and now and increasingly important in future, also data.

Property helps entrepreneurs to raise money. Having property allows entrepreneurs to use it as collateral for a loan and banks can ask an independent third party like a real estate agent to give a valuation for it. The laws protect the bank’s interest in case the customer defaults. For the banks and other investors this lowers the risk.

Just a contract about the use of some asset can raise its value. Consider a lot of land where two detached houses are built. The two owners can agree in bylaws that each owner is separately responsible for their own house perhaps with clauses on how common parts like parking space and footpaths are jointly handled. Now future buyer knows that there will not be any ticking time bombs in the adjoint house that they have no control over. The price of both apartments just went up due to this responsibility split.

For a non-fungible (unique, often hard to sell) asset there are different property classes. A small factory can cost hundreds of thousands and a big one million or hundreds of millions to build as a physical asset. With the concept of stock, it becomes possible to split this big investment into small pieces and sell shares on the market. As a limited liability company, the founders and other shareholders are in addition protected personally from losses. Only the company can go belly up, not any of the shareholders.

Once the factory is operating, it can raise additional funds by issuing bonds. Again, the company is liable, not shareholders. In the case of smaller companies where the input of the entrepreneur is key, banks will ask personal guarantees as extra protection.

When property is protected by law, this allows new forms of financial constructs to emerge that meet specific needs of enterprises and lenders. For example, equity loans are a concept where loans turn into shares if the company does not pay them back. In case the company succeeds, the loan is just paid back otherwise lenders get shares and can decide next steps of the company. Since equity loans are at the bottom during liquidation, they have higher risk and therefore higher interest rate for lenders.

As it grown and needs more funding, listing to a stock exchange may become possible. This will allow raising bigger amounts at more favourable terms than from banks. Becoming listed company again brings on a number of regulations how to report performance etc.

A legal property like the factory can also take insurances for employees or for the whole factory against accidents or occupational hazards and is subject to regulation about worker health.

Property also comes with an address that tax officials can use for tax collection purposes. Taxes again drive the whole society – schools, police and courts, health centres, roads, water works and so on.

When you do have real physical assets such as a shop or an apartment or a piece of land but this is not protected by the official legal system, you are at enormous disadvantage.

The fact that you cannot take a mortgage and raise money for investments is perhaps the biggest disadvantage. This means you and your family need to save up the whole investment or loan from unofficial markets or friends before starting a new business.

For a utility company it becomes difficult to hook up your house to the electric grid or water works because they do not have much means to collect money from you in case of non-payment. The property does not have marketable value for them. For the tenant the only option to get services is to pay bribes to have an unofficial connection to electric grid unless the electric company de facto acknowledges the existence or formally non-existent buildings. In both cases the electric company has low interest to improve their network in areas where they do not get proper revenue.

Without official title of your property, you cannot take insurance and all official forms of entrepreneurship offering for example limited liability are out of bounds. It is not possible to raise money with bonds either and government has a hard time collecting taxes.

Having property means also that people have skin in the game. They have substantial assets to lose if they do something criminal. When people have Schrödinger’s property – they have it but law says that no such thing exists - there is less to lose. Societies with widely distributed ownerships are much more stable.

What are needed are meta-rights – rights to have property rights. Antiquated laws hit countries from all directions when they prevent hard working, entrepreneurial citizens to own property. Having formal property processes that take a decade or two to complete are dead woodwork.

The Schrödinger Property Model is described below:

As a summary no one officially knows who owns what, who is accountable or how to enforce agreements. There is little accessible capital and markets are local and slow.

In next post we look at ways to improve the situation. How could we legalise extralegal property?

Next: Legalising Property