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CHAPTER 1
VALUATION OF PROPERTY
The Starting Point
Real estate is different than all other forms of investing in several ways: tax benefits, generation of income to pay for mortgages, and more than anything else, the fact that cash flow is more crucial than profits. While this point was made in the first edition of this book a decade ago, it is as true today as ever. In 2008 and 2009, it looked like real estate was done as a viable investment, but this has been predicted many times in the past. The predictions were always wrong.
Today, real estate looks better than ever for investors. Home ownership rates are way down, but rental rates are significantly higher than in the past. For investors, this means that investment property is today more popular than ever before, based on cash flow as well as profit potential. The true meaning of value in real estate begins with profitability, but ultimately it is determined by cash flow.
All investments are judged on the basis of their current and future market value. In the case of real estate, the historical rise in the market value of properties has been consistent and has served as the base for many long-term financial plans. Many people, whether they are investing only in their own homes or expanding into a portfolio of rental properties, have discovered the potential for profits through real estate.
All forms of investing should be based on study and analysis. Real estate properties vary greatly in cost as well as in quality, location, and income potential. A smart place to begin the search for real estate investments is to identify some of the common myths about this market. These myths include the following:
1. Real estate values always go up. Markets always move in cycles. Therefore, every market, including the real estate market, will exhibit periods of strong growth and periods of stagnation and even declines in market values. While these cyclical changes may be temporary, they are part of the investing process.
2. Profit over the long term is the most important criterion. While profits are important to all investors, most people who put their money in real estate cover the majority of the purchase price through financing. Because investors have to generate enough rental income to cover their mortgage payments (along with property taxes, insurance, utilities, and repairs), profits are only one of the measures by which the value of an investment is judged. Of far more immediate concern is the cash flow that you can gain from that investment. As long as rents are high enough to cover all of your expenses and payments, cash flow is positive. But if rents stop or aren't high enough to provide that coverage, your investment plan could be in trouble. This is where careful planning and analysis of risks is so important.
3. Tax benefits are so good that it's always smart to carry a mortgage. A common belief is that a mortgage, even one with a high interest rate, is beneficial as long as rental income is higher than the mortgage payments. The argument may be made that interest on the mortgage payment is deductible as an investment expense, so it does not make sense to pay down that mortgage or to get a lower balance initially. This is false. It is always better to reduce your payments and expenses; you will always end up with a stronger cash position with a smaller mortgage and lower payments.
4. You can't lose with real estate. It would be more accurate to say that the chances of losses on any investment are drastically reduced when you study the market beforehand. It is possible to lose money on any investment, but that invariably occurs because the real risks were not properly evaluated ahead of time. Real estate investors benefit from the historically strong market value growth in real estate, unique tax advantages for investors, cash flow potential from well-selected properties and well-screened tenants, and intelligent analysis in the selection of investment properties. In spite of advertising to the contrary, success in any form of investing is rarely easy or simple. It can be made so with research, which gives you an advantage over most investors.
WHERE AND WHEN TO BUY
The two factors determining real estate value are location and timing. When you begin to study the market, you start out with a large field. Just as a stock market investor starts with a potential investment field consisting of thousands of stocks, real estate investors also face a large number of possibilities and need to narrow down their choices.
Location and timing are concepts that are broadly understood by investors. In the stock market, you have market sectors, size of companies, capital strength, and competitive factors; these are the "locational" aspects of picking stocks. In real estate, location means the specific property and its immediate neighborhood, and also the city or town and larger region where the property is located.
With all investments, timing is everything. If you invest money when prices have peaked, your timing is poor; but the tendency among investors is to have the most enthusiasm and confidence at exactly those moments. If you invest money when prices are depressed, your timing might be good (only time will tell). But the tendency among investors is to be cautious and uncertain when prices have fallen. So the old advice to buy low and sell high applies to all markets, including the real estate market.
You face some artificial indicators when you look at real estate valuation. In a generally strong market, there may be a tendency to believe that all real estate is going to appreciate and that it is impossible to go wrong. Of course, you may see the same false euphoria in the stock market; but in real estate, regional trends may support this belief. Because real estate does not trade on an open exchange like stocks, it is difficult to spot short-term trends or to quantify them, and it is even more difficult to narrow down the location of a sensible real estate purchase.
These artificial indicators can mislead you if, in the search for valid data about the local market, you do not distinguish between broad and narrow forms of analysis. Mistakes in this area are of three types:
1. Reviewing regional or national data on real estate trends. The information about real estate that is easiest to find comes from sources like the National Association of Realtors (www.nar.realtor.com) or the U.S. Census Bureau (www.census.gov). Also check Zillow (www.zillow.com), Realtor.com (www.realtor.com), and Multiple Listing Service (www.mls.com). All of these sources are extremely valuable for all real estate investors, but the statistical and demographic real estate trends reported on these sites are regional and national. Real estate investors need to get down to the market supply and demand factors right in town. Average pricing trends for a section of the country or the entire nation are not of any use in timing a decision to buy investment real estate. All trends are local.
2. Application of irrelevant data to the specific market. If you are interested in buying rental property, you should also make sure that you study the applicable data. For example, if you want to purchase a fourplex and rent out its units, the decision should be made on the basis of prices, rental rates, and demand trends for similar properties. Local demand trends for single-family houses, raw land, or commercial property are not useful. While local trends for different types of real estate do tend to move in the same direction, there are no guarantees. Local economic forces, such as growth in jobs or an active tourist industry, may affect commercial property values, and increased prices of raw land may reflect a growing retirement demographic. At the same time, rental property may be lagging for a variety of reasons.
3. Misreading one form of supply and demand when your concern should be for another. The natural tendency of investors is to look to real estate because market values are rising. Most begin with the purchase of a single-family home as a rental. Some people move into this market when they decide to buy a larger home; instead of selling, they convert their present home to a rental with the idea that the tenants will "pay the mortgage" through rents. However, a strong demand for owner-occupied housing might not support a strong demand for rentals. It is possible that owner-occupied trends may be very strong, while rental demand is soft. These two markets are entirely separate. Factors influencing rental demand, even when single-family housing demand is strong, would include overbuilt apartment units. In that situation, housing prices may be rising at far above the national rate of inflation, while vacancy rates are high and market demand for rentals is soft. The supply and demand cycles for home ownership and for rentals are distinct and separate.
The question of where and when to buy is a strictly local one. It is not enough to study regional trends; you need to look at the trends in your city and, more specifically, in a particular neighborhood. Even in cities with only a few thousand residents, markets may differ vastly based on specific location. Before committing to real estate investments, it is essential to research the attributes of a neighborhood and how prices are trending, the types of rental demand and market prices for properties on a neighborhood-to-neighborhood comparative basis, and what factors influence those values (access to transportation, shopping, jobs, and schools, for example).
Analyzing real estate values requires comparative analysis, and many useful calculations certainly help. But as a starting point, you need to know the market firsthand. This is why a majority of first-time real estate investors tend to buy properties close to where they live. There are practical reasons for this, of course, but it simply makes sense to invest on familiar ground, literally speaking. You are most likely to understand the real estate trends within a few blocks of your own home and far less likely to understand the forces at work somewhere else, even in a city or town only a few miles away.
THE REAL ESTATE CYCLE
It may be fair to observe that there are two separate real estate cycles. The first is the theoretical or academic version that is studied in economics graduate classes; the second is the real cycle that is witnessed (or suffered) by real estate investors, builders, and developers. The largest cycle hit bottom in 2008 and has been working its way back up ever since. As of 2017, the market looks strong and is heading back to its high cycle level. This is the best condition for getting into the market.
Why are these different? The mathematical models of cyclical forces are useful to students whose exposure to economic forces is limited or nonexistent. Most students in economics graduate classes have never owned real estate or put money at risk in any other meaningful way, so, appropriately, their comprehension of real estate cycles will be based on theory rather than on practical experience. But experience provides investors with a far more pragmatic understanding of how money is made or lost. You see this in the stock market. Thousands of American investors jumped on the dot-com fad and bought shares of Internet stocks, many of which had never reported a profit. When the fad ended and many of those companies went out of business, investors lost money. For many people, this was the first time they had invested money. Having never had a loss before, it came as a cruel shock — but this is the reality.
In real estate, the same disparity is going to be found in first-time investors. While the market and its attributes are quite different from the stock market's tech-stock fad, the same caution applies. The theoretical real estate cycle is not going to dictate how the real-world cycle operates, in terms of how long a cycle lasts or how far the cycle swings. Real cycles are characterized by short-term changes: misleading indicators, stagnation, and random movement. It is a mistake to attempt to time purchases through observation of current cycles. These cycles — varying degrees of supply and demand — are constantly shifting back and forth, and it is difficult to anticipate cyclical movements accurately. Both supply and demand contain a vast number of market components that can be understood best in a broader view, using historical information to follow trends and looking at moving averages. It is rarely possible to gain an absolutely clear view of current market conditions. It makes more sense to make investment decisions based on the fundamental strengths or weaknesses of the market (price trends in the immediate neighborhood, comparable sales prices of property, strength of rental demand, and so on). You should remember Mr. Dumby's observation in Oscar Wilde's play Lady Windermere's Fan, "Experience is the name everyone gives to their mistakes."
To demonstrate how the difference between theory and reality play out, review the illustration of the real estate cycle shown in Figure 1.1.
The well-known economic identification points are shown in a falling and then a rising trend: recession, bottom, recovery, then expansion, top, and contraction. This model uses a base value that begins and ends in the same place. However, if prices are trending up over a period of time, it is more likely that the base value will rise as well. In other words, while these cyclical phases will occur, the beginning and ending points will not be identical. This is illustrated in Figure 1.2.
Note that the overall value of real estate in this more realistic cyclical pattern rises over time, even while the forces of supply and demand interact and change. Stock market analysis may be realistically based on a set price level, and observers may experience times when prices are higher or lower than that level. Or price trends for stocks may also rise. In any market, the tendency for long-term price averages to evolve is a fair assumption, and the supply and demand cycle acts within that longer-term value trend.
Another important variation to note is the timing of a cycle. In the illustrations, the recessions and expansions are identical in length, indicating that these forces of change are somehow predictable. In practice, however, real estate cycles may be completed very rapidly (in a year or less as a form of minicyclical change), or they may evolve over many years. In addition, the recession and expansion phases are not necessarily equal in length. Recession may occur very gradually and expansion in a far shorter period, or vice versa. The aspect of cyclical analysis that is the most interesting, in fact, is the uncertainty. When you study cyclical patterns, you even out the timing and the false starts or stops along the way.
Cycles are best understood when they are analyzed broadly and with the use of averages. In practice, however, supply and demand changes do not act in average ways. The actual movement of the supply and demand cycle is more often far more chaotic and random.
JUDGING VALUES LOCALLY
The study of economic supply and demand cycles helps you to appreciate the interactions between buyers (demand) and sellers (supply). However, the analysis of real estate has to be based on local trends, not on regional or national cycles. When you hear statistics on housing starts, population ownership levels in real estate, or average prices of single-family homes, you need to put that information in perspective. National and regional trends are interesting, but they do not reveal what is happening in town.
Local values and trends are far more important to you as an individual investor. The starting point in any analysis should be identifying the market area where you expect to operate. The market area for real estate is not all real estate, nor is it a specific type of real estate, such as a single-family home. The applicable market area is a specific type of property located in a very specific locale with a price that is within a narrow range. An integral part of your market research is gaining an understanding of local rental demand levels and market rents.
On the individual property level, you start by looking at the land, the condition of the building, and the surrounding neighborhood. The age of the property and the condition of surrounding properties are revealing because they provide an idea of whether current owners have performed ongoing maintenance, both for the property for sale and for the entire area. Neighborhoods tend to go through transitions, so condition may be a key indicator in identifying the best time to buy in an area. For example, one area may have many homes owned by older retired people whose children have grown and moved; as these older residents pass away, the homes are purchased by a new generation of first-time home buyers. (Many first-time buyers purchase older properties because they are more affordable and later trade up to newer, more recently constructed homes; while this is a generalization, it is especially true when newer homes are significantly more expensive than older stock.) In this situation, older homes may be far out of date in terms of heating, electrical, and plumbing systems; roofs and paint; and the yard. So as new owners buy these homes, a positive transition of upgrades, renovations, and improvements begins to occur. This is a positive change because as older homes are brought up to date, they also tend to increase in value. Buying homes in neighborhoods that are in the early stages of positive transition is smart timing.
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Excerpted from "The Real Estate Investor's Pocket Calculator"
by .
Copyright © 2018 Michael C. Thomsett.
Excerpted by permission of AMACOM.
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