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?
People are paying full list price and over now for Chicago area properties not in great shape. The market's been frothy over a year while while Chicago, Cook and IL GOV's are financial disasters and raising taxes on everything. There in the courts now because they want to heavily taxe soda drinkers and not fancy Starbucks drinks.
Their rather, digress. Could be the GOV will cause a local market collapse, rather than more generic market forces.
How do you know if a given Market is Overvalued or not? Anyone?
This usually is a hint...
I can't explain it, but I know when I see it.
There are a few metrics I like to look for. Can the average person afford the average house? Wage growth/ employment, the only two metics that can support real long term growth.
New construction is a key to watch (home and commercial). Construction is capital intensive and all builders expand and contract based on the economy. This is often a lagging indicator, since it takes them time to scale up or down.
Non Real estate measure
Have unusual number of ice cream and cross fit gyms posed up? When consumers have a lot of extra disposable income they buy luxury items. Additionally people are investing their own money or were able to obtain bank financing.
Most of all I look at the individual deal. A good deal is a good deal. What is your downside risk? There is a lot of measurement for the upside. If it all went bad, what would you do? Could you wether a market correction?
@Lesley Resnick Although it is understandable that when a professional really knows how to evaluate a situation, we are looking here for a final checklist everyone can agree upon and act accordingly when doing an assessment.
I do that have a check list, nor have I ever heard of one. You rarely hear advice on when to sell, which is really the issue at hand. It is always around the buy side. The buy is much easier to analyze.
It is like predicting the weather. The only correct answer is known after the fact.
The old saying of it is great, until it is not. Think in terms of 07 it was great and the party raged on and then one day, it all fell apart.
@Jonathan Twombly, @Joshua D., @Gino Barbaro,
just found this graph. I am a nerd and i think it would be interesting to share this with this forum. Contrary to the prevailing wisdom that Real Estate Market Prices "Only" go up, this shows a more accurately picture of this Asset Class and the historical plunges. There is also a Mike Milken talk regarding this same subject on YouTube, https://www.youtube.com/watch?v=fnnAnoVwzTo if more of you would like to dig in and give your input.
It would be super-cool to conclude this Forum with a checklist that anyone could use when assessing the Macro-Economics of any given Real Estate Market.
I'm going to piggyback on Jonathan's reply to your post. Our strategy is to purchase distressed, improve, stabilize, then hold. To support this strategy we run 5-year projections on all our potential acquisitions to see if we can make our CCR objectives. For us, a project is overvalued if we can't make our objectives. Naturally, we have to make a lot of assumptions as we run this analysis & if our assumptions are wrong then ...
Applying this at a macro level to an entire market we have found that we have never been able to make our CCR in markets where the CAP Rates are less than 4%. For us, these markets are overvalued.
@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.
Are all of those audiobooks? I do love to read books and do so very often, but I could never get into audiobooks. The voice just puts me to sleep. One exception was the 10x rule by grant cardone but that one he recorded himself.
I just don't get the retention, applicability, satisfaction, or sense of adventure from listening to an audiobook that I do from reading a physical book.
The odd thing is that I'm a millenial and a radiologist (a very tech oriented medical field). Sigh..
@Andrey Y. yes, 99% are audiobooks. I am dyslexic, and have a lot of trouble focusing when reading an actual book. With audiobooks i can pretty much go through 2-3 books in a day. What i also do is buy the actual book anyway so i can check graphs and some math, like balance sheets/income statements and so on. I have an updated list if you want.
@David Faulkner Your Question of: "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?"
I make a few basic assumptions:
1) Real Estate Markets tend to be local
2) Real Estate WILL go down eventually and come back up
3) Basic Demographics play a huge roll
I look at how many people are in the pool of possible buyers (age group, income, family formation, investors, hedge funds etc) and the trends as to where people are moving. I look at foreign money coming in. For instance, Chinese money drove up the prices in Vancouver Canada and that bubble will be bursting shortly. When Canada imposed a 15% surcharge on unoccupied properties, that drove the investment money to Seattle which now is also crazy high, and the money went to San Francisco and Los Angeles. Since I invest in Phoenix I expect some of that money to drive prices higher there.
I look at monetary policy and how it affects interest rates. The higher the rates, the fewer can afford to buy. That increases the renter pool and decreases the buyer pool. I look at the offset of housing starts which means the more houses being built, the more jobs and more people can afford houses. Housing permits are a leading indicator that I use to gauge how many houses will be built in the next year or so.
I look at flood zones, earthquakes and natural catastrophes (New Orleans is a risky place to invest because of hurricanes and flooding. One third of the people from New Orleans relocated to Houston and never went back to New Orleans.) It was a good time to own property in Houston and a poor time to own property in New Orleans.
Of course I look at local politics. I used to buy a lot in Seattle but now you are required to accept the first applicant or be sued. The city is sending out "shoppers" to ensure compliance. Sounds like a police state. In Washington it is a criminal act to mail to people in distressed properties but they don't define "distressed". If the owner "feels" they may get behind sometime in the future they can sue you up to 6 years later. Figure that one out.
Illinois is on the bring of bankruptcy. That to me means that pensions will fail and people expecting to live off of their pension are in trouble. Then of course there is the L.A. traffic and their crazy high prices. When I read about people who keep properties in California because some day they will be worth more yet for now are negative cash flow (losing money) I shake my head. Some states have HUGE transfer taxes just for the pleasure of selling your property. A lot of people don't take transfer taxes, property taxes and capital gains into their equations. but I do.
So, I look at trends. I look at what others are doing and how much money the are keeping in their pocket everything said and done. I ask "Is this city worth investing in for the next five years?". I assume a seven year real estate cycle. (generally)
When I see laws are changing against investing, I pull out. When I see large layoffs in an area, I pull out. When I see a new manufacturing plant is being built, I buy in.
I put some long term thought into each area I invest in.
@Jonathan Twombly, @Joshua D., @Gino Barbaro,
just found this graph. I am a nerd and i think it would be interesting to share this with this forum. Contrary to the prevailing wisdom that Real Estate Market Prices "Only" go up, this shows a more accurately picture of this Asset Class and the historical plunges. There is also a Mike Milken talk regarding this same subject on YouTube, https://www.youtube.com/watch?v=fnnAnoVwzTo if more of you would like to dig in and give your input.
It would be super-cool to conclude this Forum with a checklist that anyone could use when assessing the Macro-Economics of any given Real Estate Market.
I believe it was Schiller who also found that, over all of US history, residential real estate appreciates at about the rate of inflation. So there is almost no appreciation in real terms. So, if you are investing just for appreciation . . .
@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?
To be honest, I spend exactly 0% of my time trying to figure out where in the cycle we are because I don't invest solely for appreciation. I also have a model that I stick to, which is that my investors are unlikely to be interested unless I can provide them with at least a 7% cash on cash return in the first year. All I need to do is underwrite deals to tell me if I can hit that mark or not. I don't need to guess where the market is going or use comps or trends or anything. I just underwrite the deals using the standards I apply and the deals themselves tell me if they are worth doing or not. I feel I need to deviate from my underwriting standards, getting more aggressive or applying more leverage in order to make the deal pencil out, then I know things are overpriced.
In my humble opinion, sticking to an underwriting metric is investing. Explaining to yourself why you should deviate from your metric, or why this time is different, is nothing more than providing yourself with rationalizations why you should make this bet, because you've convinced yourself that the market will keep going up, even though the numbers are telling you the deal doesn't make sense on a cash flow basis.
Strategies that depend on timing the market are merely elaborate intellectual cover for bets. If you are trying to predict the future, and you are making a decision based on anything other than current property and market rents, you are making a bet that the future will be as you hope it will be.
You may be a good bettor. There are probably lots of great bettors on this site who have made millions and will tell you to bet the way they do.
I've never liked gambling. I always wished I could own the casino because the odds are in the house's favor. You can beat the odds in the short run but never in the long run. I don't like betting. I prefer investing.
@Jonathan Twombly I don't invest for appreciation only either. Cash Flow is King. Just thought it would be interesting to share historical values to get everyone on the bigger picture.
@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.
I mean, would you not treat the 250k find just an outlier in your analysis. All data within market research has points outside of spread.
All variables aside i would still consider the 200K as market price and just factor in all considerable variables as stated in above posts.
Forgive me if i'm missing your point.
@Bjorik Mutize The 250K is an outlier, that is why we wouldn't consider it. The key here is having enough data so you can be comfortable in making your assessment. If we look at only one point in a data set, it can't be representative as it is very biased. This is why i wanted to have the most important macro-economical variables so that, if you do come across only one property, you can assess at least from other markets WITH the macro-economical variables, that you are in the ballpark of the property price. Thanks for your input.
@Lesley Resnick Although it is understandable that when a professional really knows how to evaluate a situation, we are looking here for a final checklist everyone can agree upon and act accordingly when doing an assessment.
The original question suggested valuation of a market but follow on posts suggested a specific (possibly hypothetical) property. If finding out if a property is overvalued, then one obvious answer is to get a "price at this instant" valuation via an appraisal. From comparable sales, income, and replacement valuations you will have an idea for that property. As for getting a checklist everyone can agree upon... that isn't realistic because different people have different goals as pointed out in prior posts....
@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?
To be honest, I spend exactly 0% of my time trying to figure out where in the cycle we are because I don't invest solely for appreciation. I also have a model that I stick to, which is that my investors are unlikely to be interested unless I can provide them with at least a 7% cash on cash return in the first year. All I need to do is underwrite deals to tell me if I can hit that mark or not. I don't need to guess where the market is going or use comps or trends or anything. I just underwrite the deals using the standards I apply and the deals themselves tell me if they are worth doing or not. I feel I need to deviate from my underwriting standards, getting more aggressive or applying more leverage in order to make the deal pencil out, then I know things are overpriced.
In my humble opinion, sticking to an underwriting metric is investing. Explaining to yourself why you should deviate from your metric, or why this time is different, is nothing more than providing yourself with rationalizations why you should make this bet, because you've convinced yourself that the market will keep going up, even though the numbers are telling you the deal doesn't make sense on a cash flow basis.
Strategies that depend on timing the market are merely elaborate intellectual cover for bets. If you are trying to predict the future, and you are making a decision based on anything other than current property and market rents, you are making a bet that the future will be as you hope it will be.
You may be a good bettor. There are probably lots of great bettors on this site who have made millions and will tell you to bet the way they do.
I've never liked gambling. I always wished I could own the casino because the odds are in the house's favor. You can beat the odds in the short run but never in the long run. I don't like betting. I prefer investing.
I understand what you are saying, but how do you underwrite your exit? You have to assume an exit value and in order to do that you have to assume an appreciation rate. No?
@David Faulkner I assume that the exit cap rate will be 50-100 basis points higher than the going-in cap rate. But when going in cap rates are as compressed as they are now, this is a tough assumption to make, so perhaps the right number is 200-300 basis points higher. I don't know, because I am not buying now and don't plan to be buying any time soon.
When you do it this way, there is appreciation implied, but it is implied from NOI growth over time. You try to push rents higher, push expenses lower (or at least keep them growing more slowly than rents), and grow the NOI delta that way. If your NOI grows, then your exit price rises. At least that's my thinking.
@Jonathan Twombly Why do you make these assumptions regarding the basis point cap rates? The interval is fairly large.
@Diogo Marques Under normal circumstances, you assume 50-100 basis points higher cap rate on the exit to account for that fact that, at the end of your hold period you may need to sell into a softer market than the one you bought in. It's a standard conservative underwriting principle.
What many people are doing now is to underwrite an exit at the same (very low) cap rates that they are buying at. This way, they can project a higher IRR than is really to be expected, because right now cap rates are at cyclical lows and (probably) at historic lows in some markets that have been in play at never before seen levels because of the massive liquidity being pumped into markets around the world and the rise of China.
Because cap rates are so low historically (6.5% cap rates on C assets in tertiary markets, which have become common, are ridiculous by historical standards), it is unwise in my opinion to underwrite the exit at the standard 50-100 basis points over the going-in cap rate. If you are holding for 5-10 years, it is very likely that cap rates will be significantly higher than they are now, especially if the Fed continues to ratchet up interest rates to something approaching normal levels.
@David Faulkner I assume that the exit cap rate will be 50-100 basis points higher than the going-in cap rate. But when going in cap rates are as compressed as they are now, this is a tough assumption to make, so perhaps the right number is 200-300 basis points higher. I don't know, because I am not buying now and don't plan to be buying any time soon.
When you do it this way, there is appreciation implied, but it is implied from NOI growth over time. You try to push rents higher, push expenses lower (or at least keep them growing more slowly than rents), and grow the NOI delta that way. If your NOI grows, then your exit price rises. At least that's my thinking.
This is a good point. Improving the NOI delta is the hedge against cap rate exposure. There is a lot of risk in this market if you can't execute that improvement in margin, and I think that will catch the new, unaware entrants in this market in the event we see any correction or even plateau. All it will take is an expansion in home ownership rates off of our historically low sub-64% and a lot of apartment operators could be impacted. This could certainly be localized to some areas, like those experiencing large population influx and correspondingly large expansion in building permits. That, along with expansion in new MF building inventory in areas that are above normal in NAHB Leading Markets Index (LMI) (the green and dark green areas) could be a catalyst for NOI pressure, specifically inflation adjusted rent contraction. In other words, if millennials start buying, as , apartment demand may ease and put pressure on rents. My 2 cents.
@David Faulkner I assume that the exit cap rate will be 50-100 basis points higher than the going-in cap rate. But when going in cap rates are as compressed as they are now, this is a tough assumption to make, so perhaps the right number is 200-300 basis points higher. I don't know, because I am not buying now and don't plan to be buying any time soon.
When you do it this way, there is appreciation implied, but it is implied from NOI growth over time. You try to push rents higher, push expenses lower (or at least keep them growing more slowly than rents), and grow the NOI delta that way. If your NOI grows, then your exit price rises. At least that's my thinking.
This is a good point. Building the NOI delta is the hedge against cap rate exposure. There is a lot of risk in this market if you can't execute that improvement in margin, and I think that will catch the new entrants in this market in the event we see any correction or even plateau. All it will take is an expansion in home ownership rates off of our historically low sub-64% and a lot of apartment operators could be impacted. That, along with expansion in MF building permits in areas that are above normal in NAHB Leading Markets Index (LMI) (the green and dark green areas) could be a catalyst for NOI pressure, specifically inflation adjusted rent contraction. In other words, if millennials start buying, as , apartment demand may ease and put pressure on rents. My 2 cents.
Yep Yep! Great comment ... we learn from Warren Buffett and Benjamin Graham the importance of having a "margin of safety" ... they were talking stocks but it also applies to REI. Also, nothing you don't already know and stated in a different way, but to emphasize an important point I'd explicitly state that there is forced rent growth and market rent growth, just as there is forced appreciation and market appreciation ... both are important to consider in the short and long terms IMO, but both are created and treated very differently. If your forecast comes true, which I think it may very well, then it could create some fantastic opportunities to 1031 from SFR rentals into multis ... not today though, which is why I for one am holding tight.
This is a great question. Most investors in the State of California may be asking this questions. Someone on the post said it is not overvalued if people are still buying. I'll put it a different way: Look for slowdowns in the sales volume as a sign that the market is cooling. If prices are very high and there are multiple bids on properties - then you are still in a hot market.
Another poster said it is only possible to know if it is overvalued in hindsight. The real estate crashes usually have causes that are deeper than just local supply / demand. The last two were crashes in the financial system.
I