Tips To Avoid Housing Bubble

[realityjason]

Buying a a property is like buying a business. Nobody wants to pay too much for a business that generates only so much profits. Similarly, we need to think rationally about a property from an income approach, just like how the bankers think about a business.

You may ask: what if I`m buying one for my own use? The answer is: you should treat the home you`re buying like an investment property equally. The key idea here is you want to find out the fundamental value of a home. And history tells us that all properties and assets go back to its fundamental value sooner or later. That means, relying only on speculative values set forth by people in real estate market can cost you big discount of your net worth later when property values really adjusts. Unless you have couple million dollars sitting in your bank account, the chances are, you care about your net worth. The bottomline is you don`t want to pay too much for what a property is really worth fundamentally.

Owning a property gets you a series of rental income. So the income approach actually makes you think backward: For the rental income that you`re getting regularly, how much would you want to pay for it? Savvy investors and bankers know that we can employ the so-called Discounted Cash Flow (DCF) method. We`re not going to take 10 pages to discuss it. But the key point here is, you want to compare the fundamental value (we call it Rent-Implied Home Value) with the selling price out there to determine if it`s a bargain or not.

If your property value deviates largely from your Rent-Implied Home Value, beware! This is a strong evidence that your home value has large bubble content.

Some of the tips to avoid getting caught by bubble are:
1. Check how much is needed to maintain the gross rental income
People who are familiar with Rent-Implied Home Value concept may try to inflate it by hidding the ongoing costs needed to maintain the grosss rental income. Two properties may get you the same rental income, but one of them may cost you whole lot more to maintain.

2. Check how reliable the rental income is.
Yes, we acknowledge that there is vacancy risk. The vacancy rate actually tells you the fair probability that you can get your property rented. Be sure to find out the long term one.

3. Be sure to check if the rent yield is larger than Treasury bill`s rate
This may sound technical. But it`s important! Rent yield tells you how much return you`re getting from your property. If it`s less than T-Bill rate, why would you want to invest in this risky property in the first place when you can get more return risk-free?

4. Collect the most accurate rental and costs information
Accuracy depends on your dilligence. Garbage in, garbage out. Simple as that.

Next time you buy a property, remember, check your Rent-Implied Home Value.

 

[felicia0079]

"Bang on our forehead"

Totally makes sense to me. I`ve been searching for a way to systematically value a property but none of my realtors ever told me things like this.

This view echoes an article that I believe I read on Money magazine: stocks market grows 9-13% on average even with crashes taken into consideration (more than real estate market). If I tell our friends we`re borrowing $300K to invest in stocks they`ll say I`m nuts. But I`m congratulated if I`m borrowing $300K to invest in real estate. I still believe in real estate but some things need to be changed radically.

If what realityjason says is true, I can foresee a ground-shaking change in the residential real estate industry in terms of property assessment.

 

[TodorYordanov]

QUOTE (realityjason @ May 20 2009, 07:14 PM) WOW, so much misinformation and missing information here!

Buying a a property is like buying a business. Nobody wants to pay too much for a business that generates only so much profits. Similarly, we need to think rationally about a property from an income approach, just like how the bankers think about a business.
Most bankers do not know how to properly evaluate positive cash-flow investments rental properties. But they most certainly know how to invest your money in mutual funds.

You may ask: what if I`m buying one for my own use? The answer is: you should treat the home you`re buying like an investment property equally. Wrong! The neighborhood where I live provides me with much more than the future equity increase. Schools, trees, safety, neighbors, quite, clean, nice, lifestyle are all considerations that are not BIG part of real estate property investment decision, but are most important for principle residence.The key idea here is you want to find out the fundamental value of a home. And history tells us that all properties and assets go back to its fundamental value sooner or later. That means, relying only on speculative values set forth by people in real estate market can cost you big discount of your net worth later when property values really adjusts. If you bought into a bubble. Unless you have couple million dollars sitting in your bank account, the chances are, you care about your net worth. The bottomline is you don`t want to pay too much for what a property is really worth fundamentally.

Owning a property gets you a series of rental income. So the income approach actually makes you think backward: For the rental income that you`re getting regularly, how much would you want to pay for it? Savvy investors and bankers know that we can employ the so-called Discounted Cash Flow (DCF) method. We`re not going to take 10 pages to discuss it. But the key point here is, you want to compare the fundamental value (we call it Rent-Implied Home Value) with the selling price out there to determine if it`s a bargain or not.

If your property value deviates largely from your Rent-Implied Home Value, beware! This is a strong evidence that your home value has large bubble content. So, what is Rent-Implied Home Value?

Some of the tips to avoid getting caught by bubble are:
1. Check how much is needed to maintain the gross rental income
People who are familiar with Rent-Implied Home Value concept may try to inflate it by hidding the ongoing costs needed to maintain the grosss rental income. Two properties may get you the same rental income, but one of them may cost you whole lot more to maintain. All part of your due diligence when buying an investment property.

2. Check how reliable the rental income is.
Yes, we acknowledge that there is vacancy risk. The vacancy rate actually tells you the fair probability that you can get your property rented. Be sure to find out the long term one. Also part of your due diligence when buying an investment property.pan>


3. Be sure to check if the rent yield is larger than Treasury bill`s rate
This may sound technical. But it`s important! Rent yield tells you how much return you`re getting from your property. If it`s less than T-Bill rate, why would you want to invest in this risky property in the first place when you can get more return risk-free? Can you borrow money to buy a T-bill and cover all expenses with the interest from the T-bill alone? And have a little extra spending money after all expenses are paid?

4. Collect the most accurate rental and costs information
Accuracy depends on your dilligence. Garbage in, garbage out. Simple as that. Right, simple. Not.

Next time you buy a property, remember, check your Rent-Implied Home Value. First figure out what Rent-Implied Home Value is. Second don`t use Rent-Implied Home Value or any other tools alone. Learn how to do it properly. It`s work, its` a business, it takes time.

 

[BrianPersaud]

QUOTE (realityjason @ May 20 2009, 07:14 PM) Buying a a property is like buying a business. Nobody wants to pay too much for a business that generates only so much profits. Similarly, we need to think rationally about a property from an income approach, just like how the bankers think about a business.
You may ask: what if I`m buying one for my own use? The answer is: you should treat the home you`re buying like an investment property equally. The key idea here is you want to find out the fundamental value of a home. And history tells us that all properties and assets go back to its fundamental value sooner or later. That means, relying only on speculative values set forth by people in real estate market can cost you big discount of your net worth later when property values really adjusts. Unless you have couple million dollars sitting in your bank account, the chances are, you care about your net worth. The bottomline is you don`t want to pay too much for what a property is really worth fundamentally.

Owning a property gets you a series of rental income. So the income approach actually makes you think backward: For the rental income that you`re getting regularly, how much would you want to pay for it? Savvy investors and bankers know that we can employ the so-called Discounted Cash Flow (DCF) method. We`re not going to take 10 pages to discuss it. But the key point here is, you want to compare the fundamental value (we call it Rent-Implied Home Value) with the selling price out there to determine if it`s a bargain or not.

If your property value deviates largely from your Rent-Implied Home Value, beware! This is a strong evidence that your home value has large bubble content.

Some of the tips to avoid getting caught by bubble are:
1. Check how much is needed to maintain the gross rental income
People who are familiar with Rent-Implied Home Value concept may try to inflate it by hidding the ongoing costs needed to maintain the grosss rental income. Two properties may get you the same rental income, but one of them may cost you whole lot more to maintain.

2. Check how reliable the rental income is.
Yes, we acknowledge that there is vacancy risk. The vacancy rate actually tells you the fair probability that you can get your property rented. Be sure to find out the long term one.

3. Be sure to check if the rent yield is larger than Treasury bill`s rate
This may sound technical. But it`s important! Rent yield tells you how much return you`re getting from your property. If it`s less than T-Bill rate, why would you want to invest in this risky property in the first place when you can get more return risk-free?

4. Collect the most accurate rental and costs information
Accuracy depends on your dilligence. Garbage in, garbage out. Simple as that.

Next time you buy a property, remember, check your Rent-Implied Home Value.
Treat the home you`re buying like an investment property equally


RealtyJason, I`m glad you posted this I`ve often felt like this myself...buying a home is a big decision and I want to ensure that I get the best value for the place I buy.

I like this idea because if I was to buy another place to start a family, I would study the economic fundamentals; however, I would want to avoid living in Kildaare in Edmonton or Scarborough in Toronto.

Buying based on a investment strategy severely limits the options I have. I want to live in a cool area, I want to have a pool, a nice patio, big BBQ, I want bamboo flooring….I may not get these back in rent if I buy a house with this.

I`m not alone in this. Real estate values change from neighborhood to neighborhood because an area may have more people demanding the property to live in than potentially invest; as a result, there is a premium (supply and demand a true economic fundamental). It would be nice if every property is bought on cap rates, it just doesn`t happen


Bubble avoidance

I think of real estate using Don`s Acre analogy of a pendulum....prices rarely hit the mark. Momentum always develops in one direction or another. After Acre, I got curious about this and wanted to understand it. I read two papers on the Asian real estate bubble and saw lots of similarities to the current bubble in the US.

Here are the common reasons why bubbles are created:

1. One could never have perfect information about what a particular value a buyer and seller hold for a property and once they do their deal...the information on price is not readily available. As a result, investors may overestimate or underestimate the value based on market sentiment ("it`s always going to go up...so if I put an offer overlist I`m ok or its going to crash and I`m going to lose everything....sell for whatever we can get).

2. Supply is very limited and usually only comes in the market in chunks because of the lag in construction and planning. Developers can never actually always stay on top of demand because demand changes a lot quicker than they could stop construction and planning (wouldn`t it be funny if banks started to buy up all the real estate in a particular neighborhood when prices are low and then start blowing them up to raise values?...oh they are doing that now..see here)
3. Lenders and financial markets (especially outside of Canada) usually don`t give the right amount of capital to lead to a stable market (i.e. Lend too much cheaply or lend too little very expensively. The flow of money, combined with the fact most collateral for loans are based on land, if land prices suddenly drop the flow of capital drastically slows down...leading to credit crisis that we see now.

If you want to email me I can send you these papers that I have researched.


Based on my research I modify my strategy based on what I find. Right now, I understand the market is going through the BIG W, so when I invest I buy under-market properties that cashflow.


If your property value deviates largely from your Rent-Implied Home Value, beware!

When I think of real estate investing I think of this quote:



"There is something in common between the art of puzzle assembly and the game of go. Only when the pieces are fitted together do they acquire a legible character, gain a meaning. Examined in isolation a piece of a puzzle means nothing; it is just an impossible question, an opaque challenge".

Georges Perec, Life, A User`s Manual

Every time I read the property goldmine scorecard, I challenge every factor in the scorecard myself. I play games in my head to see if we require additional factors or we should get rid of one...time and time again, I see every factor in the goldmine scorecard are all important.

Take for example if the property value deviates largely from the rent-implied income...I guess we can liken this to the affordability index REIN members study. If I take the fact that properties are getting less affordable and putting into context that there is some major infrastructure improvements; the incomes of the people in city is increasing; there is net in-migration and the local government is really great at promoting growth, I just might buy there anyway. The other factors will drive up values further.

As for being ware....I am always wary. I have to be extra cautious by being diligent in my criteria because I do JV`s. I study the fundamentals of a particular town so in depth I know it inside out to create a complete picture. I also study other areas...for fun... and I find that this helps me put everything in perspective.

Cha Ching


Happy investing...and buying

 

[GarthChapman]

QUOTE (felicia0079 @ May 21 2009, 01:18 AM) "Bang on our forehead"

Totally makes sense to me. I`ve been searching for a way to systematically value a property but none of my realtors ever told me things like this.

This view echoes an article that I believe I read on Money magazine: stocks market grows 9-13% on average even with crashes taken into consideration (more than real estate market). If I tell our friends we`re borrowing $300K to invest in stocks they`ll say I`m nuts. But I`m congratulated if I`m borrowing $300K to invest in real estate. I still believe in real estate but some things need to be changed radically.

If what realityjason says is true, I can foresee a ground-shaking change in the residential real estate industry in terms of property assessment.

But your stocks are not leveraged, and your revenue properties are, normally by a 5 to 1 ratio by virtue of 80% mortgage financing. So your return in Real Estate is on the 20% you put down plus closing and initial capital costs. So divide the returns on the stock market by 4 or 5 so you compare apples to apples. Also note that while stocks can lose up to all of their value (just ask me) your properties never will - the worst I can think of is 20%-25% losses experienced in 1980- in Alberta and near thoses figures over the last two years.

 

[bigbabba]

QUOTE (GarthChapman @ May 21 2009, 03:01 PM) But your stocks are not leveraged, and your revenue properties are, normally by a 5 to 1 ratio by virtue of 80% mortgage financing. So your return in Real Estate is on the 20% you put down plus closing and initial capital costs. So divide the returns on the stock market by 4 or 5 so you compare apples to apples. Also note that while stocks can lose up to all of their value (just ask me) your properties never will - the worst I can think of is 20%-25% losses experienced in 1980- in Alberta and near thoses figures over the last two years.


stocks are not a passive investment as most like to think, if you can`t watch your portfolio and rebalance every once in a while then forget investing. I agree that RE will always be worth something, but it takes alot more then buying RE , the fun begins after the purchase.

 

[bizaro86]

the worst I can think of is 20%-25% losses experienced in 1980- in Alberta and near thoses figures over the last two years.

If you`re going to count the leverage on the upside for real estate, its only fair to count it on the downside as well. If you have 20% down on a piece of real estate, and you take a 20% loss, you`re return is negative 100%, not negative 20%. The leverage that helps you on the way up hurts you on the way down. I`m a big believer in real estate, but whatever filter/assumptions are applied to the upside of an analysis should also be considered when evaluating the potential downside.

Michael

PS I know you only take that loss if you sell, but the same is true for recent stock market losses, unless the individual company went bankrupt.

 

[Cargren]

QUOTE 3. Be sure to check if the rent yield is larger than Treasury bill`s rate
This may sound technical. But it`s important! Rent yield tells you how much return you`re getting from your property. If it`s less than T-Bill rate, why would you want to invest in this risky property in the first place when you can get more return risk-free? Can you borrow money to buy a T-bill and cover all expenses with the interest from the T-bill alone? And have a little extra spending money after all expenses are paid?

I agree. Tell me where I buy $100000 worth of T-bills for $20000, have the cashflow from my investment pay any interest on the original $20000 I invested, have it all paid off in 25 years, AND possibly be worth $200000 + when I go to cash in? Let me know and I`ll sign up.