With mortgage interest rates still near historic lows and property prices rising thanks to the gush of foreign money, real estate is feeling like, once again, a tantalizing investment for many people. “What are your thoughts on this?” I’ve been asked a few times recently, notably by folks who live in both L.A. and New York: the top two most targeted geographies for those aforementioned Chinese carrying suitcases full of cash.
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| Atlantic Yards in Brooklyn, New York, October 2013. Greenland Holding Group Co., the Shanghai-based builder of one of China’s tallest towers, agreed to buy a 70 percent share of the project. |
Real estate, like any asset, can be valued in one of two ways: 1.) intrinsically, and 2.) relatively. Intrinsic value is a function of an asset’s cash flow generating power. Relative value is a function of the supply and enthusiasm of other buyers. It should come as no surprise that I am staunchly in the camp of #1.
A quick primer: Real estate generates cash flow through rental income, whether it’s houses or apartments or office buildings or strip malls. Revenue minus expenses equals profit, and that annual profit stream divided by the equity you put down for the real estate is your rate of return. If you put $100,000 down on a $500,000 property and earn an annual income stream of $10,000 after mortgages, taxes, insurance, maintenance, and all other miscellaneous costs, you’re earning a 10% return on your equity. You can adjust the arithmetic if, say, you’re looking at a fixer-upper that is below market prices but requires some work. The bottom line: divide cash in by cash out. It is similar to interest payments you receive from a bond, or a dividend yield you receive from a stock.
Now the question becomes, is that rate of return satisfactory for you? To evaluate, you have to take into consideration the risks involved. Namely, how good is your tenant base, and if you have turnover, how easily will you be able to replace them? If you took a gamble on an older property, how much will it cost for an up-to-date remodel, and more importantly, how confident are you in the estimated costs? There is less risk owning a piece of property in Manhattan where the vacancy rate is 2%, versus owning something out in a desolate suburb hit hard by the subprime bust. Perhaps for the less-risky former, you’d be willing to settle for a 5% return with the possibility of escalating rents in the future. For the much-riskier latter, you may not want to take anything less than a 15% return. At this point it boils down to personal investment goals and your opportunity costs. But this very analysis is the core of intrinsic valuation. Kudos to all who practice this.
Relative valuation, on the other hand, is much simpler. Hey, what did someone pay recently for something similar?
I suppose there’s nothing wrong with relative valuation, provided that the “someone” you’re making comparisons with actually did an intrinsic valuation you can piggyback off of. But herein lies the danger that manifested during the financial crisis. After a while, amidst the feverish buying and flipping, piggybackers end up piggybacking off of each other. Responsible investors actually concerned about intrinsic value couldn’t win a bid and simply left the market. Rates of return turned negative. But who cares, right? I can always flip the property to someone else in six months for 50% more than I paid for it!!
That works… until it doesn’t. We lived through the painful bursting of that phenomenon just a few short years ago. Stunning news: real estate prices do decline. So, the answer to what I think about the re-burgeoning real estate market is: it depends on the intrinsic value of each deal. It may mean doing more work to understand the demographics and economics of the area you’re looking to invest in. It may mean getting outbid by people who don’t care about rates of returns. It may mean watching a property you were outbid on doubling in six months for no apparent reason other than there was someone else willing to pay twice as much for it. Stay steadfast, because, again, relative valuation works until it doesn’t. Once prices depart from a sensible intrinsic value, you’re playing musical chairs. You’re no longer investing, you’re speculating. Speculating can be fun and sometimes profitable, but, like a nagging nun, I feel obligated to remind you that you should only speculate with money you can afford to lose.
However, if you are patient and opportunistic and get your intrinsic valuation right, you won’t care if the music stops and the market crashes. You’ll bank your cash flows and earn your returns regardless of what’s going on. Indeed, you may even hope for a crash then, which would allow you to parlay your cash flows into new investments at fire-sale prices. That has been the simple blueprint of every great real estate investor, nay, every great investor, period, ever. What Ernest Hemingway once wrote about going bankrupt also applies to getting rich in investing: “Gradually, then suddenly.”1
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[1] The original line, in The Sun Also Rises: “How did you go bankrupt? Two ways. Gradually, then suddenly.”
