Valuing Real Estate

In the property markets that I follow, the second half of 2010 saw a material change in price expectations. Asking prices as well as achieved prices are heading down, significantly.

A number of factors are driving this phenomenon:
Time: our memory of the past is dominated by our experience over the previous three years.  The property market is in its third year of poor performance.  As a result, we are starting to trend the recent past to future expectations.  While things have been awful, I don’t think that awful will continue indefinately.

Cash: refinancing became difficult in mid-2008.  Many owners have been writing mortgage checks for the last 30 months and each of those checks can cause a little bit of pain.  Foreclosures and unemployment remain high – more pain.

Sentiment: deals that are being completed, in all markets, are being done at 25-60% off peak values.  Residential real estate is very much a word off mouth market.  While people used to brag about how much their property was worth, current chattering centers around repossessions, downward price adjustments and low entry prices.

Availability of Debt: I dropped by my bank this week to talk mortgage and business loans.  Suffice to say, it is a very difficult debt market right now. Lack of funding drives prices down.  Remember that money will not always be tight.

Expectations for residential property are as bad as I can remember.  The last time things were this negative was 1990, when base rates were in the teens and I was working in London.  Interestingly, imagine what would happen to the market if long rates return to historical averages?  It would be a short term disaster and a fantastic buying opportunity.  If the big moves in rates (over the last three days) continues then there will be a lot of pain around.

Why buy real estate?
The Great Inflation of asset prices ran from 1992-2008 in most markets.  If you are under 45 then those market conditions are the only ones we have ever known.  It’s worth reading a copy of Irrational Exuberance to understand how assets normally behave.  Pay particular attention to mean reversion of returns and long term rates of real return.

I want to own real estate for a number of reasons:

  • The option value of land;
  • To receive a net yield; and
  • As a store of real purchasing power.

Personally, I benefit through the option to downsize where I live by moving into one of my rental units.  This option is not available with a bond/stock portfolio.

What’s a reasonable net yield?  Ten year US govt bonds are ~3.5% (big moves this week).  Safe but no upside in the value of your capital.

What I do is compare a range of bond benchmarks to the prospective net yield of the target property.

When I calculate yield, I factor in the broken furnace, the roof repair, the tree trimming, the radon mitigation, the gas leak with the stove, insurance, taxes and vacancy period.  Many people forget about these sorts of issues and overestimate their true net CASH yield.

With properties that I bought in 2010, my net cash yield for 2010 will be zero.  That’s ok, as it links to my current year benchmark (check your savings account yield).  My prospective net cash yield is about 3%.  Not massive but considering my alternatives, and goals, sufficient.

Now my yield expectation is 3% but I priced the deals at 4-10% to achieve that net.  That is my margin of safety and reflects that, even with appropriate due diligence, stuff always pops up when you shift from buyer to owner.  By the way, stuff pops up in all types of markets.  Remember to insure your Black Swans.

The target yield that’s appropriate depends on:

  • Your alternative use for the funds;
  • Your view on the prospects for the people that live in that neighborhood and the local economy; and
  • The amount of land with the property, alternative uses for that site and redevelopment/subdivision opportunities.

The better the prospects, and the greater the option values, the lower the current yield I am willing to accept.

There are no fixed rules but with research and common sense you can decide on a fair deal.  That fair deal is your valuation.  The amount under valuation (that you pay) is your margin of safety.  Try to arrive at your valuation independent from asking prices.  What I do to figure my target yield for different types of deals.  Then I head to the market to find those deals.  I am selective with the type and look in a narrow geography (down to specific streets and developments).

Be careful with property investments.  They are easy to get into and can be difficult/expensive to exit.