Is Buying a Home Like Buying Stock?

Between January of 2007 and January of 2008, home prices dropped by 11.4% nationwide, according to the Standard & Poor's/Case-Shiller index. Some communities, like Las Vegas and Miami, dropped by almost 20%.

 

 

The S&P/Case-Shiller Home Price Index provides exciting headlines for the media and interesting questions for entrepreneurial investors. Why did real estate in Charlotte increase by almost two percent while prices in Miami dropped by almost twenty percent? Why are the losses in Portland and Seattle so much lower than in other areas? Real estate offers lessons for stock investors when we look beyond the averages and try to understand the specifics.

 

By March, things were even worse. In California, the median home price had dropped to $385,000, down 24% from $505,000 a year earlier. Foreclosure filings and bank repossessions have been surging, and some predict that as thousands of adjustable mortgages reset to higher rates in May and June, banks and borrowers will face unprecedented pressures. For most Americans, our primary residence is also our largest investment, and as we saw during the recent credit binge, the primary source of our liquidity. Consequently, falling real estate prices affect Americans more directly than do falling stock prices, although neither should be cause for panic. Home ownership experience provides useful lessons for investing, particularly when things look bad.

First: Review the Fundamentals

Whether one is buying a home, an income property or a share of stock, one seeks a good value. One hopes to make some money, either through appreciation, rental income, dividends, etc. This is true whether or not a residence can be considered an investment, and there is some debate on the point. Rich Dad, Poor Dad author Robert Kiyosaki maintains that a personal residence does not qualify as an investment, because he views an investment as something that pays you money, but a primary residence costs you money.

Despite speculative bubbles, houses tend to appreciate at little more than the rate of inflation over the long term. However, that is the general rule and not the profitable exception. Obviously, it varies by location, demographic trends, etc. Beverly Hills and Santa Barbara real estate offer cachet, lovely weather year-round, and limited supply, causing these properties to appreciate more reliably than others. Bakersfield, Las Vegas and Sacramento seem to offer an unlimited amount of land, and the frenzied building in these places has exceeded demand and driven prices down.

But whether or not we view our homes as investments, they are certainly assets, and expensive ones. So we still seek good value, and we need a method for determining the home's value in the marketplace: is it over-priced, under-priced, or somewhere in the middle? The method we use for determining value varies based on the type of real estate under consideration and the goals and timeframes of the purchaser. Generally speaking, there are three common methods for establishing real estate value:

Replacement: This method estimates how much it would cost to replace the structure, but does not account for the land value.

Income: Applied to income properties, this method estimates market value based on the income generated by the property. One method calculates a capitalization rate based on the net operating income of the property. Under this “cap rate” method, there is an inverse relationship between the capitalization rate and the asking price. The other common method multiplies the gross rental income (potential or operating) to estimate a purchase price. In addition to either the “cap rate” or “times gross” calculation, one must also account for the condition of the income property and likely future expenses, as well as the current and future supply and demand in the area.

Comparables: This is the most common method used in residential real estate. Prices are compared to those of properties recently sold or currently listed. Experience allows realtors and homeowners to estimate the likely value based on unique features of the property under review.

On Wall Street, many investors measure companies by their dividends and profit-to-earnings ratios, using valuation formulae resembling the replacement and income methods described above. But the comparables method also provides an excellent metaphor for evaluating stocks, because an entrepreneurial investor proceeds as if he or she were buying the entire company. The process is similar to buying a residence, but we're in it for the money, not the roof over our heads. Like house hunters, we learn as much as we can about the house, similar houses, the neighborhood, and similar neighborhoods. The more we learn, the better our chances of getting a good deal. This happens before we compare interest payments or property taxes or utility bills; we comparison shop based on the price of the house itself.

Transferable Fundamentals

Of course, relative value is less useful if an entire area is over valued, just as when an entire industry or sector is overvalued in the stock market. Consider the Technology bubble of the 1990s. That's why entrepreneurial investors make decisions based on intrinsic value and not simply one metric or methodology. Income properties are more analogous to stock investing because they are not clouded by the intangible emotional components attached to the concept of “home.” The fundamental financial concepts are the same, though. For example, a stock's market capitalization is the total price of outstanding shares, or what one would pay for ownership of the entire company. That corresponds to the down payment on a property, because that's how much you pay out of pocket to take ownership. Of course, you then also “own” a big mortgage.

The concept of “enterprise value” is something a little different. In an efficient housing market, the asking price suggests the enterprise value, because it should reflect liens, probable repairs, and other liabilities. As the saying goes, price is what you pay, value is what you get.

When evaluating a stock, we study the neighborhood, or industry, to determine whether a company costs more or less than others. To understand a price differential in real estate, we study the number of rooms, amenities such as swimming pools or marble floors, and any possible liabilities, such as a damaged roof or cracked foundation. With companies, we obtain a wide range of data to compare with market capitalization, such as assets, liabilities, sales and earnings.

All of this boils down to the most basic entrepreneurial instinct: we want top quality, but we're not buying until it goes on sale. This principle is transferable from real estate to stock market investing during normal times, but one might ask whether this applies during times of extreme volatility.

 

Why Fundamentals Are Fundamental

We maintain that times of volatility are normal times. The housing market and the stock market fluctuate; that's the nature of markets, because it is the nature of people. And different people have different goals and timeframes. Some people seek a primary residence as a long-term asset, some seek an investment property for rental income, and still others seek a speculative investment for what they hope will be quick profits. All affect the market prices, but speculator influence contributes directly to market bubbles. Any California homeowner over the age of fifty has experienced three or four (depending on your definition) serious corrections in housing prices.

We believe “correction” is the proper term, because markets always move toward efficiency, and speculation-based high prices are naturally untenable. The good news, of course, is that panic-based low prices are equally untenable. Eventually, the market for homes or stocks will reflect the actual value of the asset, so if we buy something on sale (at a discount to its intrinsic value), volatility matters little, presuming we have the presence of mind to stay the course.

A motorcycling philosopher told us he recalls the wisdom of Heraclites while riding, because Heraclites proclaimed, “One can never step in the same river twice.” Change is continuous, and our motorcycling friend explains that during every second of his ride, the small contact patch of his tires touches new ground, with an infinite range of traction possibilities: a bit of gravel, some leaked oil, etc. “I know a lot of advanced riding techniques,” he says, “but when the road gets bad or I make a mistake, it's the fundamentals - head up, knees on the tank, looking where I want to go, staying calm - that save me.”

Understanding the fundamentals of market behavior will also save investors during trying times. Many people receive their first serious lesson in finance fundamentals when they buy a home. We cite the comparables method of evaluating real estate as a good metaphor for evaluating stocks, but the greater lesson during this time of market correction is that the fundamental dynamics of the stock market are very similar to those of the real estate market. The press sensationalizes the plight of people facing foreclosure, without noting that many other people, who have scrimped and saved and waited for an opportunity to buy a home, will now get that opportunity.

Markets are indifferent by definition. Whether buying a house, a share of stock, a used car or almost anything else: take pains to know what it's really worth, and wait until you can buy it for less.

 

As described in the article, income properties are generally valued using either a gross rent multiplier [GRM] or a capitalization rate (Cap Rate). One derives the gross rent multiplier by looking at comparable properties and dividing the annual gross income by the market value of the property. When comparing a number of properties, this provides a quick yardstick: one multiplies the gross annual income by the GRM for a ballpark property value. However, the GRM does not account for vacancies and operating expenses. One calculates the Cap Rate by dividing the NET operating income of comparable properties, which accounts for vacancies and expenses. Cap Rate can also be viewed as one's required rate of return. The chart above shows the inverse relationship of Cap Rate and market value: if one wants a higher rate of return, one must pay less for the property.

 

By Lance Helfert, with contributions from Paul Orfalea, Atticus Lowe and Dean Zatkowsky.

Comments

[WAKEUP:]

Nice analysis. My non-MBA, gut feeling, after learning the hard lessons of home buying is that houses are going to be cheap, for a long time. I go back to the 1970's, in this "American Dream" thing. I would have done better to rent, all along the way, and invest the difference. And I could have lived in the same quality housing.

2008 May 29 02:09 PM