Oct012008

Fundamental Valuation of Houses – Part 2

Investment Value

Home Page ImageThe United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners’ equivalent rent of primary residence (rental equivalence). They make this distinction because a house has both a consumptive purpose and an investment purpose. The consumptive value is measured by rent or rental equivalence. There is legitimate financial reason to pay more than the rental equivalence price. The normal rate of house appreciation–not the unsustainable kind witnessed during the Great Housing Bubble–can provide a return on investment. The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage. The investment premium, which is about 10%, is less than most people think.

The rental equivalence value is the fundamental value of real estate, and it is also its consumptive value. This value can be easily measured as demonstrated in the previous section. There is an independent investment value that can also be measured and added to the consumptive value to arrive at the maximum resale value of the property. Investment value is derived from two sources: the increase in property value through appreciation and the long-term savings over renting caused by inflation. These two components are measured separately to demonstrate how they function and how much each of them is worth.

Since the return on investment generated from residential real estate occurs in the future, a discounted cashflow analysis is required to determine the net present value of the future returns. Calculating net present value sounds complex, and manually going through the calculations is quite cumbersome, but electronic spreadsheets make this an easy task. The concept is simple: how much money would investors put in an investment today if they knew the rate of growth and the cash value to be realized in the future. For instance, if investors put $100 in a bank earning 5% interest, they would have $105 at the end of the year. Net present value looks at the situation in reverse. If investors knew they would receive $105 at the end of the year and the market interest rate was 5%, they would be willing to pay $100 for it today. Similarly, the investment value of residential real estate is the value today of an amount of money to be received in the future either through sale or savings on rent.

Discount Rates

The investment value of a property can only be measured against other investment opportunities available to an investor. If investors can earn 4.5% by investing in government treasuries, they will demand a higher return to invest in an asset as volatile and as illiquid as residential real estate. The rate of return an investor demands is called a “discount rate.” The discount rate is different for each investor as each will have different tolerances for risk. During the Great Housing Bubble discount rates on most asset classes were at historic lows due to excess liquidity in capital markets. The discount rate used in the analysis is the variable with the greatest impact on the investment value. Because of the risks of investing in residential real estate, a strong argument can be made that a low discount rate is unwarranted and investors would typically demand higher rates of return for assuming the inherent risks. A low discount rate exaggerates the investment premium and makes an investment appear more valuable, and a high discount rate underestimates the investment premium and makes an investment appear less valuable.

The US Department of the Treasury sells a product called Treasury Inflation-Protected Securities (TIPS). The principal of a TIPS increases with inflation, and it pays a semi-annual interest payment providing a return on the investment. When a TIPS matures, they buyer is paid the adjusted principal or original principal, whichever is greater. This is a risk-free investment guaranteed to grow with the rate of inflation. The rate of interest is very low, but since the principal grows with inflation, it provides a return just over the rate of inflation. Houses have historically appreciated at just over the rate of inflation as well; therefore a risk-free investment in TIPS provides a similar rate of asset appreciation as residential real estate (approximately 4.5%). Despite their similarities, TIPS are a much more desirable investment because the value is not very volatile, and TIPS are much easier and less expensive to buy and sell. Residential real estate values are notoriously volatile, particularly in coastal regions. Houses have high transaction costs, and they can be very difficult to sell in a bear market. It is not appropriate to use a 4.5% rate similar to the yield on TIPS or the rate of appreciation of residential real estate as the discount rate in a proper value analysis.

Another convenient discount rate to use when assessing the value of residential real estate is the interest rate on the loan used to acquire the property. Borrowed money costs money in the form of interest payments. A homebuyer can pay down the loan on the property and earn a return on that money equal to the interest on the loan as money not spent. Eliminating interest expense provides a return on investment equal to the interest rate. Interest rates during the Great Housing Bubble on 30-year fixed-rate mortgages dropped below 6%. An argument can be made that 6% is an appropriate discount rate; however, 6% interest rates are near historic lows, and interest rates are likely to be higher in the future. Interest rates stabilized in the mid 80s after the spike of the early 80s to quell inflation. The average contract mortgage interest rate from 1986 to 2007 was 8.0%. If a discount rate matching the loan interest rate is used in a value analysis, it is more appropriate to use 8% than 6%.

Investors in residential real estate (those who invest in rental property to obtain cashflow) typically ignore any resale value appreciation. These investors want to receive cash from rental in excess of the costs of ownership to provide a return on their investment. Despite their different emphasis for achieving a return, the discount rates these investors use may be the most appropriate because it is for the same asset class. Cashflow investors in rental real estate have already discounted for the risks of price volatility and illiquidity. Historically, investors in cashflow producing real estate have demanded returns of near 12%. During the Great Housing bubble, these rates declined to as low as 6% for class “A” apartments in certain California markets. [1] It is likely that discount rates will rise back to their historic norms in the aftermath of the bubble. If a discount rate is used matching that of cashflow investors in residential real estate, a rate of 12% should be used.

Once money is sunk into residential real estate, it can only be extracted through borrowing–which has its own costs–or sale. Money put into residential real estate is money taken away from a competing investment. When buyers are facing a rent versus own decision, they may choose to rent and put their downpayment and investment premium into a completely different asset class with even higher returns. This money could go into high yield bonds, market index funds or mutual funds, commodities, or any of a variety of high-risk, high-return investment vehicles. An argument can be made that the discount rate should approximate the long-term return on high yield alternative investments, perhaps as high as 15% or 18%. Although an individual investor may forego these investment opportunities to purchase residential real estate, it is not appropriate to use discount rates this high because many of these investments are riskier and more volatile than residential real estate.

The discount rate is the most important variable in evaluating the investment value of residential real estate. Arguments can be made for rates as low as 4.5% and as high as 18%. Low discount rates translate to high values, and high rates make for low values. The extremes of this range are not appropriate for use because they represent alternative investments with different risk parameters that are not comparable to residential real estate. The most appropriate discount rates are between 8% and 12% because these represent either credit costs (interest rates) or the rate used by professional real estate investors. The examples in this section will use these two rates to illustrate the range of values rational investors in residential real estate would use to value an investment premium.

Appreciation and Transaction Fees

The portion of investment value caused by appreciation can only be evaluated by an accurate estimate of appreciation during the ownership period. The general public grossly overestimates the rate of home price appreciation. [ii] Historically, houses have appreciated at a rate 0.7% over the long-term level of inflation. From 1983 to 1998, a period of low inflation and declining mortgage interest rates before the Great Housing Bubble, the rate of house price appreciation was 4.5% nationally which was 1.4% over the rate of inflation. [iii] Appreciation rates are tied to income and rents because this is the fundamental value of residential real estate.

Profiting from house price appreciation requires getting more money from the sale of a property than was originally paid for it and not having that profit cancelled out by moving costs, transaction fees, and a large spreads between the cost of ownership and the cost of rental during the ownership period. Buying and selling residential real estate incurs significant transaction costs that are not reflected in the price. It is quite common for properties to sell for more than their purchase price and still be a loss for the seller. When people purchase residential real estate they pay numerous closing costs including title insurance, recording fees, document stamps and taxes, mortgage application fees, survey fees, inspection fees, appraisal fees, et cetera. These fees often total between 2% and 4% of the purchase price not including any prepaid interest points on the mortgage. When people go to sell residential real estate they generally go to real estate broker who will charge them a 6% commission. There has been an increasing popularity in the use of discount brokers, but the National Association of Realtors has done a remarkable job of keeping brokerage commissions at 6% despite market pressures to lower them. These transaction costs are part of every residential real estate transaction, and they take a substantial portion of the profit on properties with short holding periods, and if the holding period is not long enough, transaction fees create losses.

The negotiating abilities of buyers and sellers and the overall market environment greatly impact the profits from real estate. Sellers almost universally believe their properties are worth more than the market will bear. People become emotionally attached to their houses, and because it is very valuable to them, they assume it is just as valuable to a person who is not attached to the property. Sellers always hope to find the buyer who will appreciate their home as much as they do and thereby pay top dollar for it. The vast majority of homeowners have unrealistic expectations of appreciation. The combination of emotional attachment and unrealistic appreciation expectations cause sellers to believe their house is more valuable than it is, and when it comes time to sell, they price it accordingly.

Sellers usually are forced to discount a property from their perceived value in order to sell it, except in raging bull markets when sellers can sometimes get more than their asking price. In bear markets, they may have to discount the property significantly in order to sell it. Bear markets are the most difficult because sellers have difficulty lowering their prices, particularly if they must sell at a loss. [iv] Sometimes the difficulty in lowering price is caused by the amount of debt on the property, and sometimes it is caused by seller’s emotional issues. No matter the cause, the seller’s aversion to lowering asking price often results in a failure to sell the property. Since this process of discounting to sell is already reflected in the historic appreciation rate, no further adjustment is required to account for it.

The key variables for the calculation of the portion of investment value due to appreciation are the rate of appreciation, the investment discount rate and the transaction fees. In the calculations that follow the rate of appreciation is 4.5%, the discount rate is 8%, and transaction costs are 2% for the purchase and 6% for the sale. There is a 20% downpayment, and the loan is assumed to be an interest only to avoid the complications of a decreasing loan balance in the calculation and isolate the appreciation premium.

Due to the high transaction costs, the property does not reach breakeven until two full years of ownership. In a discounted cashflow basis, the property does not break even until after 4 full years of ownership. It is these high transaction costs that compel many with short-term housing needs to rent rather than own. Assuming an 8% discount rate and a term of ownership of 10 years or more, there is a premium for ownership of approximately 10%. This means the owner could pay up to 10% over the rental equivalent value and still obtain an 8% return on their money–assuming they can sell it for 10% over rental equivalent as well.

There is a tendency in the general public to assume the leverage of real estate provides excessive returns. It does magnify the appreciation, but since the historic and sustainable rate of appreciation is a low 4.5%, the leverage is applied to a small growth rate resulting in less than stellar investment returns.  In the previous examples, if the downpayment is lowered to 10%, the investment premium at an 8% discount rate rises to 15%, and with a 12% discount rate, there are some ownership periods justifying a premium. If the downpayment is dropped to 1%, the ownership premium rises as high at 20%. At its most extreme with 100% financing, any positive return becomes infinite because the investor has no cash investment. Ownership premiums of 10% to 20% sound large, but in coastal markets during the Great Housing Bubble, buyers were paying ownership premiums in excess of 100%. There is no fundamental valuation justification for these price premiums, only rationalizations and hopes that a greater fool will appear and pay continually higher prices, or in the case of 100% financing speculation, that losses can be passed on to a lender if market prices decline.

Table 3: Appreciation Premium and Holding Period using an 8% Discount Rate

$200,000 House Price
$40,000 Downpayment
$4,000 Closing Costs at 2%
4.5% Rate of Appreciation
8.0% Discount Rate
Year Resale Value Selling Fees at 6% Revenue From Sale Seller Cash at Closing Profit or (Loss) Net Present Value % of Home Value
0 $200,000 $12,000 $188,000 $28,000 ($16,000) ($16,000) -8.0%
1 $209,000 $12,540 $196,460 $36,460 ($7,540) ($9,482) -4.7%
2 $218,405 $13,104 $205,301 $45,301 $1,301 ($4,780) -2.4%
3 $228,233 $13,694 $214,539 $54,539 $10,539 ($653) -0.3%
4 $238,504 $14,310 $224,193 $64,193 $20,193 $2,948 1.5%
5 $249,236 $14,954 $234,282 $74,282 $30,282 $6,070 3.0%
6 $260,452 $15,627 $244,825 $84,825 $40,825 $8,754 4.4%
7 $272,172 $16,330 $255,842 $95,842 $51,842 $11,040 5.5%
8 $284,420 $17,065 $267,355 $107,355 $63,355 $12,963 6.5%
9 $297,219 $17,833 $279,386 $119,386 $75,386 $14,558 7.3%
10 $310,594 $18,636 $291,958 $131,958 $87,958 $15,854 7.9%
11 $324,571 $19,474 $305,096 $145,096 $101,096 $16,879 8.4%
12 $339,176 $20,351 $318,826 $158,826 $114,826 $17,659 8.8%
13 $354,439 $21,266 $333,173 $173,173 $129,173 $18,218 9.1%
14 $370,389 $22,223 $348,166 $188,166 $144,166 $18,577 9.3%
15 $387,056 $23,223 $363,833 $203,833 $159,833 $18,756 9.4%
16 $404,474 $24,268 $380,206 $220,206 $176,206 $18,774 9.4%
17 $422,675 $25,361 $397,315 $237,315 $193,315 $18,647 9.3%
18 $441,696 $26,502 $415,194 $255,194 $211,194 $18,391 9.2%
19 $461,572 $27,694 $433,878 $273,878 $229,878 $18,019 9.0%
20 $482,343 $28,941 $453,402 $293,402 $249,402 $17,545 8.8%
21 $504,048 $30,243 $473,805 $313,805 $269,805 $16,981 8.5%
22 $526,730 $31,604 $495,127 $335,127 $291,127 $16,336 8.2%
23 $550,433 $33,026 $517,407 $357,407 $313,407 $15,622 7.8%
24 $575,203 $34,512 $540,691 $380,691 $336,691 $14,847 7.4%
25 $601,087 $36,065 $565,022 $405,022 $361,022 $14,019 7.0%
26 $628,136 $37,688 $590,448 $430,448 $386,448 $13,146 6.6%
27 $656,402 $39,384 $617,018 $457,018 $413,018 $12,234 6.1%
28 $685,940 $41,156 $644,784 $484,784 $440,784 $11,290 5.6%
29 $716,807 $43,008 $673,799 $513,799 $469,799 $10,319 5.2%
30 $749,064 $44,944 $704,120 $544,120 $500,120 $9,327 4.7%

 

Larger discount rates eliminate the appreciation premium on residential real estate. The money tied up in a 20% downpayment on residential real estate appreciating at 4.5% provides a rate of return less than 12%; therefore when the gains from appreciation are discounted at 12%, the net present value never goes positive. When investors demand returns equal to or greater than 12%, there is no investment value from appreciation in residential real estate.

 

Table 4: Appreciation Premium and Holding Period using a 12% Discount Rate

$200,000 House Price
$40,000 Downpayment
$4,000 Closing Costs at 2%
4.5% Rate of Appreciation
12.0% Discount Rate
Year Resale Value Sales Fees at 6% Revenue From Sale Cash Back at Closing Profit or (Loss) Net Present Value % of Home Value
0 $200,000 $12,000 $188,000 $28,000 ($16,000) ($16,000) -8.0%
1 $209,000 $12,540 $196,460 $36,460 ($7,540) ($10,220) -5.1%
2 $218,405 $13,104 $205,301 $45,301 $1,301 ($7,042) -3.5%
3 $228,233 $13,694 $214,539 $54,539 $10,539 ($4,625) -2.3%
4 $238,504 $14,310 $224,193 $64,193 $20,193 ($2,861) -1.4%
5 $249,236 $14,954 $234,282 $74,282 $30,282 ($1,652) -0.8%
6 $260,452 $15,627 $244,825 $84,825 $40,825 ($915) -0.5%
7 $272,172 $16,330 $255,842 $95,842 $51,842 ($577) -0.3%
8 $284,420 $17,065 $267,355 $107,355 $63,355 ($572) -0.3%
9 $297,219 $17,833 $279,386 $119,386 $75,386 ($847) -0.4%
10 $310,594 $18,636 $291,958 $131,958 $87,958 ($1,351) -0.7%
11 $324,571 $19,474 $305,096 $145,096 $101,096 ($2,043) -1.0%
12 $339,176 $20,351 $318,826 $158,826 $114,826 ($2,887) -1.4%
13 $354,439 $21,266 $333,173 $173,173 $129,173 ($3,851) -1.9%
14 $370,389 $22,223 $348,166 $188,166 $144,166 ($4,909) -2.5%
15 $387,056 $23,223 $363,833 $203,833 $159,833 ($6,036) -3.0%
16 $404,474 $24,268 $380,206 $220,206 $176,206 ($7,214) -3.6%
17 $422,675 $25,361 $397,315 $237,315 $193,315 ($8,425) -4.2%
18 $441,696 $26,502 $415,194 $255,194 $211,194 ($9,656) -4.8%
19 $461,572 $27,694 $433,878 $273,878 $229,878 ($10,894) -5.4%
20 $482,343 $28,941 $453,402 $293,402 $249,402 ($12,129) -6.1%
21 $504,048 $30,243 $473,805 $313,805 $269,805 ($13,352) -6.7%
22 $526,730 $31,604 $495,127 $335,127 $291,127 ($14,557) -7.3%
23 $550,433 $33,026 $517,407 $357,407 $313,407 ($15,739) -7.9%
24 $575,203 $34,512 $540,691 $380,691 $336,691 ($16,892) -8.4%
25 $601,087 $36,065 $565,022 $405,022 $361,022 ($18,014) -9.0%
26 $628,136 $37,688 $590,448 $430,448 $386,448 ($19,100) -9.6%
27 $656,402 $39,384 $617,018 $457,018 $413,018 ($20,151) -10.1%
28 $685,940 $41,156 $644,784 $484,784 $440,784 ($21,163) -10.6%
29 $716,807 $43,008 $673,799 $513,799 $469,799 ($22,136) -11.1%
30 $749,064 $44,944 $704,120 $544,120 $500,120 ($23,070)