Wednesday, February 11, 2015

How to eliminate residential and commercial real estate bubbles once and for all using the newest valuation technology to calculate any property’s fundamental value (also called intrinsic value).

The intrinsic value of any real estate property (residential or commercial) including vacant land can now be determined through a new valuation analysis completely independent of the property’s current market value. Intrinsic value is also frequently called fundamental value. After the real estate value collapse of 2007-2009, analysts and media indicated market values have returned to their “fundamental values”. During the height of the real estate bubble market values had significantly increased above their intrinsic values. In many regions around the country and the world, real estate market values were 100% above the individual property’s intrinsic value and were undetected until it was too late and the bubble burst. As a result, trillions of dollars were lost, not only to the unsuspecting property owners, but to entire economies. This was because undetected risks were disseminated into the economy via loans that were sold into the secondary market and bundled into bond like financial instruments.

How does this new patent pending valuation technology, called Valuexpose calculate a property’s intrinsic value? How does Valuexpose’s new technology differ from the ineffective and misunderstood traditional methodologies in determining intrinsic value? How can these old methodologies be incorporated into Valuexpose’s new valuation methodology to easily produce a property’s intrinsic value to compare to the same property’s market value?

This new patent pending valuation methodology in estimating a property’s intrinsic value begins from a “top down” approach instead of the old method of trying to calculate intrinsic value from the “bottom-up”. What “top down” means is the rents for all property types are a well established percentage of a tenant’s business income (if commercial property) and personal income (if residential property). Even if the property is owner occupied, the owner is deriving a rental benefit based on these established percentages of business or personal income. This income depends on the demographics that use a particular property in a particular neighborhood or district. For example, a specific residential subdivision’s location might attract a demographic with household gross annual take home income ranging from $75,000 to $100,000. In the United States the percentage of your gross annual income should not exceed 30%. Consequently, rents in this neighborhood should be in the range of $1,875/mo to $2,500/mo. If the highest and best use of this neighborhood is owner occupied, as opposed to tenant occupied, this demographic will pay approximately 5%, more of their gross income due to pride of ownership, ability to remodel and customize to their individual tastes, and not be beholding to a landlord and possibly unreasonable rent increases. So the adjusted rental benefit in this neighborhood is $1,969/mo to $2,625/mo.

Every time you see a sale of any real estate property, its sale price represents the present value of the property’s future benefits. In our above neighborhood example, lets say in the mid 2000 a house was in escrow for $850,000. There were 5 backup offers for $850,000 and comparable houses in the neighborhood had recently sold for $850,000 or more. The buyer feels pretty confident about his purchase and applies for a 80% loan or $680,000. The bank also is confident about the collateral of this potential loan and engages an appraiser.

If the appraiser would have had this new valuation technology in the mid 2000’s he could have indicated the obvious $850,000 single-point-in-time market value as well as the property’s intrinsic value. The appraiser’s report would have also indicated all the markets forecasts or “bets” associated with the $850,000 market value and what the market expected the house to sell for at the end of a typical ownership holding period. Lastly, the appraiser would have evidence if the $850,000 market value was sustainable over a typical 7 year ownership period. 

If this appraiser, or by that matter, the buyer of the property had access to Valuexpose software they would have been able to simply input the $850,000 market value and the potential monthly rent, say $2,600/mo and received the following report:

Although the property’s market value is clearly $850,000 in our example, this new valuation technology flushes out the hidden risks that, until now, no one was able to quantitatively identify. This analysis indicates if the property is purchased for $850,000 the ending sale price at the end of a typical 7 year holding period must be $975,000 called reversion. It also indicates, at the same purchase date, the property’s intrinsic value as $450,000 or 100% below the subject’s $850,000 market value. If the intrinsic value is $450,000, its ending sale price (reversion) must be $510,000. Between these two intrinsic values established the subject’s equilibrium line which suggested the subject’s $850,000 current market value is not sustainable and will in all likelihood gravitate back to $510,000 equilibrium line over the 7 year holding period.

If the $680,000 loan was made on the property when the buyer purchased, the lender and the buyer would be in dire straits due to negative equity (under water) and diminished collateral of the loan jeopardizing foreclosure. What if this loan had been sold into the secondary market (Fannie Mae, etc.)? Bond rating companies (Moody’s or S&P for example) would have rated this loan much higher then if they would have had access to the Valuexpose analysis and the hidden risk associated with $850,000 market value.

In this example, the hidden risk originates in what the market is expecting the ending sale price (reversion) to be at the end of a typical 7 year holding period. If $850,000 is the subject’s market value based on comparable sales, and we know this value represents the present value of the future benefit, then what are those benefits? Lets say the appraiser, or for that matter the buyer, has determined the monthly rental benefit is $2,600/mo based on the demographic household income for the neighborhood as well as comparable rentals in the area. Also, lets assume the market is expecting household income, for this neighborhood, to consistently rise over the next few years allowing rents or rental benefits to rise at 2% annually.

In our example, if we take the present value of this rental benefit, (less total operating expenses a landlord would normally pay) from the subject’s $850,000 market value, the balance would be $600,000 ($850,000 minus $250,000* PV of net rental annuity). This $600,000 remaining value represents the PV of the ending sale price being expected by the market. Consequently, this ending sale price is calculated at $975,000 (FV of  $600,000 at 4% annual yield equals $975,000**)

To determine the subject’s intrinsic value and its ending sale price (reversion) you start by capitalizing the expected net operating annual rental income at the beginning of the 8th year (when the property is expecting to sell at the end of the ownership period) by the 4% annual yield rate ($29,000 NOI divided by 4%= $490,000 plus real estate commission =$510,000). Calculating the PV of the $490,000 net reversion after real estate commission back 7 years indicates $300,000 (PV of  $490,000 at 4% discount rate). Adding the PV of the net rental annuity of $250,000 to the $300,000 PV of reversion equals $410,000 intrinsic value as compared to the $850,000 market value.

You can see that both scenarios ($850,000 market value and its $975,000 reversion verses the $410,000 intrinsic value and its $510,000 reversion) both yield 4% annually. The difference between the $850,000 market value and the $410,000 is speculating the property will sell for $975,000 at the end of the 7 year ownership period. Although this $850,000 sale price represents its market value, the buyer, appraiser, lender, bank examiner, bond rating companies can now see this value is not sustainable.

This new valuation technology can also be applied to all commercial properties as well. Commercial rentals are a function of the tenants gross annual business income. The unit of comparison to derive the demographic strength of any commercial district is price per square foot of gross annual tenant business income. The higher the business income per square foot, the higher potential landlords rental rates will be. Based on the tenant demographic that occupies rental space in the district and their expected business income per square foot determines what the landlord can reasonably ask for rent. 

* Based on a 4% discounted rate
** FV based on 4% yield (plus 6% Real Estate commission)

Generally accepted industry standard information is available as to the acceptable amount of a tenant’s business income he can pay without significantly impacting the tenant’s profit margins. Consequently, an established commercial district’s current rental price per square foot that tenants are currently paying represents the demographic business types that are occupying space in the district. Additionally this current rent generally reflects that industry’s standard percentage of the tenant’s gross business income.

The difference between how intrinsic value is estimated for commercial property as opposed to single family residences has to do with competitive annual yields expected when buying a property. As indicated previously, Valuexpose has fixed the annual yield the market is expecting for single family housing because owner occupied housing is a necessity and competes with the safe rate capital bond market. Owner occupied single family houses generally do not use going-in or going-out capitalization rates to value these types of properties. Instead, they predominantly use the sale comparison and cost approach valuation methodologies.

However, income producing commercial properties, whether it be owner occupied or tenant occupied, take into consideration going-in and going-out capitalization rates as well as annual yield expectations as the property relates to alternative capital market financial instruments.

Consequently, Valuexpose lets the user estimate competitive all cash annual yield rates for any commercial property type. In addition, Valuexpose also lets the user indicate going-out capitalization rates similar to how the market operates. If the user knows the current market value, he/she can input this value and Valuexpose will calculate the going-in and going-out capitalization rates based on the user’s current market value estimate.

The current intrinsic value for commercial properties is calculated in a similar manner as described for single family residences except the users all cash annual yield estimate for commercial properties in substituted for Valuexpose’s fixed 4% annual yield used for single family residences.

Valuexpose’s economic fabric graphic might show an analysis result of say a retail community shopping center with a current market value of $5,000,000 derived from a Valuexpose analysis, or imputed by the user that already knows the current market value (by a professional appraisal or recent sale).

Our investor is able to find an alternative investment of similar risk yielding 7%. The tenant demographics that frequent the shopping centers marketing area are presently producing approximately $250/sf annually of  business income for tenant leased retail space. Industry standards for the typical shops in the subject’s center indicate these variety of shops can pay 6% of their annual gross sales (Dollars & Cents, International Council of Shopping Centers). Presently, the average rent in the shopping center is $15/sf annual (modified gross leases).

You can see by Valuexpose’s economic fabric graph the $5,000,000 current market value is expected by the market to have an ending sale price at the end of a 7 year investment holding period of $6,500,000. This verifies the $5,000,000 current market value because the present value of the ending sale price (less real estate commission) and the present value of the annual net operating income rental annuities equals $5,000,000 discounted at the markets annual risk rate estimate of 7%. 

The ending sale price of $6,500,000 (called reversion) is estimated by the market using a going-out capitalization rate of 4.5% which is used to capitalize the expected NOI starting at the beginning of the eight year. Consequently, if the buyer pays a current market value of $5,000,000, collected the expected annual NOI for 7 years, and sells the property for $6,500,000 (less real estate commission), he will indeed meet his expected 7% annual property yield. If he leverages (finances) his $5,000,000 sale price he can even achieve a higher equity yield on actual cash invested in the project.

Notice in the graphic for the shopping center, to have a current market value of $5,000,000 this implies the tenants must be generating $350/sf in annual sales. In reality, the tenants were previously said to be generating $250/sf in annual sales. Consequently, the property’s intrinsic value is calculated by capitalizing the property’s eighth year NOI by the 7% yield rate (plus real estate commission) not an arbitrary going-out cap rate that can manipulate the ending sale price which in turn manipulates the current market value. Using the current 7% competitive annual yield as the going-out capitalization rate indicates an ending sale price of  $4,100,000 (this adds a 6% real estate commission). Therefore, if you take the present value at a 7% risk rate of the expected annual NOI annuities plus the present value at a 7% risk rate of the reversion (less real estate commission), the property’s current intrinsic value is $3,500,000. Notice that both the current intrinsic value of $3,500,000 and the property’s current market value of $5,000,000 both produce a 7% annual yield for the investor throughout the final sale of the property. Also notice the subject’s $3,500,000 sale price is in line with the tenant’s sales per square foot of $250/SF, whereby the subject’s $5,000,000 market value is $350/SF.

Although the market has determined the subject’s current market value is $5,000,000, Valuexpose flushes out the hidden risks associated with this market value. Valuexpose indicates there is a high probability this $5,000,000 current value will gravitate downward during the course of  the seven year investment holding period to $4,100,000. Consequently, the investor would only achieve an annual property yield of 2.5% far below the expected 7% yield he could have achieved with an alternative investment of similar risk. By taking the difference between this 2.5% yield and the 7% expected yield indicates a 4.5 annual yield opportunity cost to the investor. It’s interesting to note if you add this 4.5% opportunity cost to the 7% expected annual yield (equaling 11.5%) and use as a discount rate for the NOI annual annuities and the $6,500,000 ending sale price, the result indicates a current market value of approximately $3,500,000 (equivalent to its intrinsic value).

Consequently, if you are buying this property, you should be negotiating the current market value using more than comparable sales. If the seller thinks his property is worth $5,000,000, than he knowingly or unknowingly thinks you will be able to sell the property for $6,500,000. If the seller’s $5,000,000 market value asking price does not correspond to the $250/sf in annual sales generated by the tenants business income, the buyer should increase his risk rate by 4.5% to compensate for the added risk. Consequently, the seller will have to lower his expectation of the ending sale price or  increase the risk rate for discounting. Either way, the sale price is lowered closer to the property’s intrinsic value of $3,500,000.

Valuexpose not only flushes out hidden risks that cause speculative real estate bubbles, but it can also flush out hidden risks associated with limited supply real estate bubbles. An example of a limited supply bubble occurs when a particular market has less of a real estate product than there is demand. The only time a property’s market value will significantly separate above its intrinsic value, in an under supplied market, is if the demographic character does not change, but the tenant is temporarily willing to pay a rent in excess of an industry standard percentage of his business income per square foot. Using our last example, lets say the shopping center’s current market rent is $18/sf modified gross (as opposed to $15/sf industry standard rent). Imputing this data into Valuexpose generates the following economic fabric graph:

Notice the subject’s $3,900,000 intrinsic value is higher because the market rent is higher due to limited supply. However, this indicates tenant sales must be $275/sf annually. We know the actual retail sales are $250/sf annually so this $18/sf current market rent is unsustainable. If you don’t adjust the current rent of $18/sf back to $15/sf industry standard rent, the current market value of the property will appear to be sustainable because the intrinsic value is artificially high. If you adjust Valuexpose’s market rent downward to fall in line with industry standards regarding percentages of business income that can be paid, the intrinsic value will fall back to $3,500,000 current intrinsic value and $4,100,000 ending intrinsic sale price reversion flushing out hidden risks associated with a real estate bubble caused by a temporary limited supply of a property type. Consequently this “top down” method deriving intrinsic value is forward looking and is consistent with the experts consensus that value (whether it be market value, rental value or intrinsic value) is the present value of the future benefits.

Now lets look at the traditional valuation methodologies in deriving intrinsic or fundamental value and how it differs from the above “top down” new valuation methodology. These methodologies have a basis that starts from the “bottom up”. The best example of this is the replacement cost method. Most appraisals of a property’s current market value include the cost approach, sales comparison approach, and the income approach. The value results of these three approaches will arrive at similar values if done correctly. These three values are reconciled into a single current market value.  In our shopping center example, this current market value would be $5,000,000. As you can see, the replacement cost will not indicate intrinsic value. In real estate bubbles, construction costs, land values and entrepreneurial incentive are artificially bid up above historic equilibrium levels. The only way the appraiser can try to estimate the property’s intrinsic value by the replacement cost is to adjust the “as if vacant” market value of land downward; adjust the current replacement cost downward.; and adjust the current entrepreneurial profit downward to what an entrepreneurial incentive should be when supply and demand are at equilibrium. You can see all these adjustments are based on what has happened in the past and are hard to quantify as being applicable to the future benefits. Other “bottom up” methodologies in estimating intrinsic value are frictional vacancy, feasibility rent and a variant of feasibility rent called equilibrium rent. All three of these techniques either look to the past for data or use current replacement costs to arrive at an adjusted rent that may be different than the subject’s current market rent.

The problem with this “bottom up” methodology is the appraiser will capitalize this adjusted rent’s net operating income by a capitalization rate extracted from the current market place. In a bubble market, this cap rate will be “infected” with irrational exuberance of what the ending sale price will be resulting in underestimating or overestimating the subject’s intrinsic value.

The confusion about all the “bottom up” methodology techniques is that they don’t create where the equilibrium line should be during an investment ownership period. Valuexpose’s “top down” new technology establishes the intrinsic values to create an equilibrium line during the property’s ownership; where the property’s current market value is in relationship to the property’s current intrinsic value; where the top or bottom value lie on the economic wave graph (increasing, decreasing, recession, or recovery); where the property’s current market value lies within this wave cycle; how much time is left before the property’s current market value begins to move towards the equilibrium value line; and whether or not the property’s current market value is sustainable during the investment ownership holding period; and how the property’s equity yield will differ from the estimated competitive property yield with various financing scenarios.

Lastly, if your property is to be developed or remodeled, Valuexpose will clearly indicate if the proposed project is economically feasible and what the “as is” value must be to make the project economically feasible. In addition, the development timeline will show all the prospective values as you reach waypoints in the development (as if entitled”; “as if complete” at non-stabilized; “as if complete” at stabilized. If your developing a subdivision or condos, the development timeline will also indicate the “as if complete” bulk/ wholesale value (all units sold to one person); and the aggregate retail (if sold on a unit-by-unit basis over time).

Valuexpose has 13 property classifications, over 300 property types (most will be available in 2015), and 5 different analysis modules depending on the physical and economic state of your property.

Just select one of our videos regarding your specific property classification and property type. You can even select if you are going to develop or remodel your property type or whether it is currently existing. No matter what property type scenario you choose, Valuexpose will answer any questions you seek regarding your specific property type. Go to Valuexpose home page and click “why Valuexpose” on the dashboard to get an extensive list of questions answered for your property type in each development scenario (modules 1-5).

The team here at Valuexpose is committed to providing you all the information you need to make your development or investment as successful as possible. We are dedicated to providing you this information as easily, quickly and affordable in your early contemplation of a project or investment. The critical information obtained from Valuexpose regarding your property type will protect you from making irreversible mistakes in planning and financial investments.

I want to personally wish you success in all your real estate plans and have the confidence that Valuexpose is here to help you successfully execute those plans.

Best wishes,

Raymond L Dozier, MAI