Value investing benchmarks for real estate investors
There is no doubt that when it comes to long term investing, of at least 5 years or more, value investing is the best investment strategy when it comes to stocks. What most people don’t know is that when it comes to physical properties, value investing, invented by Benjamin Graham, perfected by Warren Buffett, is also the best strategy, at least in my opinion.
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.
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