Real Estate Investing: Fundamental Value

In the Introduction to San Diego Real Estate Investing, we discussed the Fundamental value as the key component of an investment analysis.  Now that we’ve defined the Four Values, let’s take a closer look at how to calculate and use the Fundamental value.

Methodology
While creating four values per property involves extra work, it is not as difficult as it appears.  The first two values – Break-up and Intrinsic – can be calculated using cost-per-square-foot estimates, which you update from time to time with local contractor clients.   The final value – Utilitarian – is based on a standard CMA and can be calculated by any competent real estate agent or appraiser.  Remember: it will reflect not only the comps, but the difference between what an investor and an owner-occupant will pay.  It should be tracked in relation to the other values to define arbitrage opportunities.

The Fundamental Value is our most important tool and requires you to get tapped into the investment side of the neighborhood.  There are three basic steps to reaching a Fundamental Value.  First, find the average rental income paid for a similar home in the same specific area of the potential investment.  This rental amount will serve as your baseline PITI.  Second, work a loan scenario backwards to arrive at a loan amount that, given the prevailing rates and terms, will produce that PITI payment.  Finally, add a down payment to the loan amount.  Let’s take a close look at each step:

1. The first step is often the misstep.  It takes some experience and longevity to know, with a reasonable level of certainty, what a particular property will rent for on the open market.  If the investment is in an area one knows well, it shouldn’t be much of a problem to look up equivalent rents on various online sites.  If you are not familiar with the area, all rental research should be accompanied by a drive-by of the rental properties.  Better still, make an appointment with the landlord or current owner to see the inside.  The more accurate and specific you can be at this step, the safer your investment will be going forward.  If you are not familiar with an area you can also search out those who are: realtors, leasing agents, appraiser, etc.; pay them a small consulting fee to “access” their knowledge.
2. The second step is the most straightforward.  Mortgage calculators, which can be found online, require you to enter three of four variables in order to solve for the fourth.  Enter the term of the loan (for simplicity sake we will always use 30 year fixed, but there are scenarios when a shorter term loan would be appropriate), the prevailing interest rate and the desired payment.  The calculator will provide the corresponding loan amount.  (Warning: Although straitfoward, there is a great  possibility for error during this step.  Most mortgage calculators base their computation on only the principle & interest portion of the total payment.  If this is the case, make sure you back the insurance and tax payment out of your PITI before entering it into the calculator.)
3. Adding the down payment is the final step.  The Fundamental value you arrive at is the sum of the loan amount and the down payment.  Simple, yes?  But not easy.  The down payment is a variable and the number you use is based on your client’s risk aversion, liquidity and long-term plans.  On top of which, you can also use this method to get a Fundamental Floor Value which I will explain in a moment.  So, how do you choose a down payment number?

The Down Payment

 Most non-owner occupied home loans require a minimum 20% down.  The rate and fees are generally better at 25% down and better still at 30% down.  Yet a greater down payment is not always the answer.  You have to look at your client’s overall liquidity, what work, if any, must be done to the investment property and what your client’s long term goals are.  If your client only plans on buying one investment and can put 30% down while maintaining adequate liquidity, this will create a very safe, long term cash flow.   On the other hand, putting only 20% down lowers the cash flow and increases the cash-on-cash return of equity appreciation.  Add to which, your client may be looking to purchase more than one investment property, in which case the slightly higher interest rate and payment stemming from a lower down payment is offset by the increased remaining liquidity available for the next purchase.  Beyond all of that, you have the matter of rehabbing.  If a property requires work the investor may opt for a lower down payment in order to increase available funds for materials and labor.  If the investor is planning to refinance the property after the work is done (as we do in the Infinite Investment Strategy) then the initial down payment should be minimized, as liquidity is more important than interest rate.

Those are some involved calculations to make, but as I said they are based on a few simple ideas like risk aversion, liquidit and long-term plans.  This is one area where an experienced investment advisor will pay great dividends.  There is a secondary calculation that can be done while creating the Fundamental value and weighing various down payment scenarios: the Fundamental Floor value.  This can be very useful and deserves some explanation.

The Fundamental Floor Value

If, at step 3 above, you were to add 3.5% as the down payment, you would effectively be calculating an investment’s value in relation to a homeowner’s FHA purchase loan.  This is going to be a much lower value than those calculated for the Fundamental value due to the small down payment.  But, it will give you a virtual floor for pricing in a falling market.  Put another way, the Fundamental Floor value tells you how low home values have to fall for a potential owner occupied purchaser to feel safe buying a house, knowing that if something unforseen happens they can rent it out rather than lose it to a short sale or foreclosure.  This is a little understood but extremely important value to understand when you are in a declining market and the supply of homes, even though priced below fundamental value, is too great for the demand - thus keeping everyone on the sidelines.  I don’t often advocate “timing” the market, but the Fundamental Floor value will give you some idea of when the floor is near.  (Warning: This type of evaluation is predicated on the idea that the area itself is not fundamentally flawed.  If the economic fundamentals of an area have failed, this calculation carries little value.)

Final Thoughts

The importance of the Fundamental value cannot be overemphasized.  Nor can I state strongly enough the importance of understand your (or your client’s) degree of risk aversion and goals.  Finally, if you are unsure about the lending side of this equation, contact your lender and allow them to do it.  Fundamental value is too important to get wrong because of a math error.

Filed under: INVESTORS , Fundamental Floor, Fundamental Value, investor's down payment

Real Estate Investing: The Four Values

Most small to mid-size real estate investors are forced to rely on “comps” for their valuation of a potential investment.  This is the method commonly employed by appraisers and the real estate industry as a whole so it’s really been the only choice available… until now.  If you are a regular reader, you know I have found the existing tools in real estate to be inadequate for the needs of myself, my partners and my clients.  The following is an explanation of how I value properties when we are deciding which property to write an offer on or where to cap our offer price.

CMAs
Over the past six months I have been discussing with my partner Brian Brady different ways to value a property.  Having both come out of the securities field (I enjoyed some pretty exciting [read: stressful] years as an options trader - he was a bond trader), our discussion revolved around how property would be valued if it were a security investment.  First, a Comparative Market Analysis or CMA – which is based on comparable properties or “comps” – would be used only as a qualifier or a secondary validation.  They are circularly self-serving and relationally compromised.  Instead of comps, we should be looking at a more financiallyuseful value.

A New Method
There are actually four values to any property.  The first may be interesting, but is not often directly helpful for our investments.  The next three should, however, be calculated every time we look at a property.  Here are the four values in ascending order:

BREAK-UP VALUE – this is the value of the land itself along with any profits to be made selling pieces of the home before tearing it down, minus the cost of tearing it down.  In Illinois, for example, there are companies that advertise a home about to go under a radical rehab.  Buyers come to the home and everything is auctioned off: staircases, doors, windows, cabinets, etc.  After such an auction you combine the money in your hand plus the value in your land and subtract the expected cost of your demo contractor to arrive at the break-up value of your property.

INTRINSIC VALUE – this is the value of the land plus the actual cost to build a model match home using today’s material and labor costs.  Don’t forget the fees, permits and so on plus the potential for temporary housing costs incurred while building the home  (loss-of-use cost).  This is most often calculated by ascertaining the value of the land itself and then multiplying a “per square foot” cost for construction.  (Your local General Contractor can give you such a number.  As always, try to find three “per square foot” costs and average them.)  Total those costs and you know what a property is worth intrinsically.

FUNDAMENTAL VALUE – this is the value of most importance to an investor.  It is calculated using comparable rents for the neighborhood in relation to a property’s cost-of-carry.   It is the KEY to correctly valuing an investment property.  Once calculated we have little trouble knowing what financing is going to look like and whether the deal is a money maker.  This is how non-owner occupant investors would evaluate a property.  “Does it pencil out” is another way of asking the property’s fundamental value.  This kind of analysis will also tell us when prices are out of line.  (Details on calculating this value can be found here.)

UTILITARIAN VALUE – this is the Fundamental Value plus the non-specific value that accrues to a person owning their own home.  Brian Brady jokingly refers to this as the “purple wall” value: the added premium a person is willing to pay for the freedom to paint the walls of their home purple.  While not easily calculated; it is often easy to quantify.  Look at any area where “fixers” are being sold.  You will find a price discrepancy between what investors will pay who wish to make repairs and still earn a profit (either monthly or as a flip) and someone who actually wants the home for their own.  When you are bidding on homes to rehab and/or flip as an investor, your price is based on #3 (Fundamental Value) and you should never compete with someone looking to make it their own home because they will pay the utilitarian value.

Conclusion
Using these four valuing methods, we can make informed, rational decisions (even while missing out on some of the run-ups) that should leave us financially sound in the long term.  An investor’s comfort with and use of the fundamental valuation will, to a large degree, determine that investor’s long term profitablity.

Filed under: INVESTORS , Break-up Value, CMAs, Fundamental Value, Intrinsic Value, Property Value, Real Estate Investing 101, Utilitarian Value

It Takes More Than Comps to Beat the Competition

As real estate agents we are always looking for ways to help our clients make sound decisions.  If we find a way of doing so that also differentiates us from the market – all the better.  In the next two posts I am going to share a new way to value property that not only gives clients a vastly superior ability to make home-buying decisions, but should decrease defaults and foreclosures substantially too.  Do you think that will make me a better agent?  More valuable?  Here’s one more way to differentiate yourself in the marketplace of real estate agents.  (Warning: this post and the next involves some arcane securities concepts and new ideas that will require even more of your time and effort.  If this does not interest you, stop reading now.  Pick up a newspaper.  Enjoy the classifieds.  Maybe polish up the old resume…)

CMAs
In a recent article by Greg Swann discussing the woes of the real estate market, he mentioned homes selling for less than they would cost to build.  He referred to homes priced “below their fundamental value.”  Over the past six months or so I have been discussing with Brian Brady different ways to value a property.  Having both come out of the securities field (I was once a securities broker and “enjoyed” some pretty exciting… read: stressful… years as an options trader on the exchange floor), the discussion revolved around how property would be valued if it were a security investment.  First, Comparative Market Analysis or CMAs would be used only as a qualifier or a secondary validation.  They are circularly self-serving and relationally compromised.  Instead of “comps”, let’s wow our clients, protect them and increase our value as agents at the same time.

A New Way to Value
Remember I warned you that this would involve extra work.  That is because there should be four values to any property and they should all be calculated before we advise our clients.  Here are the four values in ascending order:

1. BREAK-UP VALUE - this is the value of the land itself along with any profits to be made selling pieces of the home before tearing it down, minus the cost of tearing it down.  In Illinois for example, there are companies that advertise a home about to go under a radical rehab.  Buyers come to the home and everything is auctioned off: staircases, doors, windows, cabinets, etc.  After such an auction you combine the money in your hand, the value in your land and subtract the expected cost of your demo contractor to arrive at the break-up value.
2. INTRINSIC VALUE - this is the value of the land plus the actual cost to build a model match home using today’s material and labor costs.  Don’t forget the fees, permits and so on or the cost of not being able to use the home (loss-of-use cost).  Total those costs and you know what a property is worth intrinsically.
3. FUNDAMENTAL VALUE - this is the value of a home based on the neighborhood rents vs the cost of owning.  Often expressed as a property’s cap rate (although that is more common in commercial real estate).  This is how non-owner occupant investors would evaluate a property.  “Does it pencil out” is another way of asking the property’s fundamental value.
4. UTILITARIAN VALUE - this is the Fundamental Value plus the non-definable value that accrues to a person owning their own home.  Brian Brady jokingly refers to this as the “purple wall” value: the added premium a person is willing to pay for the freedom to paint a wall purple if that is their desire.  While not easily defined, it is often easy to quantify.  Look at any area where “fixers” are being sold.  You will find a price discrepancy between investors who wish to make repairs and still earn a profit (either monthly or as a flip) and someone who actually wants the home for their own.  When you are bidding on homes to rehab and/or flip, your price is based on #3 (Fundamental Value) and you will never outbid someone looking to make it their own home because they will pay the utilitarian value.

Methodology
While giving your client four values per property involves extra work, it is not as difficult as it appears.  The first two values can be based on square footage estimates, which you can update from time to time with some of your local contractor clients.  (Don’t have contractor clients?  Great opportunity…)  The Fundamental Value requires you to get tapped into the investment side of your neighborhood or farm.  Again, if you are not doing this already it is an opportunity to expand your business while making your business unique.  The final value is based on a standard comp value, but should be tracked in relation to the other values.  This kind of analysis will tell you and your clients when prices are out of line and once again, differentiate you by your expertise.  Imagine including a four-value analysis in your counter to an offer!

Conclusion
If you, as an agent, were to make all four valuations on a property your client was interested in buying or selling you would most assuredly stand out from the CMA carrying crowd.  More importantly, your buying clients will make informed, rational decisions (even while missing out on some of the run-ups) that should leave them little chance of a foreclosure.  Your selling clients will know when prices are out of line and how aggressive they should be in their marketing and price reductions.  Best of all, you will have yet another way to stand out, add value and provide superior results for your clients.

There is one other aspect that can be added to your property valuation tool box.  It is even more securities based, but will give you the ability to analyze the values you develop and provide your clients with a sound decision-making framework.  I will share it in the next post.

(This post was originally published here.)

Filed under: BUYERS, INVESTORS, MARKETING, REALTORS, SELLERS , Break-up Value, Fundamental Value, Intrinsic Value, MARKETING, Utilitarian Value