The idea behind investing in real estate is a simple one. Buy Low and Sell High. The beauty of this strategy is that it is simple and true. This approach holds true whether you are investing in real estate, stocks, or barrels of oil. The investor who can consistently buy when prices are significantly lower than the true value will earn substantial financial profits. Yet like any simple strategy with tremendous potential, it is always a bit more difficult to implement. How do you effectively value real estate investments?
Establishing a method to valuing real estate is not easy. Yet, it is absolutely necessary for the investor who hopes to consistently make successful real estate investments. Utilizing the correct techniques can drastically improve your chances of making smart investments with attractive returns and limited downside risk.
So How Do You Value Real Estate?
The key to value real estate 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 pay for a property is primarily drive by:
– Household Income: 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: Household income sets the range of potential home values. Yet, the availability and cost of similar properties is also critical because most buyers will compare properties. Obviously most buyers would prefer to pay less for a comparable home if they can find a cheaper 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. This tells us how much residents might be willing and able to pay for a given property. We then use 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. However, it is quite common for specific markets to get out of balance. We’ve also seen the whole country get out of balance at times. During the housing bubble, the sales comp approach led to steadily higher property valuations. There were times when comps were two and three times higher than the rental income approach.
So Which Approach Should You Use?
For the investor that aspires to earn attractive investment returns without taking unnecessary risks, the answer is clear. 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. It only tells you how much similar properties are selling for today. It provides no firm indication of where prices might be next year or ten years from now. In the short-term, acceleration in the rate of foreclosures or a decline in the availability of mortgage financing could dramatically depress sales comps.
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 Michigan investors who value real estate based on the rental income approach can be confident 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. Investors who value real estate with this approach will see consistently positive results. 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.
Similarly, for several years, housing prices fell well below what residents could afford in many markets. 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 todayÂ’s market.
Setting Investments Up to Win
The conservative investor does not gamble on a never-ending increase in prices. Instead use 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 several factors. Your experience level, the property location, and your financial situation are a few factors to consider. Consider a property where the rental income approach suggests a valuation of $100,000. You may want to discount that by 15-30% to give yourself plenty of cushion for unexpected events.
Taking This From Theory to Practice
In future articles, I will discuss in more detail exactly how to value real estate with the rental income approach. I will also include real world examples for you to consider. In addition, I will walk through methods to best use sales comps to supplement the rental income approach for the conservative investor.
In the meantime, take a look at Available Investment Properties that we have analyzed with this approach.