How Do You Find Value In Any Real Estate Market?

Albert Einstein once said: “We can’t solve problems by using the same kind of thinking we used when we created them.”

When it comes to solving the problem of finding good value in any real estate market, it is almost impossible to do so if you just think within the real estate paradigm, but it becomes much easier and clearer if you move your thinking above the real estate paradigm and into the finance paradigm. After all, finance is the invisible hand that drives the real estate market.

Value vs. Price

First of all, we may need to distinguish between the value and the price of a property. The price of a property is the dollar figure you pay in a property transaction between two parties. The value of a property can be above or below its price, in other words, what the property is really worth.

For example, if the price of a property is $500k, but its value is $600k, then you can say that you have found good value. However if the price of that property is $500k, and its true value is only $400k, then you have bought an overpriced property. So our goal is to always buy properties where the price is lower than its value, and this can be done during both good and bad times in the market.

The problem is, no one really knows what the true value of a property is. It is up to each individual to have their own formula. I will show you mine in just a moment, but I need to give you the reasons behind my calculation first.

The Big Shopping Centre

Let’s look at how a shopping centre operator charges their tenants rent. This will help us work out the value of a residential property.

A shopping centre usually charges each store’s rent by how much that store makes, rather than by the size or location of the store.

For example, you may have two identical size stores side by side in the same location, if one is a jewellery store and the other is a newsagency, the jewellery store will usually pay a lot more rent than the newsagency. If you are the owner of the jewellery store and protest this as unfair, the shopping centre operator will be glad to offer your store to another jeweller who may still see enough profit in renting that location even after paying a lot more rent than the newsagency next door.

You can see that one of the key functions of a shopping centre operator is to ensure that it offers enough reason for each store operator to make just enough money to stay operating in the shopping centre after paying a forever increasing rent that wipes out the best part of their profit.

In a strict financial sense, the shopping centre operator’s job is to empty the pockets of each store owner by leaving them just enough to survive and keep paying their rent. The day the store owner can’t pay the rent, the shopping centre operator will either replace them with someone who can, or stop increasing the rent and wait for the next earliest opportunity to do it again.

Let’s apply the shopping centre concept to residential properties. Can you imagine the following for a moment?

• Your city (Melbourne, Sydney, Brisbane, etc) is a big shopping centre;

• The stores in this big shopping centre are called your family homes and you are the store operator;

• The rent for each store is the mortgage you are paying for your home;

• The shopping centre operator is the banks (e.g. over 90% of the mortgage lending is done by banks in Australia);

Your Surplus is the Bank’s Focus

If we apply the same logic of a shopping centre, the banks (i.e. the shopping centre operator) are forever looking to empty your pockets. Anytime they find that you still have money left and are not using it to pay for a bigger mortgage, they will find a way to ensure that you do☺.

If you think I am being harsh on the banks, maybe you should ask your parents and grandparents when was the last time they felt a home was cheap to buy in comparison to their income?☺. The answer is likely to be: never.

For example, if the banks discover that in a particular suburb, the average family only uses 30% of a single income to pay for their home mortgage, where an average family can survive by using 50% of their combined income to pay for a home mortgage, then clearly families in this suburb can still pay for more mortgages.

To increase the mortgage repayments for all the home owners in this suburb, the banks can’t just increase the interest rates for this suburb and not for others; hence the most obvious solution is to push the property prices up in this suburb so that they can increase the size of the mortgage.

How do banks push up the price of a particular suburb? By lending people in the suburb more money with easier qualified criteria. This includes easy lending to local government, property developers, property investors and home owners. For example, instead of lending home owners only 60%-80%, the banks can lend 95%-100% to this suburb.

Banks are similar to shopping centre operators, between equity and income, they tend to follow income, i.e. the banks will follow whoever still has surplus income after their current mortgage repayments and living expenses, and lend them more money. This in turn can push up property prices.

Current Examples

Let’s look at a few real life examples of this in application:

1. Over the last 15 years, the baby boomers (between the age 50 and 64 currently) have the highest disposable income after mortgage repayments, the banks technically followed them around and threw money at them.

Wherever the baby boomers have wanted to live for the last 15 years, the property prices in those areas seem to have gone up much faster, because they can obtain finance very easily and push up property prices. You can say, home prices in the baby boomers’ stronghold areas have outperformed the average Australian money supply growth which is about 9% a year;

2. During the next 15 years, the baby boomers group will become within 1-15 years of their retirement. Once they have less than 15 years of working income left, banks will stop offering them 30 year mortgages. So all of a sudden, the baby boomers’ high disposable income will no longer be as powerful as before.

For example, the average age of a baby boomer is 58, giving them 7 years until retirement. The banks can only offer a 7 year loan for any home mortgage under normal circumstances, and this can greatly reduce the finance that a baby boomer can obtain, hence slowing down the property price growth in their areas.

But for a person who is only 49 today, they can still obtain a 30 year home loan. (If you are over 50, you have to prove to the banks that you can pay off the entire home mortgage without selling your home upon retirement. This has become law since January 2011.)

So in the eyes of the banks (i.e. the shopping centre operator), the baby boomers (i.e. the store operators) can no longer afford to pay higher rent (i.e. a bigger mortgage repayment). The banks have to wait for the next opportunity to increase the mortgage size, or find someone else who can afford to take on a bigger mortgage in those areas.

The only issue is that we don’t seem to have a large enough group of income earners with sufficient equity to replace the baby boomers at the moment. Unless the government starts introducing a Second Home Owners Grant☺ or the banks start offering quasi-equity to bridge the equity gap for the next generation.

You may have noticed that the baby boomer stronghold areas have not performed that well recently. I would not be surprised to see these areas continue to underperform in the market over the next decade until such time as the next generation of higher income earners gather enough equity to move into these areas while the baby boomers finally decide to downsize.

3. Over the last few years, you may have seen property prices go up quite steadily in the Greenfield areas, i.e. outer suburbs where people buy house and land packages.

Traditionally, the income in these Greenfield areas was not high enough to attract banks’ interest, but the recent immigration trend has changed that condition. In fact, many of these outer suburbs will become middle suburbs over the next 2 decades.

The baby boomers currently represent 1/3 of our entire workforce. They can only be replaced by an even larger size of working migrants to keep our tax base sufficient.

These new generation of migrants are mostly between the age of 26 and 45, and have qualifications and skills that are in shortage at the moment. Hence they enjoy a higher than average income. But due to their lack of equity, they are not ready to move into the baby boomers stronghold suburbs, which are traditionally second or third home suburbs.

Due to the relative higher income and low equity of this new generation of migrants, the mortgage repayments of these migrant families often only represent 30% of a single income.

It is very obvious to the banks that these new generations of migrants still have too much income surplus that is not being used to pay for a mortgage. It is the banks’ duty to empty the pockets of these new migrants just like they did to the baby boomers in the last 15 years☺!

The easiest way to do so is to push the property prices up for the new migrant stronghold areas by lending more money to them. The higher the property prices go, the emptier their pockets will become.

This is not to say that the local Gen X and Gen Y’s are not important for the banks to follow, but their size is insignificant in comparison to the new migrant population. For example, the new migrants (i.e. 3 million) coming to Melbourne will represent 75% of the entire current Melbourne population (i.e. 4 million), and the new migrants coming to Sydney (i.e. 2 million) will represent 44% of the current Sydney population (i.e. 4.5 million).

If the performance of the baby boomers’ stronghold suburbs for the last 15 years is any guide, we shouldn’t be surprised to see the new migrant stronghold suburbs for the next 15 years outperform the average. This trend has become more and more evident over the last 5 years, and I believe it will continue for another decade or so.

A ‘Strange’ New Trend

This is why we are seeing a strange new trend in just about every major city in Australia at the moment:

• The suburbs that have made us the most money in the last 15 years have started to underperform the average, as most of them are baby boomer stronghold areas, where the driving force behind the growth from the last 15 years (i.e. the high disposable income that can be used for borrowing purpose) has started to disappear;

• The Greenfield suburbs that we have traditionally considered as lower socio-economic mortgage belt areas, have suddenly become almost the only areas that are consistently performing well at the moment. Simply because the higher income of these new migrants has changed the outlook for these areas.

Over 50% of new properties sold in the last 12 months in major cities have been sold to migrants. One can only expect migrants to “beget more migrants” in the same ethnic community. These suburbs may have a very good chance of outperforming the average over many years to come.

The Value Formula

So here is the value formula that I apply whatever the market conditions:

If 1/3 of an average single income in the suburb can cover the average home mortgage repayment, then this suburb presents itself with good value, provided the income can be used to obtain a 30 year mortgage.

For example, 1/3 of a single annual income $75k is $25k, which can cover a home mortgage of $360k. So in a suburb with an average home price of $350k-$450k, with an average single income of $75k, this suburb represents good value to buy, regardless of whether the market is going up or going down at the moment.

There are a few key points to remember when applying the value formula:

• Not all properties between $350k and $450k represent good value, so you need to check the income for that area as well;

• You can move the property price point upwards or downwards so long as you link it to income. For example, if an average single income in the suburb is $150k, and an average home mortgage is $720k, you will find that suburb can represent good value as well;

• When applying the value formula, you still shouldn’t ignore all the good common sense rules of real estate investing. While the value formula can help enhance your chance of success it should not be used as the only measurement;

• The suburbs that represent good value at the moment may not represent good value in the future;

• The suburbs that do not represent good value at the moment may represent good value in the future;

• The suburbs that represented good value in the past will not necessarily represent good value in the future;

• The suburbs that didn’t represent good value in the past may however represent good value in the future.

The Limitation of the Value Formula

There are a few limitations in regards to using a value formula:

• You may miss out on some spectacular growth for some areas where their growth was mainly driven by human emotion rather than value. This is no different to people missing out on the dot.com rise where the value formula to measure stocks made all the dot.com stocks look overpriced.

• The value formula doesn’t tell you whether an area can consistently perform better over a much longer term. While you can tell if an area is good value for now, it may or may not represent strong long term growth. This is no different to people buying stocks or shares at a discounted price, which doesn’t then guarantee the share will outperform the market over the long run.

• If the rest of the market is not aware of the discounted prices for these areas, it may take some time for the prices to reflect an area’s true value. In other words, the value formula can protect you more from the downside rather than giving you an upside.

Summary

Most property investors have their own rules when it comes to predicting future property performance, but if your rules are based on the wrong underlying reasons, then your prediction can be misleading unless most people also act according to the same wrong underlying reasons, making them all wrong at the same time. Hence it may appear to be right or at least workable☺. For example, for thousands of years, we all had no problems living under the wrong assumption that the earth was flat.

So I am not here to convince you to take on my value formula and abandon the predominant view of the market participants, because regardless of how convincing or logical an argument is, if the majority of the market participants do not agree with it, the argument will be less effective. Hence it is my intention that you only use this value formula as another benchmark to double check your own conclusions of the property market.

Personally I am not going to hide the fact that majority of the residential properties in Australia do not currently represent good value based on my value formula. So at this time we need to be even more selective.

However, I don’t expect property prices to crash either, at least not the properties that represent good value based on the above value formula. But many property investors can get stuck with a non-performing investment portfolio for a long time if most of your properties are overpriced in comparison to their value. So now is a good time to review your entire property portfolio and define a more suitable investment strategy moving forward.

Finally, just in case some people may think that there is a secret banker sitting in the dark corner trying to empty your pockets all the time, it is just normal business behaviour for the banks to constantly look for ways to maximize their profit by lending more money to people who can still pay higher interest repayments. You and I would do the same thing if we were given the job to run a bank. I am just glad that the law of maximising the banks’ profit will never change, hence we can always benefit from this law during good and bad times.

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