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

Pricing Analysis is Greek to Me

I think most of us can agree that real estate agent, as a profession, lacks ”street cred”.  The reputation for our industry is not high and I say this despite the reputable people I meet here and elsewhere.  Two ways to effect a change in that perception are: raise the bar of competition and adopt a better model.  Sometimes we can do both.

In a recent post called It Takes More than Comps to Beat the Competition, I introduced a pricing model based on how assets are valued in the securities industry.  As a former stock broker and options trader, I can tell you that the methods employed in the real estate world for valuing assets and advising clients are rudimentary.  A more thorough understanding of what a property is worth and a framework for better understanding what that knowledge suggests would not only help us to do our job better, but it would separate those that use the tools from those that do not.  Adopting a better model de facto raises the bar of competition.

A Quick Primer
From a securities standpoint, price is rarely the sole motivation behind a buy or sell.  We are usually trading volatility or time or both.  An asset’s value then, is affected by these two items.  This is evident in real estate too.  Good agents take these factors into account when they do comps, but we are generally lacking the common language and function for applying them.  By adopting a better model, we gain these tools.

Volatility
Let’s use options as an example: an options contract is valued in relation to the underlying stock.  This valuation is called its delta.  On a scale of 1-100, a delta of 100 means the options contract might as well be stock.  It is traded, hedged and valued as if it were the underlying stock.  A delta of 20, on the other hand, means the options contract is very unlikely to approach the value of its underlying stock.  It has only a 20 percent chance of holding value.  I would therefore trade, hedge and value it quite differently.  Now a delta of 50 suggests the potential for the contract to eventually carry the full value of the underlying stock at 50/50.  Here’s the important thing to remember: as volatility increases, deltas move toward 50.  What does that mean?  It means that the more volatile the market, the less sure I am what the outcome will be.  At a very high volatility, virtually all possibilities move away from the extremes of “sure thing” and “long shot” to become 50/50.

As the real estate market started to scream upward, property values skyrocketed and equity became more and more of a “sure thing” (in trading lingo we were “in the money”).  Yet in reality the delta of these homes was dropping.  The steeper and more frenzied the rate of appreciation, the less sure we could be of our homes true value in the future.  By the end of the run-up, deltas had to be approaching 50.  As chinks in the credit and lending armor began to appear, deltas would have dropped below 50!  The only way to capture this equity was to close out the position: i.e. sell your home.  The real estate market is liquid, but not that liquid.  If you had not planned on selling your home (and at any given time the majority of people do not), there should have been little confidence in the paper equity that had built up.

Time

The time frame our clients are looking at obviously affects the valuation of a home.  From a buyer’s perspective, the longer they plan on staying in a home the less concerned we become with temporary price fluctuations in the market and the more concerned we become with proper financing.  Real estate, for the most part, is a cyclical, appreciating investment.  Time works in our favor to “heal all wounds”.  The cost of money, however, is not so forgiving.  Time compounds our debt-based mistakes in the same way that compounding interest corrects them.

From a seller’s perspective, their short term and long term goals affect their decision making as to whether to sell and the length of time they can afford to be on the market impacts their pricing.

Bring it All Together
In preparation for meeting a client, begin by assessing and understanding all four values of a property: the BREAK-UP VALUE, the INTRINSIC VALUE, the FUNDAMENTAL VALUE and the UTILITARIAN VALUE (go back to the post referenced above for more on these concepts).  Once a snapshot of pricing has been provided (and that’s all it really is, whether using a more comprehensive four-value view or basic “comps”) there is one more step: provide an analysis for the prices – put them in a framework.  What is the volatility of the current market and what is the time expectation of your clients?

When volatility is high in an appreciating market, home values are increasing but the delta is dropping.  Obviously it is a great time to sell.  But it is your understanding of how low delta is getting that dictates how aggressive your pricing should be.  If volatility is high in a depreciating market, values are dropping but at some point deltas begin to rise indicating a good time to buy.  How fast delta is rising dictates how aggressive to be on your offers.  Low volatility leads to balance and a high degree of confidence in the outcome of buying or selling.  Combine this with your clients’ time expectations.  The further out in time we go, the lower the overall volatility.  An assets true delta becomes clearer and therefore the decisions easier.

Once you have done the four valuations and assessed the two factors, 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.  You will even create arbitrage opportunities: is the volatility in one area greater or less than than the volatility in another?  This is an obvious benefit to your investor clients but it goes a long way to helping home buyers make a rational decision too.  If you are creative enough, it should impact your listing side marketing too.  Think about it…

Whether your client is interested in buying or selling is secondary.  The purpose of that meeting… that job interview, is to get hired.  When all is said and done, sitting down with such a thorough analysis gives you an edge in advising your clients.  Not every client will understand all that you present, but you might be surprised.  Dumbing down real estate makes us look foolish.  Many of your clients are having these exact conversations already with their financial planner, stock broker, HR rep or even the neighbor next door.  More importantly, they are hiring you because you understand it.  That is called job security.

Providing thorough expertise on what home prices are, why they are moving and how your client should react will not change the market value of a property – but it will most assuredly change your value.

(This post was originally published here.)

Filed under: BUYERS, INVESTORS, MARKETING, REALTORS, SELLERS , Arbitrage, MARKETING, Property Value, Real Estate Future, Volatility