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What is the True Value of Real Estate?

By April 8, 2016 No Comments

Investing in real estate is somewhat like investing in stocks. To profit from a real estate investment, an investor must determine the value of a property they want to buy and then make an educated guess about how much profit that property will generate based on forecasted rental income and property appreciation.

The biggest difference in determining the true value of a real estate investment and the true value of a stock investment is the ease and accuracy of the information that can be obtained. If a real estate property has a history, it’s relatively easy to determine the historical trends for income and expenses and then be able to accurately forecast future performance based on past performance plus some factor for inflation.

Real estate professionals and appraisers spend their time establishing data on all types of real estate investment properties. They have a good idea of the true value of a real estate investment by knowing the amount of income that has been generated or is expected to be generated, the operating expenses that have been incurred or will be incurred in the future, and the resulting net operating income (NOI).

By establishing the relationship between NOI and historic sales prices, appraisers and practitioners can determine the capitalization rate for a given property type. To determine the capitalization rate (“cap rate”) for a property simply divide the NOI by the sales price. For example, if a property had a net operating income (income minus operating expenses, excluding depreciation and mortgage interest) $100,000 and it sold for $1,000,000 the cap rate would be .10 or 10 percent.

If ten similar properties sold and the cap rate range for those properties was between 9 percent and 10 percent, based on age and condition, you’d have a pretty good indication of what the value would be for a similar competing property. If NOI (“I”) divided by Price (Value or “V”) equals Cap Rate (“R”), then NOI divided by Cap Rate equals Value. It’s called the IRV formula.

I ÷ V = R   or put another way   I ÷ R = V

Determining the true value of a stock is another animal altogether. It’s almost impossible to find out the true value of a stock. Usually, the most obvious measure of a stock’s value is its share price. Unfortunately, comparing different stocks’ share price is like comparing apples to oranges. For instance, by manipulating the capital structure, a company has a lot of control over its share price.

If a company has a huge number of shares outstanding, it can drive down its price per share. A stock split where the number of shares is doubled or tripled will drive down its share price. The company has the same market value as before but since the number of shares have doubled or tripled each share is proportionately worth less.

So if stock price doesn’t work to determine a stock’s value, how about market capitalization? As market cap, i.e., the total number of shares outstanding multiplied by the share price, is compared among companies, you would think that the one with the highest market capitalization would be the best value. By itself, market cap doesn’t tell you much about whether a company’s stock is a good deal or a bad deal. Companies have wide differences in net profit from quarter-to-quarter and consequently big differences in stock price.

Not to get too much in the weeds, but financial academicians and stock market professionals have struggled with market capitalization being the determining factor in a stock’s true value. The S&P 500, like most security indexes, is a capitalization-weighted index. The larger the member company’s market cap, the larger its weight in the index.

Unfortunately, cap weighting has faced much criticism. When the dotcom stock bubble burst in 2000, a group of investment experts came up with an alternative approach to cap-weighted indexing. They called it fundamentally-weighted indexes.

Fundamental Indexation is based on a security’s intrinsic value. One theory called efficient market hypothesis (EMH) states that the price of any given traded security reflects all relevant known and available information that any changes in the information are reflected instantaneously in the security’s price.

In other words, price always equals true or intrinsic value and market-beating techniques such as charting or fundamental analysis are simply a waste of time. Most market practitioners, however, believe that the price of a stock at any given time equals true value, plus or minus some random error or “noise.” In a competitive marketplace, there’s always a “noise” factor.

As you can see, determining the true value of a real estate investment is a relatively simple task while determining the true value of a stock is almost impossible. There is no “noise” factor when it comes to determining the value of a real estate investment. And, if you want to get technical, the definition of the intrinsic value of a company is the value of its tangible assets.

When General Motors and Enron went bankrupt, the intrinsic value of those companies and the stock’s value went to zero. The value of every investors stock became totally worthless. On the other hand, even if a property struggles to pay its bills, it still has value. At the end of the day, unlike a bankrupt company whose stock value is zero, a real estate investment has value because it’s a tangible asset. Somebody will want to buy it.

So, if you want to invest wisely for the future, invest in real estate not the stock market. There’s plenty of “noise” out there without having your investment portfolio become a part of it.