I spend all day every day looking at, and working on, foreclosures. At times it can be downright depressing. Given that the primary cause of foreclosures is price declines, brought about by excess inventory, created in part by foreclosures, it is easy to see how the doomers argue that we are in a self-reinforcing death spiral with NO bottom.
In reality, nothing could be further from the truth. There is a bottom, Let me explain.
Nearly all residential appraisals are based on comparable sales—comps. Most commercial appraisals rely more on the cost basis approach to valuation, or on income capitalization. For those who think of homes as an investment, the income capitalization approach should make perfect sense. The idea here is that rents (income), minus expenses and divided by investment (sales price) equals the return on investment (capital). This return on capital is commonly referred to in the industry as the “cap rate”, and should be considered analogous to the percentage return you’d receive on other investments like stocks or treasuries. So a commercial building with a cap rate of 6% on a $1 million dollar investment should be expected to generate a return of $60k per year.
If you look at cap rates for residential real estate by estimating realistic rental values it isn’t hard to see we’ve had a problem the last few years. In my neighborhood houses that were selling for $850k at the peak rent for about $2k/mo. After deducting property taxes and insurance (assuming zero maintenance and zero vacancy), the cap rate is about 1.5%, or a “one and a half cap”. Now let me ask you: How is this a good investment? You might want to answer “appreciation”. But keep in mind that unless rents increase, rising prices only continue to lower the cap rate. Thus appreciation is fundamentally limited by the growth of rents or how bad of an investment one is willing to make.
You can quickly and easily estimate where the bottom might be in your market by looking at local rental rates, multiplied by twelve, subtracting taxes and insurance, and dividing by a reasonable cap rate. That, of course, begs the question of what a reasonable cap rate is. In my opinion it will vary according to the property. Perhaps as low as 2% for a trophy property in a fabulous location, to 12% or more in high crime rate areas where you fear for your life.
The one reform I’d really like to see before this mess is over is the death of the comparable sales appraisal approach. By tying lending limits to local rents, we can ensure that homes remain a great investment for everyone. In places like Stockton, where prices have fallen as much as 40%, cap rates are quickly becoming attractive. While inventories are still downright scary, agents are seeing a noticeable uptick in sales.
Perhaps a sign they are close to the bottom.
Sean
Sean, you rule!
Radar revolutionized the business, and made our hunting a million times easier…keep up the great work!
Thanks for FINALLY doing a blog so I can stop emailing you “What’s going to happen next?” every other day!
http://www.farbelowmarket.com
Loved this piece, Sean. I’m in agreement here but “the death of the comparable sales appraisal approach” … gasp, choke!! Do you mean that RE agents also will no longer use the comp method and have to use simple arithmetic to figure out the list price??? That might thin out the ranks.
James Frangella
Sorry I wasn’t clear James – I only meant that lenders shouldn’t allow the sales comparable approach as repeat sales can be subject to increases due to speculation rather than fundamentals.
That won’t stop hot markets from becoming speculative – but it will require cash to push prices beyond the fundamentals, rather than allowing buyers to speculate with the banks money that us taxpayers inevitably end up paying for.
I certainly think that setting sales prices and making offers will revolve around the comparable sales approach – just restrained by lender limitations of reasonability.
Sean,
Terrific post up until the sales comparison comment. I know exactly what you’re saying though, but what lenders need to do is revamp the whole way they think about appraisal. Instead of being a single point in time incident, it should be a continuous and on-going valuation dialogue. Think of it this way, if they “mark to market” securities, they should treat the assets collateralizing pools similarly versus relying on automation or other 3rd party analysis that was not a party to the origination of the debt. Appraisals, industry wide, tied to securities, should have a present and “future value” component to be recertified a period later, say 1 year. In doing so, they can appropriate provisions adequately against losses necessary to adjust rates or upfront premiums with the market, not in perpetuity of the market.
As to relying on a cap rates in a residential assignment, it would be done in addendum to the sale comparison method anyway. But what is more important, in my judgment, is median income analysis. A bank simply can not lend 80/20 finance on $850,000 in a $60,000 a year median area. Lenders were not absent the resource to be prudent, hence Paul Volkers’ recent comment that the system failed the test of the market. Securitization is great as long as incentives to originate/distribute quality, not quantity, are aligned throughout the money chain.
Michael
Hi Michael,
Thanks for the post. Care to take a stab at defending the sales comparison approach vs. moving to income capitalization as I suggested?
I certainly don’t see that the income approach is done as an addendum today. And while median income may be a better measure of prudence, it is too broad a brush given individual property differences. Comparable rents can better reflect differences like size, ameneties and location which should certainly still play a role in valuation. While hopefully still eliminating run ups in sales comps due to speculation or the financial engineering of payment to increase price.
Sean
Very nicely done.
That issue of what a reasonable cap rate is always does rear its head, doesn’t it? I’d like to learn more about what’s reasonable and how to determine it.
We’ve hit a point in Sacramento where many areas are witnessing sharp upswings in year-on-year unit sales. Unit sales in 95828 and 95829, for example, have increased 172%! That area saw the kind of price decline that you quote for Stockton. Other areas are seeing unit volume increase more modestly, but on the whole I think we’re at the price where demand will continue to stay strong.
Thanks for the additional data points John. I’m really anxious to see the April home sales data from DataQuick. Should give us some idea as to whether these increases are isolated just to the hardest hit areas, or if there is something more widespread happening. In any case it is good to see some activity again.