Valuing Real Estate in Today’s Market

January 24, 2012 in Real Estate

VALUING REAL ESTATE IN TODAY’S MARKET

The idea behind investing in today’s real estate market is a simple one.  Buy Low and Sell High.  The beauty of this strategy is that it is simple and true.  Whether one is investing in real estate, stocks, or barrels of oil, if an investor can consistently buy when prices are significantly lower than the true value and sell when prices are significantly higher, he or she will earn substantial financial profits.  Yet like any simple strategy that offers the potential for tremendous financial gain, it is always a bit more difficult than it seems to actually implement.

Establishing a method of valuing potential real estate is not easy, but it is absolutely necessary for the investor who hopes to consistently make successful real estate investments.  In fact, utilizing the correct techniques along with a little bit of work can drastically improve the chances of making smart investments with attractive profit potential and limited downside risk.

SO HOW DO YOU DO IT?

The key to determining the value of a particular property is to focus on the fundamentals of residential real estate.  Residential real estate offers housing for area residents.  Local residents’ ability and willingness to pay to live in a particular property is what determines its value.  Exactly how much residents might be willing to pay for a property is based on a variety of factors but two of the most important are:

-          Household Income: A good rule of thumb is that most families can afford to spend 30-40% of their household income on housing costs.  Thus the higher the area income, the higher home values can potentially go.

-          Availability and Cost of Alternative Housing: While household income provides a range of potential home values, the availability and cost of similar properties will be an important factor because most buyers will look to compare properties.  All else being equal, most buyers would prefer to pay less for a home if they can find a cheaper but equally appealing alternative.

There are two primary valuation techniques that take into account both of these fundamental factors.

-          Sales Comparison Approach: Looks at the recent sales prices of comparable homes to determine how much residents might be willing and able to pay to purchase  a given property

-          Rental Income Approach: Looks at the current market rental rate for comparable homes to determine how much residents might be willing and able to pay to rent a given property, then uses this data to back into the equivalent purchase price

In a normal real estate market each of these techniques should lead to approximately the same value, but it is clear that the real estate market has not been normal for many years.  During the housing bubble, the sales comp approach led to steadily higher property valuations that were at times two and three times higher than the rental income approach.  Today following the bursting of the housing bubble, the rental income approach will often lead to valuations quite a bit higher than the sales comp approach in many metropolitan areas, including Detroit.

SO WHICH APPROACH SHOULD YOU USE?

For the investor that aspires to earn attractive investment returns without taking unnecessary risks, I strongly recommend that you use the rental income approach as the cornerstone of your valuation analysis.  I say that for one reason, LONG-TERM STABILITY.  The problem with the sales comp approach is that it is a short-term analysis, which only tells you how much similar properties are selling for today with absolutely no indication of where prices might be next month, next year, or ten years from now.  In the short-term, further acceleration in the rate of foreclosures, decline in the availability of mortgage financing, or an increase in the need and/or willingness of banks to unload foreclosed properties at even greater discounts could dramatically depress short-term sales comp valuations.

The rental income approach, on the other hand, is a long-term analysis.  It is based on the historical long-term stability of household income, which in turn leads to stable rental rates.  Even in a state like Michigan, that has experienced considerable economic volatility over the past couple of decades, household income has been stable over the long-term.  In fact from 1984-2007, household income in Michigan has never declined over any long-term period (defined as 7 years or more, taken from http://www.census.gov/hhes/www/income/histinc/h08.html).  Since prevailing rental rates are largely based on available household income, rental rates should maintain similar stability over long-term periods.  That means that the Michigan investor who purchases properties based on the rental income they generate today can be confident that the corresponding rental income approach valuation should be an accurate approximation of the true long-term value of the property.

DON’T GAMBLE ON THE SHORT-TERM

There is one major caution for the investor considering utilizing the rental income approach.  This analysis is most appropriate for long-term buy-and-hold investors.  This approach should be very effective at determining the long-term value of real estate.  In fact, the rental income approach would have accurately predicted the bursting of the housing bubble.  However, there is no effective gauge of what housing prices will do in the short-term (defined as less than 7 years).  In the short-term housing prices can accelerate to levels well beyond what buyers can really afford, as we saw throughout the first half of this decade.  Similarly, over the last two years, housing prices have fallen well below what residents can really afford on a monthly basis.  This decline has been driven by an oversupply of homes for sale, stricter lending standards, and a large number of potential buyers stuck on the sidelines because of recent dings to their credit or because they owe more on their current home than it can be sold for in today’s market.

The conservative investor does not gamble on the short-term market moves, but instead uses the rental income approach to determine where housing prices should end up and prepares to take advantage of that.  This includes:

-          Investing For the Long-term: If you purchase at prices below the rental income valuation you will likely make money when the market stabilizes, but NO ONE KNOWS EXACTLY WHEN THAT WILL BE.  Conservative investors should prepare to hold their investments for 5-7 years and preferably longer.  If you can sell for a profit before then great, but an investor should always prepare conservatively.

-          Using the Right Financing: The ability to wait out a down market is often based on the financing used to acquire the investment.  Using cash that will not be needed for 7 to 10 years is always best, but that is not realistic for many investors.  Low-cost permanent financing that does not require any balloon payment can be nearly as good as long as the monthly payments can easily be covered by the rental property income.  Short-term financing can kill you in this market as you may find yourself forced to sell at a huge discount, potentially locking in large, unnecessary losses.

-          Using a Margin of Safety:  The final key for the conservative investor is to always maintain a significant margin of safety.  The size of this margin of safety will depend on your experience, your particular area, your financial situation, and the particular property you are considering.  That means that if the rental income approach gives you a valuation of $100,000 you may want to discount that by 15-30% to give yourself plenty of cushion for unexpected events.

In the coming weeks, I will discuss in more detail exactly how to determine the rental income valuation including real world examples.  In addition, I will walk through methods to best use sales comps to supplement the rental income approach for the conservative investor.  If you would like further information on available investment opportunities or would like to discuss a potential real estate investment in your local market, feel free to contact us for additional information.

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