Tuesday, September 27, 2016

Warren Buffett’s “Value Investing” Secret Formula is a Solution to Solving Real Estate Bubbles (Part 2)

“Real knowledge is knowing the extent of one’s ignorance”, Confucius

In part 1 of this series, we discussed how Value Investing paradigm for the stock market has created enormous wealth for investors like Warren Buffett. The use of Value Investing made sense in evaluating trades do to the volatility and “corrections” that periodically occur.

Up until around 1970, Value Investing innovative techniques for real estate were not created and were unnecessary because property market values, cost of production, and fundamental values were in sync with each other.  Since then, in many residential and commercial markets, property current market values and their associated costs of production have significantly detached above these properties current fundamental values.

This “Margin of Loss” gap creates a hidden risk that market participants are unaware of until the real estate bubble burst. By that time the financial damage has occurred. This damage does not just impact the property buyer, as in the case of our stock market example, but rather the whole “food chain” that made loans, purchased loans, and bought financial instruments collateralized by these loan. 

The time is right to innovate a Value Investing strategy for real estate. “Margin of Loss” gaps are appearing in unsuspecting real estate types and locations around the country mainly due to: 
  • Globalization and “hot” money flowing into real estate from other countries. 
  • Loose money lending standards and misguided political policies.  
  • Investors taking greater risks in search of higher investment annual yields due to low annual yields of risk free alternative investments.
  • The markets “Irrational Exuberance” and speculation regarding a property’s forecasts.
  • Unsustainable market rents due to unresponsive bank lending for development projects that are needed to keep up with normal supply and demand for certain property types.   
Any one of these “causes” will create a “Margin of Loss” gap between a property’s current market value and its current fundamental value. The reason being is because these “causes” throw off the economic balances that were bullet pointed in Part 1 of this series. 

The trick to protecting yourself in these situations is to know exactly how big this gap might be, if any,  for your specific property using a Value Investing analysis BEFORE you buy or lend. 

So how can Value Investing techniques be used for real estate? You currently can’t buy this information from a valuation expert or trusted advisor. The valuation industry has not adapted  this new technology and continues to only give their opinion of the appraised property’s current market value. As previously indicated, this current market value of a property could have significantly detached from its fundamental value creating a wide “Margin of Loss” gap. 

Valuation experts reflect the market’s expectations by using recent comparable sales and other market metrics. Built in to these comparable sale prices and other market data are the market’s forecasts. If these comparable sale prices are not reversed engineered into the market’s forecasts, valuation experts and their clients will be unaware of any imbalance between the four economic balance bullet points indicated in Part 1 of this series. 

In these volatile changing times, we are still making buying and lending real estate decisions solely based on a property’s current market value opinion derived from comparable sales. In addition, we are not even analyzing the market’s forecasts that make up the property’s current market value opinion. Lastly, by not using Value Investing technology, we cannot see how dangerous the markets forecasts might be until we know the exact “Margin of Loss”, if any, between the property’s current market value and its current fundamental value. 

By continuing to value property in a “Vacuum” is analogous to “rearranging the deck chairs of the Titanic”. No matter how many accurate current market value opinions you receive on any given property, the results will be the same if a large “Margin of Loss” gap is not detected and the property is purchased or used for lending purposes. 

The general market of buyers and lenders cannot be expected to learn and create complex financial models, complicated algorithms and computer coding, and learn generally accepted appraisal standards needed to create a competent Value Investing paradigm technology.     

So a team of valuation experts, coding developers, web designers, and financial mathematicians were assembled to create a Value Investing Software for Real Estate called Valuexpose. This recently launched cloud based product was designed so that even the novice can learn and perform a Value Investing analysis on any property type and in any physical or economic condition.  

We are currently assembling a team of early adapters to train and use this product at no charge.  
Message me and I will send you a login and password to gain access to the software. Also, free training will be provided through a Udemy™ on-line training course specifically designed for the Valuexpose software. We are limiting the early adapters to 100 users that will receive a free lifetime membership at no charge for their feedback. 

The Dodd/Frank financial reform, tighter lending standards, limiting supply, low interest rates, and government guarantees have done nothing to stop bubble formations. As a matter of fact, these “reforms” are actually fueling new and more dangerous bubble formations. These formations are occurring in various property types and in various locations. There are thousand of different types of bubbles forming all over the country. “One bubble size fits all” is a misconception.

Please comment and share this post to keep the conversation going in solving the real estate bubble problem. Become an early adaptor of this new technology that takes investment analysis to the next level and standard of care. 

Warren Buffett’s “Value Investing” Secret Formula is a Solution to Solving Real Estate Bubbles (Part 1)

“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.   

Sunday, September 11, 2016

Why Aren’t Bankers Embracing New Valuation Financial Modeling that Stops Real Estate Bubbles?

The last real estate housing bubble bust has devastated peoples lives and this country’s economy to the tune of 20 trillion dollars. Economic analysts are telling us bubbles are occurring once again in residential and commercial properties around the country and world. Another real estate valuation collapse could do irreparable harm to this country and its citizens. 

Why in the world do lenders continue burying their heads in the sand by not embracing a new automated valuation technology that immediately stops this carnage if implemented into their lending policies?

This new valuation technology easily alerts bankers and lenders if a specific residential or commercial property has entered a dangerous bubble rendering the property’s current market value unsustainable in the future. Even worse, if these loans are sold into the secondary markets and packaged into bond-like instruments, rated high by Moody’s Ratings or S & P Ratings, and sold to the retirement funds, people and institutions will suffer all along this “food chain” when these bubbles bust. 

Warren Buffet famously said, “Price is what you pay, value is what you get”. For years, stock market analysts have been basing their trades on value investing techniques. The essence of value investing is buying stocks at less than their intrinsic value and staying away from stocks with asking prices significantly above their intrinsic value according to Benjamin Graham. The discount of the market price to the intrinsic value is called the "margin of safety".

Intrinsic value, or sometimes called fundamental value is much harder to estimate for a business entity than for a real estate property. Business entities have many more speculative assumptions the analyst has to make when compared to real estate assumptions. 

Why hasn’t the valuation industry property appraisers embraced value investing analysis in their appraisal reports? Appraisers only report a property’s current single-point-in-time market value to the lenders and their other clients. Valuation experts reporting their opinion of a property’s current market value are reluctant to further opine this opinion of value is not sustainable. Their fear is it will taint the appraisal use for lending or purchasing and that their clients will never use their services again. 

One fellow Appraisal Institute designated MAI appraiser (top designation in the valuation industry) wrote to me:

    “I don’t see our role as appraisers to control anything about the market, nor do I take any responsibility for swings/bubbles in property value if I am doing my job correctly. Do you feel that it is our job to solve this problem?”

My comments to this property appraiser was that our job is not to be misleading to our clients. No matter how accurate an appraiser’s opinion of current market value might be, it can be misleading. If the appraiser knows his market value opinion has significantly detached from the property’s current intrinsic value, there is a certainty the appraiser’s opinion of value is not sustainable. This is because the markets forecast for this property, that makes up the property’s current market value, are unachievable due to the market’s irrational exuberance forecasts.  

So there you have it. Everyone is passing the buck and washing there hands of responsibility and risk to the next person or industry.
  • Sellers, with the help of Realtors, are passing their properties off to buyers whose values are based on “comparable sales”.
  • Appraisers are “doing their job correctly” appraising these properties based on “comparable sales” without a value sustainability analysis.
  • Bankers are basing their loans on the appraised values and selling many of these loans into the secondary markets that have government guarantees.
  • The secondary markets are bundling these loans into bond-liked financial products.
  • Moody’s and S & P agencies are rating these financial products AAA based on the accuracy of the appraised values so they can be sold mainly to retirement funds and other institutional investors.
As indicated earlier, value investing for stock has been used for years. This type of analysis protects the informed investor from buying a stock at a price that significantly exceeds the stock’s intrinsic value potentially jeopardizing the investor’s equity.  

Why hasn’t real estate industry instituted value investing analysis? Investors in the stock market that ignore value investing simply lose their equity when the stock goes down due to excessive risk taking. 

But let’s drill down and see why the real estate industry ignores value investing analysis.

  • Informed sellers know they are selling their property at the top of the market (I don’t blame them).
  • Realtors are making their commissions (I don’t blame them).
  • Valuation experts are making appraisal fees by not “rocking the boat” with a value sustainability analysis.
  • Banks are making their loan fees and selling the loans off into the secondary markets without a value sustainability analysis disclaimer.
  • Moody’s and S & P rating agencies making their fees by giving AAA ratings to loan bundles without a value sustainability analysis.
  • The government is building political capital and economic activity by guaranteeing these financial products without a value sustainability analysis.
  • Investment banks are making commissions by selling these products to institutional investors without a value sustainability analysis disclosure.
You can see why the stock market analysts and stockbrokers use value investing analysis that flushes out a stock price’s value sustainability hidden risks. If their investors loss money, they will not use their services again and possibly will sue for damages. 

On the other hand, the participants in the real estate industry do not take any responsibility for there actions as indicated by the above appraiser’s sentiment “nor do I take any responsibility for swings/bubbles in property value if I am doing my job correctly”.   

What is a reasonable solution to this problem that will actually make all the real estate participants more money then if we do nothing at all?

First, let’s look at the scenario of doing nothing and maintaining the status quo like we are presently doing:

  • Due to the 2006 bubble collapse, appraisers are now heavily regulated and appraisal fees have dropped significantly due to emerging middlemen called Appraisal Management Companies.
  • The banking industry is now heavily regulated and skittish of making portfolio or development loans they intend on keeping. They are mainly loaning to sell the loans into the secondary markets or loaning on properties that qualify for government loan guarantee, i.e. SBA.
  • Current loan demand and development exceeding lenders willingness to loan has created a housing imbalance resulting in unsustainable rental rates and incredible hardships for renters.
  • All of these negative reactions, including the Dodd/Frank financial reform, have not prevented bubbles from occurring again as macro economist are predicting. In fact, these negative responses are contributing to more bubbles formations. 
All of these new regulations and conservative lending policies are stifling economic growth and causing even more dangerous real estate bubble formations. 

By continuing to base lending practices on a property’s current market value without a value sustainability analysis is like rearranging the deck chairs on the Titanic. No matter how much regulation over site we institute in making sure appraisers accurately arrive at a property’s current market value, undetected bubbles will continue to form.

So what’s the answer? 

First, encourage buyers, sellers and Realtors to continue arriving at whatever sales price they think is appropriate for any property. I agree with the above quote from the appraiser saying, “I don’t see our role as appraisers to control anything about the market”. 

Second, do not change how the valuation industry is currently arriving at a property’s current market value. The appraisal process is more than adequate based on generally accepted appraisal standards and regulations that are in place. 

Third, allow the appraisers to offer their clients a value sustainability analysis that quantifies exactly where their opinion of the property’s current market value resides in relation to the property’s current intrinsic value. This new technology is basically a mechanical process that is hard to manipulate. This analysis graphically shows the client where the property’s current market value opinion resides on the economic wave cycle, how far the market value has detached from its equivalent intrinsic value, and which direction the current market value is headed in the future based on the equilibrium line direction.   

Forth, only loans intended to be sold into the secondary markets or guaranteed by the government must have a value sustainability analysis in addition to a licensed appraisal of the property’s current market value. 

Fifth, with value sustainability analyses, rating agencies will have a full disclosure of the hidden risks associated with loan bundles. They will be obligated to take this into consideration when risk rating these financial instruments that are to be sold to institutional investors.  

The benefits of these reforms include:

  • Appraisers can offer a value sustainability analysis as an additional profit center and service without retribution from the client.
  • Lenders can tailor their loan risk analysis on a property-by-property basis instead of loan black balling entire classes of property types. This is a better distribution of capital and keeps lending from drying up across the board. They will also better insulate themselves from lawsuits and loan take backs if full risk disclosure via value sustainability is given the secondary market loan buyers.
  • Realtors will see more stable markets devoid of the lean commission years after a bubble bursts.
  • Rating agencies can also better insulate themselves from government fines due to miss-rating loan bundle financial products.
  • The government will have less risk of having to bail out financial institutions due to catastrophic real estate bubble collapses.
  • The public’s real estate equity and retirement funds will be more secure barring a black swan event that is not remotely anticipated by the market.

Somebody has to step forward with this new standard of care reform and be the person on the white horse. Is it going to be the valuation industry, banking industry, rating agencies, or the government? If these institutions don’t take a leadership position, should buyers of real estate request a value sustainability analysis from their advisers or should they do it themselves?

As a yoga enthusiast, the idea of this ancient practice is to constantly seek balance. Similar to the practice of yoga, intrinsic value and its equivalent ending sale price intrinsic value are what make the equilibrium line that business wave cycle revolve around. 

This equilibrium line is a specific property’s balance going forward into the future. The closer a property’s current market value is to this equilibrium line determines the stability of our economy. The only way to stop bubble is one property at a time. 

With globalization, money laundering, low interest rates, changing government policies and flight of capital from other countries, we are going to experience dangerous real estate bubbles in the future without this new technology. No matter how these events impact a property’s current market value, sustainability analysis will always cut through these disruptive forces by indicating fundamental value balance and future equilibrium direction for each property. READ MORE