Real Estate Investing: Arbitrage

If you are investing in San Diego real estate, or any real estate for that matter, there is a single idea you should be using to evaluate every property of interest.  Outside of Wall Street, however, it’s rarely discussed and you may be missing out on this infinitely useful and fundamental concept in investing.  You see, real estate investing may be unique in a number of ways, but the ultimate objective differs little from most other forms of investing.  Whether your goal is cash flow, equity appreciation, tax relief or wealth protection: in the final analysis you are looking for an arbitrage.

The market, if it’s open and transparent, balances pricing between competing interests.  On one side there is a seller.  The seller believes there is an acceptable profit (or loss of future profit) for a reduction of risk.  On the other side there is a buyer.  The buyer believes there is an acceptable potential for profit (or future profit) relevant to an increase of risk.  These levels of acceptable risk and commensurate reward encompasses many variables and are generally beyond the scope of one article.  What’s important is this: the ratio of risk and reward varies from person to person!  It is this difference in opinion, as the saying goes, that makes a horse race.  It is also where we find opportunities to create a profitable investment.  (Notice I say “a profitable investment” rather than just profit.  That’s because I am referring here to an outcome matching your goals.  Flipping a house may create a literal profit, but so can taking a monthly loss against gains for tax purposes.  Profit is generally an increase in immediate cash, whereas a profitable investment may be rewarding in other ways.)  You do not have to understand all of the variables (although we do and it certainly makes a difference), the investor’s primary concern is a comparative knowledge of their sum total.  That is to say: a knowledge of when the risk and reward are out of balance.  This creates an arbitrage opportunity.

(Note: this is not an arbitrage in the true sense of the word.  A true arbitrage takes place almost simultaneously and involves no market exposure.  This is done in electronic markets that are extremely liquid… neither of which applies to real estate investing.  Going forward, I am using arbitrage in a simpler context: the opportunity to create a profitable investment by recognizing a discrepenacy in the marketplace.)

When pricing gets out of balance, the very act of arbitrage will right it again.  Our job then, is to find  – or create – these opportunities.  There are three areas you can arbitrage in real estate: knowledge, timing and finances.  If any one of these creates an advantage in pricing that the market hasn’t (or can’t) balance, you have found a profitable investment.  Let’s take a look at an example for each of these and see how they interact.

Example 1 – Knowledge Arbitrage

There is a home for sale and it has a cracked slab.  This has sent most buyers running in the opposite direction and for good reason: if you don’t know how to properly fix a cracked slab your expense risk is completely unacceptable.  Plus, this lack of knowledge prevents you from properly pricing the property which means you cannot write an informed Offer to Purchase.  You should pass.  The seller, Sliding-Away Sally, knows all of this is happening because she has been advised by her very informed and helpful listing agent.  She has therefore priced the home according to her belief in an acceptable gain (or loss of future profit) against a reduction of the risk and potential for future loss associated with a cracked slab house.  Now, along come our hero: Arbitrage Andy, and he knows quite a bit about cracked slabs.  He knows roughly what it will cost to fix based on his own inspection and he has access to people who will do the work.  Arbitrage Andy looks at the work involved on Sliding-Away Sally’s place and sees that there isn’t nearly the work everyone thinks there is.  Due to his superior knowledge, Arbitrage Andy is able to buy this house for much less than it’s worth, perform the work and reap the reward of a knowledge arbitrage.

Example 2 – Timing Arbitrage

A home owned by Sloppy Sam is not for sale… yet.  The listing agent doesn’t want to put it on the market in its current condition.  It is such a mess that neither Sloppy Sam nor the listing agent have a good idea what it might sell for once it is on the market, but they’ve priced it according to their belief in an acceptable gain (or loss of future profit) against a reduction in the risk that comes with owning this mess.  Along comes Arbitrage Annie and she sees the agent leaving the house (his car is plastered with advertising) so she stops him and asks if the place is going to be for sale.  She discovers that it’s for sale now, but no one  knows about it yet.  Arbitrage Annie asks to go inside, sees that the “mess” is purely cosmetic asks what they want for the “dump.”  A little embarrassed, the listing agent throws out the low number he has previously discussed with Sloppy Sam.  Arbitrage Annie looks around disappointed, takes another 5% off and says that’s the best she can do.  The seller takes the offer and Arbitrage Annie, thanks to being ahead of the competition and quick to act, will enjoy a very nice profit for her timing arbitrage.

Example 3 – Financial Arbitrage

Here’s a relatively simple example: the Not-so-Nice Niece and Nephew of Dead Donald want his house sold so they can pay off bills with their share of the profits.  They have two offers in already when Arbitrage Alex talks to the listing agent and discovers the seller’s needs.  He offers less than the other offers and gets accepted because he can pay all cash and close in seven days.  The estate of Dead Donald believe the reduction in profit is balanced by the short escrow and the lack of exposure to the lending world created by the all cash offer.  Arbitrage Alex gets a great deal on an investment because he had liquid cash and could act quickly on a financial arbitrage.

There are many ways these three opportunities may interact.  I have personally done deals involving all three of the scenarios presented.  In the end, you will find your profitable investments are those in which you were able to leverage your ability to recognize and act on a knowledge, timing and/or financial arbitrage.

Filed under: INVESTORS, Arbitrage, finance, knowledge, profitable investment, Real Estate Investing 101, timing

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