“Price is what you pay, value is what you get”, Warren Buffett
According to Mr. Buffett, current market value is the “Price” you pay for a property. This price can significantly differ from the same property’s current “Value”. By “Value”, Mr. Buffett is referring to “Fundamental Value”.
Many years ago, Mr. Buffett understood this economic foundation and created a process of basing his purchasing decisions on a property’s fundamental value called “Value Investing”. You see, Mr. Buffett knew the laws of economic business wave cycles revolved around fundamental values.
Using this formula mainly for stocks, he successfully purchased an interested stock if the stock’s fundamental value was greater than the market’s asking price (called current market value). The difference between these two values in this buying scenario is called the “Margin of Safety”.
Mr. Buffett’s formula for arriving at a property’s fundamental value (also called Intrinsic Value) was based on an the company’s fundamental economic expectations in the future. This formula stripped away any of the market’s “exuberance” speculation and other “irrational” forecasts. Mr. Buffett’s formula also allowed him to input his own risk tolerance to find those stocks with the greatest “margin of safety”.
This Value Investing paradigm is used by the most successful stock and company investors like Mr. Buffett. The vast majority of investors are picking stocks solely on the prices of what competing stocks are selling for. Even if the an interested stock’s price is below what competing stocks are selling for (comparable sales), the selling price could be significantly above the stocks current fundamental value without the buyers knowledge. Although this stocks selling price appears to be a “bargain”, in reality it is most likely a “suckers” purchase as the value always falls towards its fundamental value over time.
With “sucker” purchases, the only person that loses when the stock slides towards its fundamental value is the purchaser. What if commercial banks started loaning 75% to 80% of the buyers stock’s purchase price? Ever worse, what if these banks sold these loans into the secondary markets that had government guarantees against loan losses from any cause? What if these secondary markets bundled these loans into financial instruments and had them AAA rated by Moody’s or S & P? Lastly, what if these financial instruments were sold to retail investors and retirement funds?
Without the buyers, banks and rating agency knowing what the stock’s fundamental value was when purchased, this whole “food chain” could be vastly underestimating the risks they are taking.
Fortunately, this type of “food chain” for stock does not exist and consequently places the risks solely on the stock buyer. If stock advisors don’t factor in the these risks in advising their clients, indirect losses can occur to the advisor if the clients don’t use their services again.
Traditionally, real estate has been considered a tangible asset made up of land value, construction materials, labor costs, and developers profit. The “rule of thumb” was that the current replacement costs, less any depreciation, of a finished property was considered to be the property’s fundamental value.
This “rule of thumb” worked well when real estate values and their cost to produce did not change very much from the years between 1900 and 1970. This was because the balance between a property’s cost to produce and the property’s market value selling price were roughly the same during those years. From 1970 to 2006, the housing price index went from 20 to 180 before crashing back down to 120. Commercial market values followed this same trend over the last 100 years.
Actually, the property’s market value was not made up of the cost of production but rather the markets forecasts of the benefits they will receive once the property was purchased. It just so happened market value and the cost of production were the same during those years because of these four economic balances that existed.
- The annual all cash risk rate’s (property yield) present value was accurately applied to the anticipated benefits expected by the buyers during their ownership.
- The market rent or market rent benefit (if owner occupied) was in the right proportion with the users demographic household annual income for residential properties, and also in the right proportion with the users demographic business annual income for commercial properties.
- The property’s market rent expectation increases kept up with actual users expected annual income increases.
- No irrational speculative expectation of the property’s future selling price appreciation was factored into the property’s beginning market value sale price.
During this time period, the forces of supply and demand did not significantly impact any of the above four economic balances. Consequently, property market values stayed in close proximity to the property fundamental values. These economic forces kept new development costs of production in check and economically feasible.
Stay tuned for part 2 in this series that will explain how residential and commercial real estate’s economic forces have gotten out of balance in some property types and in some US markets. The lack of synchronization with rational forecasts of just one of the economic forces can cause a significant detachment between a property’s current market value and its current fundamental value called a real estate bubble.
In these circumstances, no matter how accurate your property’s current market value might be, even if you can buy the property below this market value, you might be buying a “suckers” purchase without knowing the property’s current fundamental value.
This series of posts will propose a solution as to how you can economically protect yourself in this volatile real estate market. The answer is a Value Investment paradigm for real estate using advanced technology. Please comment or share this post to start the process of solving devastating real estate bubbles.