Carol Wydra, 56, is a tried and true value investor. Buying undervalued assets and selling overvalued ones is her passion. So in July 2005, when she read a post on her favorite Web site, valueforum.com, that said real estate prices had hit their peak, she took it to heart.
Wydra and her husband were already thinking of moving, and decided the time was right to jump off the housing bubble. So she put her four-bedroom, two-and-a-half bath colonial home in Williamsville, N.Y., up for sale, and it was sold in two weeks. She got $335,000 or $110 per square foot for her house, which is located about 12 miles outside of downtown Buffalo. She firmly believed that she had "sold high."
Now her quest was to "buy low" using a value investor's approach to home buying. After doing some research she determined that the Nashville, Tenn., area appeared to be both desirable and undervalued. So Wydra put her belongings in storage and moved to the region, staying in residence hotels while she looked for her new home. Her husband, a marketing executive, lived in a rented apartment in Santa Monica, Calif., where his company is based, while she pursued her quest.
Wydra spent three months living in hotels looking for her new residence, making her dinners with the one small pot she carried from hotel to hotel and doing her laundry in hotel washing machines. Why put herself through an ordeal?
"I wanted to prove that you could use value investing discipline to buy a home instead of dumping my gains into another inflated house," she says. Indeed, most home-buying in recent years has followed the "momentum" or "growth stock" model. Realtors understandably pitch the "buy high, sell higher" approach and in some resilient markets like San Francisco and New York City, this generally has worked well.
But Wydra wanted value and she insisted she wouldn't pay more than $100 per square foot for a one-story new construction house. According to trulia.com, the median price for four-bedroom houses in the Nashville area last year was $113 per square foot. "I got little encouragement from agents. They told me my house did not exist, and that if it did, they would have already purchased it," says Wydra.
Patience finally prevailed. After looking at 200 houses, Wydra found exactly what she wanted: a new four-bedroom, three-bath ranch house with "wide hallways, shiny new hardwood floors, soaring ceilings and a great kitchen" in Lascassas, Tenn., for $295,000, or less than $90 per square foot. She picked Lascassas because of its proximity to Nashville and Mufreesboro, Tenn., areas that are booming in part because of a new auto plant from Nissan. A couple of months after she closed on her purchase, a house across the street sold for $120 per square foot. Wydra says she’d do it all over again in a heartbeat.
In the stock market, being a value investor means buying stocks when they are trading at low prices relative to underlying fundamentals--things like earnings, cash flow, assets or book value. Eventually these inefficiencies disappear and value investors are paid off handsomely. However value investing takes lot of hard work, patience and an ability to quiet one's emotions. This isn't the way residential real estate is typically bought and sold.
But there is a new reality forming in real estate. Houses are sitting on the market longer, the subprime end of the market is a mess and new home sales are in the doldrums. Should home buyers adopt a value approach to the market?
Wydra is an extreme case. She even calculated a real estate version of a price-to-earnings ratio. To find it, she divides the purchase price of a house by the rental income she could expect to get in one year. Her old house sold at a “P/E” of 10, and she bought her new house at six.
David Lereah, chief economist at the National Association of Realtors, has a somewhat similar strategy. But he uses it to compare markets--not individual houses--to one another. Divide the mortgage debt service in a market by the median household income in that market. (Using mortgage debt service rather than median purchase price shows the cost of borrowing money in that area. And using median household income, not your own, gets to the cost of living in the area.)
For instance, says Lereah, Las Vegas was at a “P/E” of 27 in early 2006. That compares to a historical average of 22 for Las Vegas, and might have been a warning that prices would fall. Even higher is San Diego, at 40. But Lereah doesn’t think that San Diego would have to come back down very far, certainly not down to the national average of 18 to 22, to be fairly valued, because he says there are factors (culture, industry, weather) that raise the value of cities in California and many other markets.
Historically, San Francisco sits in the 25 to 28 range for Lereah's "P/E" ratio, and Louisville, Ky., averages 10 to 15. Those differences are lasting, and so you shouldn't buy a Louisville house thinking it'll rise to a San Francisco valuation. It works the same way that U.S. Steel trades at a P/E of just nine, even after months of tremendous gains, while tech company Apple Computer trades for 34 times earnings. Different industries trade at different premiums.
That distinction between the historical valuations of different markets is why several real estate investors say that “value investing” in real estate is actually a dangerous strategy. In the wake of the recent real estate boom and bust, lots of markets have come down in price considerably. It’s easy to confuse a cheap house in a good neighborhood--you’ll need Wydra’s brand of patience to find one of those--with a neighborhood that has declined in price across the board and may not come back up.
Many markets were propped up by speculation, say experts, which in real estate comes in the form of houses classified as second homes and “investment properties.” When prices come down and that demand subsides, what’s left is demand from people who want to live in a certain market. Unless you’re certain that there’s going to be an influx of new people, you shouldn’t count on that demand changing.
Says John Hogan, president of homebuilder Viscaya Development Group in Atlanta, “I wouldn’t be a pioneer right now in terms of searching in transitional areas.” Instead, he explains, there are opportunities in markets that have held their value. Don’t look for a house on the fringe when you can find one in town.
Further, says Hogan, following the price dips in markets that are suffering, like many of Florida’s submarkets, will lead to more pain. “I don’t think that Florida has bottomed yet. There’s still a lot of extra inventory in Ft. Myers, Miami and Jacksonville,” he says.
The other risk of buying in areas where real estate prices have recently gotten a haircut is hidden supply waiting to come back onto the market. Dan Cooperman, a managing director at Terra Capital Partners, a firm that has $3.2 billion worth of real estate, says that a lot of developers stopped building when prices came down, but any increase in housing prices will lead them to start building again. When that happens, housing supply will go up and it’ll be harder for homeowners to sell their homes for a gain.
It’s not hopeless to take a chance on dicey locales. Taconic Investment Partners made good money betting on the Manhattan neighborhood of West Chelsea a decade ago, where it owns the building where Google now has its New York offices. The firm is currently betting on the East New York section of Brooklyn to shed a negative reputation and gain in value; Taconic recently bought nearly 1,000 housing units in the neighborhood.
What does Taconic look for? Charles Bendit, a principal at the firm, says that he wants to see other investments in a neighborhood, and that he wants to see that those investments are having an impact. He points to the Gateway shopping center in East New York. If it had opened and not gotten shoppers, then he would have passed on the neighborhood. But instead it’s been successful, and that speaks to a neighborhood in the process of revitalization.
Interestingly, although Bendit buys neighborhoods that seem cheap, he buys neighborhoods that are already getting investment. Here, he’s waiting to see a signal that there’s money flowing into a market, and he is following that momentum. It’s a strategy that more closely resembles growth investing.
Not that there isn’t bottom fishing to be done. Cooperman, of Terra Capital Partners, recommends hounding the loan officers of local bank branches to see what foreclosures are imminent. Make an offer just as the bank forecloses on a property and they’ll be happy to be spared the loss of the mortgage payments. If you don’t have the stomach for investing in foreclosures, stick with buying a house that you actually plan to live in.