Investment Theory for an Uncertain Market

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To say that the [tag]real estate market[/tag] is uncertain would be the understatement of the century. Are we near the bottom, or are significant declines yet to come? We see [tag]real estate[/tag] for sale with ads touting 10%, 20%, 30% below market. But what is the market, and how can we possibly determine fair market value? As a rehabber I look at ARV, or after repair value, but who is to say what that value will be in the months it may take to complete a project?

There is a common thread that runs through all investment markets. It is true of the stock market, bond market, commodities market and real estate market. All markets abhor uncertainty. What’s an investor to do? Do you buy now? What if the market drops another 20%? If you wait, the market may go up. Everyone has an opinion, but nobody really knows. Markets have a tendency to turn around when you least expect it.

The pundits all have their forecasts and predictions. The “market is about to turn”, “the market is going to “continue to tank”, “inventory is too high”, “days of supply is shrinking”. On and on it goes. You can find a theory that supports whatever your view might be. If you are going to predict, you should predict often…sooner or later you’d be right. I learned long ago not have much faith in all of these predictions. There is a saying in the financial markets that states, “economists have predicted nine of the last three recessions.” Think about it.

Market uncertainty spawns fear and fear paralyzes markets. Intuitively, most people know that you should try to buy when markets are near their low. Human nature, however, keeps people from investing because they fear they will make a mistake. What’s an investor to do?

Minimizing Risk

All investment requires that you take risk. Even in a “safe” [tag]investment[/tag], like CDs, you have the risk that inflation may outpace the interest that you earn. Risk can not be avoided, but it can be minimized or managed. In the stock market you may minimize risk by buying when a stock is selling below its “book value”, which is simply the value of that particular company’s assets. The theory being that the stock could not fall very far below that or the company could become a takeover target.

What if you could apply this theory to real estate? If you knew you were getting value, would you buy? Would you feel safer knowing that you could establish a theoretical bottom for the market? If you are able to establish this market floor you may see the market go below it, but it would return that floor as markets stabilized. In a market that is expected to experience population growth, you can apply this theory. People need to live somewhere. The growing population will put pressure on supply which, in turn, will lead to more housing being built. This steady demand will prevent housing from falling below its book value for very long.

Book Value

Simply put, the book value of a house would be its replacement cost. If existing housing is selling for more than it would cost to build [tag]new homes[/tag], you will see builders stepping in to take advantage of the situation. On the other hand, if new homes cost less than existing [tag]houses[/tag], you will see buyers purchasing the new homes. Both situations will cause a market correction.

This correction does not happen overnight. Existing supply needs to return to a balanced situation. Builder inventory, [tag]foreclosures[/tag] and excess homes for sale must be absorbed by the market. The fact is that it will correct because that is what markets do.For a long-term investor in a growing market, this can be to your advantage. While the market is adjusting you will be able to find bargains. You need to determine the cost to build new [tag]housing[/tag].

If you look for property that is selling at a significant discount to book value you should do very well. You just need to be patient while the market goes through its gyrations. If you are in a market with a declining population, the book value theory is no sure thing. If you are a speculator who is looking to flip properties, the book value theory probably won’t work fast enough.

“In life you can’t have everything, where would you put it?” – Steven Wright

Note By BiggerPockets: These are opinions written by the author and do not necessarily represent the opinions of BiggerPockets.