1. Potential loss of remaining unpaid mortgage value for oneself and next-of-kin if were to become disabled or died

This is perhaps the single largest reason for not paying off housing loan even for primary residence. Most breadwinners will have mortgage insurance for this home to pay off remaining loan in the event of death or total permanent disability. If one has $200 000 cash lying idling in various bank accounts and use for a fully paid out house, then in the event of death, his family only got the fully paid out house while if he instead leave it lying in the banks, his family will have got a fully paid out house (paid off by mortgage insurance) and the $200 000 cash as well in the event of death.

2. Opportunity cost of locking cash in house

In general, the housing loan interest rate is around 3% to 4%, by fully paid out the loan, one can save the 3% to 4% for the next 10 to 30 years, depending on period chosen. However, one will also be cash strapped by the same amount of the next 10 to 30 years, because the amount is going to be substantial, somewhere in the region of $100 000 or more, the opportunity cost will also be great if it is not used to pick up stocks selling in bargain price during stock market crashes. Even if one were to play it safe in the stock market by investing in ETFs tracking indexes, the return will most probably be more than 3% to 4% more than 20 years down the road.

3. A mortgage is the least expensive loan

To give a figure for illustration, it doesn’t make sense to lock $200 000 in house to save 3% to 4% interest rate only to pay 24% interest in credit cards debt when you want to buy something that you like or 7% in car loan when the $200 000 is used to exchange for 100% house equity. The idea is to leverage on the loan with the least interest rate.

4. Invest in a single premium endowment

This is for those who are particularly risk adverse. One of the considerations in purchasing endowment policies despite offering guaranteed yield that is higher than a bank fixed deposit is that given a relatively long period of premiums commitments and economic uncertainty in today’s times, there is a good chance of inability to make payments years down the road. The single premium endowments do away with the risk of inability to pay off the premiums.

In the case of having a windfall of $200 000 (figure used is for example) or $200 000 savings from a high income and bonus job, one will still do better to invest in a single premium endowment for around the same loan period and interest rate as mortgage, than to use the same $200 000 for a fully paid out house, as this not only offset the interest rate from housing loan but also provide additional death and total permanent disability benefits.

There may be a penalty for surrendering before a certain date, but if did not surrender, $200 000 inside an endowment policy can earn compound interest with the final amount be substantial 20 years down the road than if were to lock inside the house, since the $200 000 will not increase in value and the market price of house will continue to rise regardless of whether the house is 20% equity/80% mortgage, or 100% equity.

5. Net Worth remain the same if paid off the housing loan

Net worth of an individual is calculated by total assets minus total liabilities of that person. If $200 000 cash is shifted into $200 000 house equity, the net result is the same as $200 000 cash in banks and $200 000 in mortgages. The only difference being that of having your $200 000 cash frozen inside housing equity.

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2. All the interest rates that everyone needs to know
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The problems inherent in market value for physical properties,

Most realty investors continue to believe that a below market value means getting a good deal, just like if a blue chip trades at $10 2 days ago and $5 now means that it is a good buy. However, whether it is a bargain depends on the sale price in future and not the purchase price today. Market value comes from appraisals doing the valuation. There are three reasons why appraisals are less than accurate in accessing the true value of a piece of property.

1. Appraisals almost ignore fundamentals of economics

Basically, they give little thoughts to whether there will be changes in some geographic areas demographic profiles. Three keys factors that will affect value of properties more than 10 years down the road at least are jobs, incomes earned by the jobs and amount of population having those jobs and incomes 10 years later, or when you wished to sell in future.

2. Fallacy on extrapolating from recent past

Just like with stocks, people almost always have the tendency to focus on the recent past, by recent, I mean at most relevant data from 1 year ago until now. The rationale behind it is simple, if similar properties in the same neighborhood sell for this price in the recent past, then this one by right, based on common sense should sell for this price also.

3. Other areas are ignored

A same size apartment in state A may costs more than another in state B, it does not mean that the one in state A is not a bargain buy, because market values in state A are accessed based on other properties in the specific urban area in state A, it ignored other factors like economics fundamentals between these two areas.

Even for a given urban area in a state and city, there are different neighborhoods, communities and subdivisions. Houses for these different subcategories may offer more value for money than others.

In conclusion,

There is a need to source for and analyze other current market data on real estate market in order to reach a reasonable conclusion on the intrinsic value of a piece of property rather than just simply below market price. This is true for stocks as much as it is true for real estate. In other words, the returns and how much returns depend on both purchase price now and sale price in future.

What are some other market data that value investors need to look into for more accurate assessment of intrinsic value, not market value?

There are at least six, briefly listed here and elaborate in the coming post.

1. Difference between asking price and selling price, in a statistical sense.

2. Amount of inventory of unsold apartments.

3. Time taken for listed properties to sell, on average.

4. Vacancy rates and number of for rent ads.

5. Amount of mortgage applications, delinquencies in mortgage payments and rates of increase/decrease in foreclosures.

6. Properties under contract

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2. Value investing benchmarks for real estate investors
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Your house is a great asset because not in the sense that it does not put money in your pocket but that it prevents more money from being taken out of your pocket and prevents money from being taken out of your pocket in perpetuity. Robert Kiyosaki argument on why house as primary residence is a liability, not an asset missed out an important point.

Short of sleeping on the streets, you either sleep in your own house over the night or on somebody else’s house by paying a rent, which is money out of your pocket anyway.

Owning your own home is a great investment not because the price is going to increase significantly in the short or long run but because the income from home will provide a good return on your investment. On the surface, it may seemed that paying mortgages leads to an outflow of cash but paying rent is leading to an outflow of cash as well. The difference being that the mortgages payments will stop one day while rent payments will continue forever because you need a roof over your head. He is not wrong in saying that owning a fully paid house still result in cash outflow like property taxes but not owning a fully paid house will be even worse because the rent payments will be substantially higher than property taxes decades later given the general trend in housing inflation.

Let us now look at how home ownership can put money in your pocket. Your house is an asset because it prevents more money from being taken out of your pocket unless the alternative is sleeping on the streets but heck, you need a license to sleep on a street for some country and the license cost money! Yes, by the strict definition of asset and liability, your house takes money out of your pocket but not owning anything and staying in a rented house also take money out of your pocket. The only difference being that all one has to show for after staying in a rented house for over 20 years is rent receipts instead of a house that can sell for a sizeable sum.

When I want a bigger house, I first buy assets that will generate the cash flow to pay for the house.

Robert Kiyosaki, author of Rich Dad Poor Dad

That really depends on the size of income and how much is left after meeting monthly spending because based on current yields as in cash flow from dividends only of most financial assets now, it will be a long time before one can upgrade to a larger house. By the time there is cash flow from assets that to pay for the house, the price may already inflate such that have to spend even more for same larger house.

As we shall see below, owning a house does put money in your pocket, but just that this income is more invisible compared to if you were a landlord, the rental income is the income. To put it simply, assuming that $1800 per month is the rent being paid for a house if did not own that particular house. Then the same $1800 per month is the money that is not taken out of your pocket if you owned that house. To illustrate my point, let us assume some figures to have a better picture.

To determine the home income or money being put inside your pocket as a result of home ownership, constructing an income statement for the house will be a good idea. The home income will get larger each year because rent may increase due to inflation but mortgage payments do not, provided it is a fixed rate mortgage as opposed to adjustable rate mortgage.

Income

Savings from rent $18,000

Expense

Mortgage payment $8,644

Savings from tax $1558

Property tax $1,620

Insurance $255

Maintenance $1460

Home Income $4463

Not considering if the price paid for house is too high or not, we can see that the belief that your house is an asset still holds true in this day and age. The savings from rent is the rent need to pay if were to rent the same or similar house in the same location from a landlord, the bottom line is what you gain if you were to own the house. In addition, technically speaking, the income from home after first month divided by down payment for house is the return on investment and that is usually a substantial amount, a yield one is unlikely to see when investing in other financial assets like stocks and bonds, hence you can see that home ownership does put money in your pocket, not only because it prevent more money from being taken out of your pocket. Take note that this happens independent of whether your house rise or fall in value.

Home income grow substantially after house is fully paid out after maybe 30 years as the mortgage payments become zero while savings from rent is going to be even higher since there will most probably be inflation in rent for the same house 30 years later. This is not considering home ownership allows the breadwinner to buy a life insurance with mortgage protection which pays off remaining mortgage should anything unfortunate happens to him or her and there is no life insurance with rent protection.

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2. Value investing principles in using debt for real estate investments
3. Danger of Rich Dad Poor Dad

While REIT is not a totally risk free investment, the fact is that people will need physical places to stay, work and shopping as well, thereby contributing to the demand and results in the certainty of rental income for REIT. In addition, the ownership of mainly physical assets by REIT means that in the worst case scenarios of a particular REIT going bankrupt, most probably due to using excessive leverage and rental income is unable to cover up for a prolonged period of time as a result of recession, the physical assets means that you will still get something back from your investments. This also means that directly owning the REITs will be more cost-effective than through mutual funds due to its perceived lower risk.

In view of the above facts, there is still REIT which goes bankrupt and erases shareholder value along the way. One example of which is General Growth Properties, more specifically, it is a commercial REIT. This is where learning from history helps, any business that needs to acquire large capital assets from plants, power stations, and cable lines to retail malls will need to use debt in order to increase return on equity. The General Growth Properties is unable to refinance existing debt obligations going to reach maturity result in bankruptcy filing. Circumstances leading to a higher risk of REIT going belly up will be discussed in future.

The classic fundamental analysis of stocks using metrics like price-to-earnings ratio, earnings-per-share ratio, etc do not really apply to REIT, even though REIT is also traded like a stock on stock exchanges. There is a good reason behind it, to understand why, take a good look at the hypo ethical financial statement of a REIT below,

ABC REIT

Revenues

Rental Income 3,200,000

Total Revenues 3,200,000

Expenses

Properties Maintenance 400,000

Taxes 110,000

Real Estate Insurance 20,000

Asset Management Fees 8,000

Administrative Expenses 30,000

Depreciation 500,000

Total Expenses 1,068,000

Net Income 2,132,000

In most other non-REITs stocks, their main businesses are not in owning and operating real estate, their fixed plants and equipments initially bought will physically degrade, hence the need to subtract a non-cash expense of depreciation from the revenue to arrive at net income. However, as you will know by now, physical properties usually does not depreciate in value and often increases in value in the long run. In addition, depreciation expenses are usually a significant item on an Income Statement. Precisely the reason why using net income and metrics derived from net income like price-earnings ratio is not a good yardstick for gauging the performance of REIT.

A more suitable and accurate metric for measuring and predicting the performance of REIT is funds from operations. In other words, because net income is after subtracting depreciation but depreciation does not really count for the case of REIT since houses and shopping malls don’t really depreciate over time, the FFO provides a much more accurate picture for estimating future value of an REIT. Take note that funds from operation is a bit different from cash flow from operations normally encountered from analyzing other businesses other than REIT.

The definition of Funds from Operation, or FFO,

FFO = Net Income + depreciation – gains from property sales

However, as property need maintenance from time to time, much like you needs to repaint your house after several years; accounting for capital expenditure will paint a more accurate picture of existing income from properties under the REIT.

The definition of Adjusted Funds from Operation, or AFFO,

AFFO = Net Income + depreciation – gains from property sales – capital expenditures

As you can see this AFFO is to be used as “net income” for further analysis and not the actual net income you see in published financial statements because AFFO is the real cash flow of an REIT, unlike most other businesses. Do take note that both the FFO and AFFO figures are usually reported in the notes accompanying the financial statements.

Valuation models for REITs

1. Net Asset Value

Whether you can use net asset value to value a company really depends on the company. For other businesses like Google and Facebook, goodwill accounts for much of their market value but for a REIT which mainly own real estate and derives its income from real estate, net asset value is a good estimate of value. For example, YouTube is purchased for more than $1 billion even though its tangible and measurable asset is its servers hosting users’ homemade videos so net asset value is not suitable for valuing YouTube but suitable for REITs.

You use price-to-book for most other stocks but NAV for REITs.

2. Price-to-FFO

This is similar to price-earnings ratio where the FFO is used instead of earnings for reasons mentioned above.

3. Price-to-AFFO

This is similar to price-earnings ratio but after accounting for capital expenditure.

4. Discounted Cash Flow (Using AFFO)

One of the valuation tools for value investing, the same discounted cash flow analysis can also be used to value REIT but just that will be using AFFO instead of free cash flow.

5. Dividend Growth Model

Not every business can simply use the dividend growth model; this valuation method assumes for some reasons that the businesses will continue to have the certainty in revenue for perpetuity. An example is Coca Cola, a person who regularly drinks Coke today and in the past is highly likely to drink Coke in future too, hence the certainty in revenue. Another example is monopolistic companies providing essential services like transport, telecommunications, and postage and banking, which will retain their monopolistic positions as a result of legislation protecting their monopolistic positions. All these can safely use the dividend growth model to accurately estimate current intrinsic value.

For the same reason, dividend growth model is not suitable for valuing companies like Creative Technology and Apple Computers. As discussed above, due to the nature of REIT in the first place, using dividend growth model is also a good tool for estimating value.

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1. Value investing principles in using debt for real estate investments
2. Value investing benchmarks for real estate investors
3. Predicting appreciation of real estate value 5 years down the road

Economics 101 tells you that when there are too much money running after too few goods, prices of goods will rise. The same logic holds true for immovable properties also. Whether there will be significant appreciation in houses or any other types of properties depends on whether there are many dollars chasing after limited number of properties.

It is not hard to see that the big three, jobs, incomes and population, (not General Motors, Ford and Chrysler), accounts very much for how much price appreciate for more than 5 years down the road. However, this is only one part of the equation; the other part is supply and costs of land for housing and other types of real estate purposes.

“Buy land – they ain’t making it anymore.” Will Rogers.

Adding on to the fact that there is only a finite area of land on Earth, there is also environmental regulation that prohibits development that clearly endangers those already endangered species, from various plants to animals. This further adds in to the benefits of investing in real estate compared with stocks and especially bonds.

That is, assuming that supply of land is limited and costs of land also rises with time, then the following equation holds true,

Increase in Jobs + Increase in Income + More Humans = Higher Real Estate Values

This relation is easily seen and will be obvious to people involved in area of investment. The more people in a particular geographic area with jobs plus high income, rent levels and subsequently property values will be pushed up. People need a roof over their heads and places to shop and other avenues of entertainment. In short, employment is the basic foundation of purchasing power.

In another sense, what you are really investing is not really the real estate, but local and regional economy of that real estate. Other than growth, stability is also crucial, I think so far, no one invest a cool US$1 millions in war torn Afghanistan yet. In the case of a stable city, state and country, it is wise to check with respective places’ economic development agencies certain key data like whether the area is greatly cyclical in its economies and if the local area “GDP” increase with only little downturns.

It is not difficult to verify this fact from historical data, just take a look at cities with rapid growth in both jobs and incomes, and with limited supply of land, like Seattle, Washington and of course Hollywood.

As a result, the first thing to do when deciding to invest in a piece of property is to check the geographic area potential and its likelihood for expected growth in the three main parameters.

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The distinctive key of value investing lies in it using multiple benchmarks when deciding on the value of an asset, instead of subscribing to modern finance theory of prices of asset already reflect the value of that asset, assuming perfect information to all people participating in the market. Other features of value investing includes margin of safety for the required rate of return and risk. Margin of safety got a similar meaning to safety factor in engineering.

In other words, most people subscribed to modern finance theory that a piece of real estate or stock is undervalued simply because it is lower than the prices of its related peer’s market prices.

In addition, when it comes to real estate, people always have the idea that due to population increases and increases in construction costs as a result of inflation, the value of a property always goes up. That is true in the long run, but how long is long? Don’t forget that the causation of recent financial crisis is due to everybody believing in this idea, both owners and lenders alike. The fact is that in the short run, at least within 5 years of time, prices of property did not really go up.

This post is an overview of some other benchmarks used to determine the intrinsic value of a physical property. They will of course be different for stocks. They will be further elaborate in future posts.

1. Cost of rebuilding the same property

This will examine the short run causation that will cost houses and buildings to drop and rise in prices. New houses and buildings are constructed by large corporations listed on stock exchanges; however, supply of new housings usually does not meet demand exactly, eventually they are not building computers and can be like Dell, built to order.

2. Per unit cost measures (similar to net asset value per share for stocks)

Examples of commonly used per unit cost measure for properties include price per square foot, price per apartment and price per front foot. Just like financial ratios are not to be used in isolation when deciding on buys and sells, figures of per unit cost should also not be used in isolation when doing property investment.

But they are still meaningful numbers for comparison.

3. Cash flow – current cash return on investment in the property (similar to dividend yields for stocks)

This basically expressed the positive cash flows per month/year as a percentage of down payments, like for the case of stocks the dividends receive as a percentage of price paid for the stocks, i.e. dividend yield.

4. Discounted cash flow (present value of future cash flows from rental income net of all mortgages and expenses)

This is perhaps the best measure of value; Warren Buffett has already defined the intrinsic value of an asset as the present value of its future positive cash flows that can be retrieved from that asset during its remaining life.

The same holds true for physical properties, just that in this case, the future positive cash flows are simply its rental income. To understand this concept, one must first comprehend time value of money concepts.

5. Monthly gross rent multipliers (similar to price earnings ratio for stocks)

This simple mathematical operation is to check whether price is too high or rent is too low.

Monthly gross rent multiplier = sale price of property / gross monthly rent

Where gross monthly rent is rental income before deducting all mortgages and expenses.

The simple rule resulting from this ratio definition is that monthly gross rent multiplier above 140 usually results in negative cash flows (unless down payment is in increased) which is not wise for a wise and value investor.

5. Probability of appreciation in potential

Whether a piece of asset, be it stock or real estate, can increase in value in future, depends totally on whether they can generate more revenue than now when future comes.

There is no doubt that it is much easier to predict the future for real estate than for individual stocks. For the case of real estate, basically more jobs, incomes and population in future for that particular geographic area where the property lies means that value of real estate will increase.

6. Can more value be created?

One of the reasons why Detroit big three (General Motors, Ford Motor Company and Dysler) sinks while Toyota and Honda manages to survive and excel during both economic boom and recession times is that they kept prices of automobile the same while increase value by innovation in engineering, i.e. lean manufacturing, just-in-time, improved fuel efficiency etc.

In a similar sense, there are many ways that slight physical touch ups to properties can increase its price more than what it cost to improve that property.

As you can see, by reviewing these benchmarks, sometimes, paying more than market value can generate high return with suitable margin of safety, as what Buffett does for Coca Cola during the 1980s, and paying less than market value can give low return with no margin of safety, like overpaying for large and brand name companies like Citibank, Merrill Lynch and General Motors.

This is true for stocks as much as it is for physical properties.

Related posts:

1. Value investing principles in using debt for real estate investments
2. Predicting appreciation of real estate value 5 years down the road
3. Why your house is an asset and not a liability

No one places 100% cash down when buying properties for investments, other than primary residence. Although the price of a physical property seldom drop to zero, unlike that of stocks where even for a well know blue chip like Enron and Lehman Brothers can fall, its price can still dropped in the short run. In addition, using some leverage for buying properties increases return on owner equity.

Real estate investors can safely use leverage, that is using debt to finance the purchase of physical properties when the following conditions are fulfilled,

1. Maintain sufficient cash reserves

As I mentioned before, the price of houses can fall in the short run. Default on mortgages for more than a few months will result in foreclosures on the property, if the market is not good for properties when it occurs, then investors will be liable for any outstanding sums owed to the finance companies or banks involved in selling you the mortgages.

Even the best properties in the best districts can suffer from unexpected lack of tenants due to economic downturns. As a result, either got cash reserves or steady income from jobs or elsewhere for at least three months of mortgages payments, just in case got three months without rent from tenants.

But when your rental units get more and more, there is diversification of cash flow from different rental apartments, hence you can reduce the cash reserves.

2. Try to avoid negative cash flows

As what Warren Buffet tells us, there is no need to switch at every pitch like most professional fund managers. Value investing tells us to wait for the near perfect pitch. Just because you have $100 000 to invest in properties does not mean that you should invest that $100 000 by buying a property in the next 10 months.

Negative cash flows are when rental income cannot cover mortgage and other expenses. It is like owning a business with negative cash flows for quite a long time, retained earnings cannot pile up and increase shareholder value.

When there are negative cash flows,

a. Place more down payments

b. Try to restructure or negotiate the deal

c. Look for other properties to invest

3. Beware of pro fomas thinking

Do not have the idea that you can increase rent so that rental income exceeds mortgage and other expenses in future. This will most probably lead to unable to find tenants and high turnover of tenants. At the end of the day, this can attract a lower quality of tenants.

4. Avoid over financing

Beginner investors in real estate will be likely to over leverage, do not burrow more than what the property is really worth.

Related posts:

1. Value investing benchmarks for real estate investors
2. Predicting appreciation of real estate value 5 years down the road
3. Look beyond market prices for realty investments