How to tell if a Market is Overvalued
Financial Advisor · Cascais, Lisboa · Member since 2015 · 199 posts · 83 votes
How do you know if a given Market is Overvalued or not? Anyone?
Diogo Ferreira
It's only overvalued if know one is will to pay for it.
This /\
also:
What's the average days on market
What's the days' supply
Slowing pace of new mortgage origination
What are home prices being listed for vs actually sold for
Ok, anything else that is important to know that we haven't covered yet?
The main theme is multifamily investments. Long Positions. Value Add play. It is important for every investor to have a checklist on this theme. Like P/E and other types of metrics used in the stock market or valuing a private company.
@Diogo Marques I would agree with @Andrew Johnson. It's difficult to tell in the abstract if something is overvalued or not. The best you can do is come up with a thesis, an evaluation model, and some metrics that you stick to. If your model is to buy at a 3% cap and hold forever (like many of the very wealthy New York families do with New York City real estate), because your primary concern is capital preservation, then perhaps it's not overvalued. But if your model requires you to buy at an 8% cap rate because you need to pay your investors and want to have something left over for yourself, then perhaps the market is overvalued.
The point is that you cannot really answer the question until you decide what "value" is for you. Then you need to be extremely disciplined about sticking to your metrics so that you don't talk yourself into paying more for the property than it is worth to you.
Are there many homes for rent in the area?
Is there new housing nearby?
Is there room for new housing?
Is the city population likely going to increase or decrease?
If you had a half acre of land that was bare and decided to build a house like what you are looking at from scratch, what would it cost you for the house (and the land purchase)?
Are there jobs nearby?
It is all supply and demand. If there are more supply of properties at a particular price point than buyers willing and able to pay that price demanding it, then it is over priced and prices will likely fall. Supply and demand fluctuate with time ... if you understand the dynamics of what causes both to fluctuate, then you can better predict long term pricing. Able to pay is also an important detail on the demand side ... in 2006 you had plenty of demand, but the only way they were able to pay those market prices was with unsustainable lending practices ... when those dried up and owners were no longer able to pay, demand dried up and those foreclosed homes added to supply. If all available supply is being quickly snatched up by well qualified buyers and renters, and there is no practical way to increase supply, then the market is not overpriced ... if any of those things change (as they do over time, and you can usually watch and see them change), then it could become overpriced.
Note that none of this has anything to do with cash flow or flip profits. The market does not know nor does it care what your return expectations or investment strategies are. If your investment strategies don't work in the current market environment , it is not the market's fault, it is time to adapt your strategies to the current market (with an eye out to be hedged for the future) rather than expecting the market to adapt to your strategies.
Diogo Ferreira Bottom line: It's only possible in hindsight. People have say the Bay Area market has be unsustainable for years. The same with Los Angeles and likely more than a few other geographies. Those markets are still ticking up and projections show them still rising. Again, accuracy is only ascertainable in hindsight.
You can look at inventory levels, DOM, price reductions, housing starts, etc. Those are all nice hints I suppose. But it doesn't mean that those metrics won't change next month.
I think what's more productive is to come up with your investment thesis. Do you want to get in now while rates are low(ish)? Do you want to wait and don't care if rates go from 4.5% to 5.5%? Just making up rates there. Are you looking for a quick flip? Are you looking to hold for 5 years? Looking to hold for 30 years? Bottom line: you have to figure out what it is you believe in, what it is you want, and then see how the market(s) map to those desires. Maybe it will be reasonable, maybe it won't, you can adjust expectations or adjust geographies.
"unsustainable for years" is a contradiction of many definitions of word unsustainable. How long does something have to last before it is considered sustainable? A day? A month? A year? A decade? A century? A millenia? In the case of CA, prices have been above the national average (unsustainable and over priced to some) for 40+ years ... even at the trough of the great recession CA prices were still way above the national average. In the long run we're all dead, so expand the time horizon enough and nothing is sustainable as far as any of us are directly concerned ... short of that, I agree that you need to carefully define your time horizon and assess the impacts that has on your strategy before you answer these questions ... or sometimes not even short of that; personally, some of my assets will go to my children, so my time horizon for some investments extend well beyond my own death. Food for thought. Good discussion topic, BTW.
@Jonathan Twombly, @Andrew Johnson, @Alexander Felice, ok so let's do a practical exercise:
Kansas City, MO. We are looking for a Multifamily building 100+ units, mismanaged "Mom&Pop Store" as a value add play. Go in, use let's say 3k to improve each unit, and get the NOI to a more efficient level. This is the exercise.
Picking up our "Is this overvalued question", by all means, i would like to hear your thoughts on the price that is marked to Market on a property like this, and why would you go in or not.
Let it rip.
@Diogo Marques I would agree with @Andrew Johnson. It's difficult to tell in the abstract if something is overvalued or not. The best you can do is come up with a thesis, an evaluation model, and some metrics that you stick to. If your model is to buy at a 3% cap and hold forever (like many of the very wealthy New York families do with New York City real estate), because your primary concern is capital preservation, then perhaps it's not overvalued. But if your model requires you to buy at an 8% cap rate because you need to pay your investors and want to have something left over for yourself, then perhaps the market is overvalued.
The point is that you cannot really answer the question until you decide what "value" is for you. Then you need to be extremely disciplined about sticking to your metrics so that you don't talk yourself into paying more for the property than it is worth to you.
There are some very good points in this on the difference between price and value. They are not the same thing. Price is what you pay and value is what you get. Value to you may be different to value for others ... however, if you ever want to purchase with a mortgage, refinance, rent it out, insure it, take on partners, sell, etc. then at some point you must also concern yourself with value to others.
@Diogo Marques I take a slightly different track. I try to look at events in the economy and anticipate the market for 6 mos out or whenever I plan on selling the flip. I also try to gauge how many properties in each of my markets will default in the next downturn. Basically, I don't want to chase the market down the price ladder. For instance, I know from previous cycles that once an area starts laying people off, it takes about 6 months for their houses to hit the pre-foreclosure market - sometimes it takes a little longer but it isn't immediate. When jobs are coming into the market (high tech in this case) , as they are in Phoenix, and the local news is that 10,000 apartments are being built and it is anticipated that won't be nearly enough, I take note. When California raises taxes, I know we get a fresh influx of people here. When the Fed raises rates, I know that slows the market (except in California ;-) But, I was taught by an engineer that everything has it's "tinsel strength" (the point where it fails). It's my job as an investor to know the tinsel strength of the market and to notice the obvious signs around me.
@Account Closed the idea is to hold, not flip. Maybe sell but in 5 years time.
@Diogo Marques The way you pose the question now, it becomes for me more a question of risk than value or price. There are too many open variables (like the going in price, the cap rate at that price, the rents now, the rents after the value add, the time the repositioning will take) and vague terms ("mismanaged"), so I will just say that controlling for all these variables, the issue becomes how long you think it will take you to execute this plan, what kind of capital structure you have, where you think the market will be when you finish, and what your hold period is going to be.
For example, if you are doing anything that requires you to sell or refinance in the short-term, then you are taking risk that the market is going to turn against you before you complete your capital program. You seem to be contemplating a repositioning strategy, and for 100+ units, you're basically talking about a year or more to complete your program, because you have lease expirations distributed more or less evenly throughout the year. If your plan is to refinance or sell after the program is over, then you are making a bet that interests are still going to be in a tolerable range and that exit cap rates will still be relatively low. You could get a double-whammy since, if interest rates rise enough, cap rates will certainly follow. So, if this is your strategy, you are making a bet on the market staying strong and the question becomes, how confident do you feel about that bet.
If you are planning to hold for a long time and don't need to refinance, then there is less timing risk inherent in this deal. If the cash flows you're generating are strong enough to make your debt service coverage ratio, then you can hold the property long enough to see the dip in equity values and the rise again during the next cycle.
In addition, it depends on how well you are buying the deal - here is maybe where we get to your "value" question. If you are buying based on current cash flows and the deal is priced based on those cash flows, then your value-add is going to create value for you as soon as you complete the program, and perhaps the additional NOI will be enough to offset any decline in cap rates that happens between now and then.
However, if the deal is priced at the future value based on the theoretical NOI you will get after you implement the program, than this is not a deal to do. There is no meat left on this bone. You are buying for good value either if (a) the seller has completed the value-add and you purchase for that value at a cap rate you're happy with or (b) the seller sells a pre-value add property at the value based on current rents and you do the value add yourself and capture the value. However, if (c) you are paying the post-value-add price based on future rents and you have to do the value-add yourself, the property is very much overpriced.
This answer is pretty rambling, and I apologize. Hope this makes sense for you.
@Jonathan Twombly first of all, i apologize if my question looks a bit unstructured. I am dyslexic,... To be super simple:
Let's take this example: say you look at a house in an area you know very well. You also visited similar houses in similar neighborhoods. You come to the conclusion that the market price is 200k for that type of particular house in that particular type of neighborhood. If you come across a house that is 250k you immediately spot that it is out of whack of the median analysis data you have. So you do have a point of comparison.
3 Questions:
Coming back to our Hypothetical example of the multi family complex, do you:
1/compare with other 100+ similar multi family buildings and do your assessment like the example above
or
2/you use the most prevalent type of unit in the building, let's say: 1 bad, 1 bath and compare it with other similar houses even if not in an apartment complex.
...
3)The other part is regarding markets, and this is why i brought this up: Do you know that the house you looked at is overpriced if you compare Kansas with Kentucky? So you say: this house in Kentucky is much cheaper, and both places are similar.
Regarding the remaining parts of the mismanaged mom&pop and the capital structure, let's leave this out for a moment, as this part can be addressed afterwords.
I think these topics bring lots of value to investors, so i thank you in advance for taking time to address this.
@Diogo Marques I had to look up Cascais, Lisboa looks like a very nice place. If the property is in Portugal, I would want to track Brexit and the Euro. It is likely that the EU economy will falter before the States, for complex reasons, and with that in mind I would find properties that you can rent for below market now and still make a profit. I would rent them at market rate of course but be able to reduce the rent to keep tenants so I wouldn't be negative in cash flow. My simple guess is that 2018 in the EU will be rough financially. The unfunded pension liabilities in the States makes long term holds here a little riskier. But with so many boomers retiring, they will both enjoy the proceeds from the sale of their houses to facing a declining income from pensions and Social Security. Jamie Dimon of JPMorgan Chase thinks Yellen of the Fed is trying to crash the economy. And, unwinding QE is fraught with "we've never been down this road before". So, I watch and I realize, these are the golden days to invest, it might not be so in a year or two.
@Diogo Marques With multifamily properties of 5 units and more (considered commercial in the US), you are not only looking at comparable properties. Mainly I conduct a cash-flow analysis. I want to get at what the NOI will be under my set of buying assumptions. So, for example, I may know that my cost of insurance is higher than the seller's and that the property taxes will be assessed to a higher value after I buy, so I will use those numbers rather than the seller's. Similarly, if I know that the seller's labor costs are too high, I will consult with my manager and get a better number and use it.
Once I have worked through all my assumptions, I can generate a pro forma NOI. I then try to gauge the price I think I am going to have to pay to get the property. I plug that into my model and see if it spits out high enough returns that my investors will go for the deal and I can raise the capital.
Now that I have a price, I compare it to recent deals in the market. It is not really easy to do because properties are so unique. The competing properties may be in varying conditions when they were purchased and that affects the price. They may have different amenities. The apartments might have better layouts. So, it is much more art than science. What I am doing with the comps is just making sure that the price I am willing to offer is not out of line with the prices paid recently for other comparable, competitive properties.
I would not, as you brought up, compare assets across markets. Every deal and every market is local.
You could say that one market over all is more or less expensive than another market, based on prevailing cap rates. But to decide whether the cheeper market is a better deal, you need to dig into demographics and make sure that the cheaper market does not have declining population, etc.
@Jonathan Twombly Lot's of value here. I get the cash flow part and your assumptions that come out of your model. And even a dcf analysis to be more specific. So, just to hit the point home, with everything the same, and i do mean everything the same, would you go in where in any given market that particular deal is cheaper?
@Diogo Marques It's hard to imagine EVERYTHING being the same in two different markets but, yes, if everything were exactly the same and I had to choose between a more expensive and a less expensive market for the same asset, I would go with the less expensive market.
@Jonathan Twombly Thank you for taking time sharing your precious advice with this Forum. As a gift, here's my book list for you from the last couple of months of readings.
@Jonathan Twombly Lot's of value here. I get the cash flow part and your assumptions that come out of your model. And even a dcf analysis to be more specific. So, just to hit the point home, with everything the same, and i do mean everything the same, would you go in where in any given market that particular deal is cheaper?
With your DCF analysis, you will need to project out changes in income (rent) and expenses to get to your cash flow projections. You will then need to project out further your exit value. This is where the differences are likely to show up ... if you always assume the same rate of rent increases, vacancy rates, appreciation rates in exit values to all assets regardless of what market they are in, what class of neighborhood they are in, what the quality of the tenant base is, etc. then yes you will likely come out that the cheaper property is the better deal. This is not reality, though; everything is not the same.
The reality is that different markets do in fact have different rent growth rates, appreciation rates, tenant quality, etc. and you should be using different estimates based on historical data in those different markets to form more realistic projections in calculating IRR. More expensive properties are likely that way because they have higher appreciation rates, higher rates of rent increases, and a better class of tenants which produce a less volatile and more passive cash flow stream, and a premium is built into this higher price as a result.
The differences could be very difficult to spot too if you are not intimately familiar with the market ... even in seemingly the same market, a property may trade for a huge discount to a similar one literally a few blocks away ... it MAY be a great deal, or it MAY be that all the locals know that the cheaper property is just on the other side of the "wrong side of the tracks" and even though it is only a few blocks away it is in a much rougher "war zone" neighborhood with drug dealers, gangs, theft, homicides, etc running rampant, but you as an outsider looking in may not realize that looking only at the prices, pro forma NOI projections provided by the seller, pictures, etc. that the lower price is justified and not a great deal ... this is one of many reasons remote investing can carry much more risk ... caveat emptor.
Just because a property is cheap does not necessarily mean it is a good deal or a better investment. Just because a property is more expensive does not necessarily make it over valued or a bad investment. Do not confuse price with value.
This is a Great Question, and is similar to a Question I had a few months ago about a program called 'Housing Alerts'. Has anyone purchased and used this program? If so, how did it work for you?
Thanks for any input you have on this.
@Diogo Marques I had to look up Cascais, Lisboa looks like a very nice place. If the property is in Portugal, I would want to track Brexit and the Euro. It is likely that the EU economy will falter before the States, for complex reasons, and with that in mind I would find properties that you can rent for below market now and still make a profit. I would rent them at market rate of course but be able to reduce the rent to keep tenants so I wouldn't be negative in cash flow. My simple guess is that 2018 in the EU will be rough financially. The unfunded pension liabilities in the States makes long term holds here a little riskier. But with so many boomers retiring, they will both enjoy the proceeds from the sale of their houses to facing a declining income from pensions and Social Security. Jamie Dimon of JPMorgan Chase thinks Yellen of the Fed is trying to crash the economy. And, unwinding QE is fraught with "we've never been down this road before". So, I watch and I realize, these are the golden days to invest, it might not be so in a year or two.
Ken, my take would respectfully be the opposite. The golden days for investment are not before the crash; they're after. Markets have potential energy, meaning that the higher they go, the stronger the pull of gravity is on them. If the Yellin/Dimon hypothesis turned out to be true, my preference would be to wait until all those boomers are forced to sell at rock bottom prices in the crash and become renters. You then pick up assets cheap and then have more tenants to rent to. Those sound like golden days to me! Warren Buffet is fond of saying, "Be scared when others are greedy; be greedy when others are scared." It's a philosophy I try to live by.
@Jonathan Twombly I look at the market in three phases. (I think we generally agree)
Phase 1 we are in is to do quick flips (Subject To, no rehab, resell quickly with owner financing for cash flow), build liquid cash to be used later, buy & hold only if the price I can buy a particular property at will get me through the coming drop (buying well below today's market value). Not Buy & Hold though. I realize you do Apartments for Buy & Hold and of course that is a very solid strategy. However, 99.99999999% of people on BP are not doing apartments. And, houses are a different strategy and on a different cycle in my humble opinion.
Personally, I would jettison any house that has a negative cash flow unless I was convinced I had a quick exit in the event the economy turned and everybody wanted to sell at once again like 2008. This good phase should last for the next year or so. So, cash flow, and build cash reserves.
Then I think we move into:
Phase 2 major realignment, prices drop for about 3 years (boomers sell to downsize & want single floor houses & apartments - the ole' knees ain't what they used to be for stairs) & Gen Xers aren't buying - too much student loan debt and the down hill slide will be a bear. A lot of houses will come into the market with little demand and it will still be too volatile during this time to buy houses to hold.
(Apartments will be hot, hot hot, especially if they have elevators). I expect to buy Subject To on the down slope, not hold, but rather sell to otherwise qualified buyers that can't get bank financing. The Fed won't be able to figure out how to unwind QE causing continued Fed trouble in the markets. It will takes years to sort out.
Phase 3 about 3 to 4 years from now, prices are at bottom again and it's a Great Time To Buy especially if you planned ahead and have cash. Buy & hold, Buy & hold, Buy & hold. Warren Buffet's world.
So, my take is that it is a great time to be in the real estate market, there is a lot of money to be made for the next year. Things go south after that for a few years and then as always, it bounces back.
Great break down of the market phases and shifting strategy to fit so you can stay active, safe, and profitable throughout the cycle. I have a similar philosophy, but can also appreciate that it is difficult in practice to execute and time properly. You touched on it a bit in your previous post, but back to the OPs original question, modified a bit for the context of your post, what signs do you look for and how do you personally go about telling when each phase transition will start and end, and therefore that it is time to switch up your strategy?