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.

Related posts:

1. Value investing principles in using debt for real estate investments
2. Value investing benchmarks for real estate investors
3. Is dividend yield a good indicator of value for a 3 to 5 years holding period?

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 investing in structured products is like being screwed

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. Why investing in structured products is like being screwed