Real estate valuation and market opportunities

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Lately I’ve been researching on real estate valuation and have come up with a few reflections on market opportunities for investors. No matter how skeptical individual investors might be but sound investment analysis involving commercial property on individual deals can gain useful insight. We know that for institutional investors. But what do retail investors know about it? Adjusting for the meaningful size property investments require, direct retail investors should apply the same methods to their investment options.

The logic that applies to ‘gaining useful insight’ stems from some additional features real estate markets exhibit versus the securities markets. Properties have – with differing degrees of depth – well developed markets where one can sell (or buy) from land parcels to vacation homes, from shopping malls to downtown condos. But unlike securities markets, where you can buy or sell very quickly and easily at very low transaction costs with no additional burdens, properties (and especially commercial properties like a hotel resort or a shopping mall) have markets that don’t offer such operational efficiency.

Nor is the property market as informationally efficient as securities markets’ are. Indeed, there are noises that enable deals with potential and significant positive (and negative) net present values. The first type of noise is a valuation noise: at any given time an investor can’t know exactly the market value of a property; buildings aren’t just listed on a web site that you can trade at that same price instantaneously. Research and time are the tools an investor has to figure out a reasonable market value and even allowing for a lot of both one couldn’t be sure of a precise value. Because of the inherent scarcity of price information opportunities and threats are available of a sheer size not even imaginable in the securities markets. Parties involved in the deals may miss relevant information regarding a property: they make mistakes.

But even when counterparties don’t make mistakes with hindsight we could see that one party got the better side of the deal while the other suffered the consequences. Chances are that one party had better information in some cases not because of a better pre (or post) due diligence but just because they were lucky to find out something the other party didn’t. In other cases, one party might be a better negotiator and thus get a bigger piece of the pie. Even the necessity to close a deal quickly may cause the party to suffer substantially.

Valuation noise tends to average out around zero, though for some investors close scrutiny and a good amount of work might lead to systematic better deals than others. There’s another noise affecting properties and that is the inertia to which real estate markets adjust to relevant news and information. It’s the partial adjustment occurring within given and short time horizons that brings about a certain level of predictability nowhere to be found in securities markets. Market timing and property picking may enhance performance over the short and long haul, though investors should consider that transaction costs are much greater than the ones typical of stock or bond markets.

Both valuation and predictability noises carry important consequences for careful investors. Timing is one such factor that needs to be considered carefully: during a bear (or maybe falling in real estate) market investors will know prices are likely to continue decrease for several years and will be wary not sell on a trough. One reason why investors sell near trough levels is usually the excessive amount of debt that cannot be carried forward. Thus investors with modest leverage can outrun prolonged losing streaks by holding on to their properties knowing rents and market values will start rising again. The real question is whether retail investors can afford to reach the critical wealth and research infrastructure needed to access such deals. After all properties, and commercial properties above them, don’t trade for a few dollars in 100-stock parcels on a stock exchange.

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