Home Values: Part 4

Originally we discussed the difference between price and value. Again I emphasize that typical tools such as "comps" (comparisons of one home to similar homes that have sold in the area) are indicators of price, not value.

Then we discussed the first two major indicators I use to help understand the value of a home. These indicators, population growth and the growth of available housing, are helpful in understanding the demand of an area.

Last time I wrote about the third major factor in understanding a local economy and it's ability to sustain housing prices, income. Since housing is a necessity, like milk or gas, it tends to climb with cost of living and inflation, which (over the long-term) correspond closely with salaries.

The a commenter called me out on not understanding an area which I made assumptions about, but I've never visited. Again, remember that real estate is local, and only the locals can really understand the market. Which brings us to our final bit, dealing with a specific house.

Real estate agents will often tell you that they bring an expertise and knowledge into property that isn't matched. But the real estate profession is based more on selling feelings than numbers. Just for kicks, the next time you are buying a house and the agent mentions something like "this is a wonderful school district", ask him/her to quantify the value of the school district. For example, would this house be worth 22% less if it were in an adjacent district? Can they show numbers to prove it?

The impact of schools on a property's value is not necessarily tied into the actual quality of the school system either. Using our lovable grade system, it's easy to realize that a C+ school system that is surrounded by F-rated school systems has a much greater impact on the value of a property than an A+ school system surrounded by A's.

As a value investor (or a wannabe one) these are questions that we need to ask. After all, we don't plan on raising our kids in that property, so the only value a good school district has for us is in a premium to the sale price.

Let's say that you are interested in a house. This house is average in just about every way for the county, except that it's in the best school district in the county. The other schools in the area are relatively bad. The seller is asking for $120,000 for the home, where you've judged most homes to be valued at about $100,000.

The question becomes, is the good school district worth a 20% premium of what you think is a fair value price for the county? Let's do some more basic math.

Let's say that the average house in the county is currently asking about $110,000 (so we have, in our opinion, an over-valued market). We compare home sales in the good school district with equivalent homes sold in the not good school district (this could be over quite a period of time, it doesn't have to be in just the past few months. In fact the longer the set of data the better). Through our research we discover that the average home in the good school district has sold for about 30% more than a similar one in a worse district.

So when we throw that onto our county average, we discover that a house in that area is, by our calculations, valued at around $130,000. So even though the county itself is generally over-valued, and this house is costing more than the average home in the county, we have evidence that suggests that this home would be a good value.

Besides schools, here are some other factors that you should consider taking into account when calculating the value of a property:

  • Amount of land. Obviously more land is worth more, but how much? In a very crowded area, having twice as much land as your neighbors could make your property worth more than twice as much. But in a sparsely populated county, having 50% more land than your neighbor might only be worth a 15% premium (especially considering zoning regulations).
  • Proximity to major landmarks. Is your townhouse within walking distance of a subway station? The local high school? What about shopping or a major park? In more rural areas where you have to drive to get anywhere, this might not as significant a feature.
  • Condition of home. The obvious base case is a home that is in move-in condition. Obviously if a house needs a lot of work, the house has a lower value. Making these adjustments is best left to professionals, which is why I strongly recommend that you leave fix-n-flips to investors who've worked as carpenters, plumbers or builders of some capacity. Relying on a contractor to help you assess the value of a home is a risky proposition unless he's related to you (Biff and I prefer to stay with move-in ready homes and only adjust based on the home inspection).
  • Rental conditions in the area. What's rent like in the area right now? For a fix-n-flip this might not matter much, but for someone who buys and holds, this matters. Remember, a property that is a fantastic value for someone to buy and live in, isn't necessarily a great value for an investor.
The end goal for a value investor is that he wants to create a formula that he can input variables into and get out a single number.

To extend our earlier example, assume that the investor has done his homework. Using the first two posts he establishes what he believes to be a average home value for a county ($100,000). He finds a home within this county that he is interested in, and the asking price is $120,000.

Crunching the numbers he discovers that (all other factors being the same):
  • a home in the best school district is worth about 10% more than an average home
  • a home within 5 blocks of the subway is worth about 25% more than an average home
  • a home with about 10% less land than it's neighbors is worth about 5% less
  • the home needs a new roof, which will cost about $15,000
We assume, of course, that our fictional home is in the best school district, within 5 blocks of the subway and is on a slightly (about 10%) smaller lot than it's neighbors. Our value investor then plugs these factors into his fictional formula and sees that, according to his calculations, the home is worth about:
$100,000 (average home)
+ $10,000 (school premium)
+ $25,000 (subway premium)
- $5,000 (land premium)
- $15,000 (condition premium)
= $115,000
So what has our investor discovered? He's discovered that his formula is telling him that $120,000 is too much to pay for that house right now. Does that mean that he can't buy it? Of course not, maybe he has a hunch that he wants to play (maybe he thinks that building regulations in that area are about to tighten up considerably, which would increase the value of the property). Does this mean that if he buys the property he's going to lose money? Of course not, ask the people who bought eBay stock at 200, before it soared past 300. Just because an item is over-valued doesn't mean that it'll revert to the mean immediately.

You even have to consider the possibility that his valuation forumla is wrong or simply inadequate.

All he's really learned is that his impartial and unemotional evaluation of the house has told him that the property is over-priced (remember, he created this formula based on what factors he thought would impact homes in his area). He can take that advice or throw it away as he likes. But that's just one more crucial tool in his bag of tricks that lets him make more informed desicions than the typical home buyer.

Obviously this is a very simple formula, one that almost anyone could construct with Google and access to sale histories (if you don't have MLS access, you could even use a tool like Zillow). The more experienced the investor, the more complex his formula might become. For example, a person living in Fairfax might know since Fairfax is a home for many government-related officials, every time there's a shift in power in DC, new appointees come in and old appointees stay as higher paid lobbyists, boosting the income.

So a clever investor might feel that the results of the 2008 election will greatly increase the number of highly paid lobbyists in DC. If he then ran his numbers and Fairfax was under-valued when considering the salary boost that he anticipates, he would see the area as a great place to buy over the next year or so.

Another clever investor in Iowa might find out that an Ethanol plant will be built in his town itn he next year or so. Doing research on similar towns, he finds that such contruction has often boosted that town's median salaries by 20-30%. This might be worth putting into his formula, to see where he thinks the values of homes are going in his area.

If nothing else, simply trying to build a valuation formula can often teach you so much about an area, even if you tend to disregard the results of your calculations. More investors have been burned from having too little information, than from having too much. Give it a shot and see what you learn.

What other variables in a home are worth quantifying? (Yes, this is my shameless attempt to see who is reading these posts and actually thinking about them)