I have been reading the book ‘Seeking wisdom – From darwin to munger’ which talks of various mental models and applying them to a problem to analyse it in detail.

The book is itself inspired by charlie munger and his lecture on the same topic. I have attempted to apply some models to valuing and analysing real estate.

The first post was valuing the real estate as a financial asset like stocks and bonds

The second post was trying to invert the problem.

The third post was looking at psychological baises in valuation of real estate. I will follow up with more posts on the same topic with other models.

I would like to add a personal approach for a first time buyer (buying for personal use)

If you are buying a house to stay (not investment), the maximum value of the investment would be driven by two numbers – EMI and personal debt to equity.

Let me explain
Suppose I earn 40000 as net income. My current networth ( all stocks, bonds, cash etc) is 10 lacs (10 lacs = 1 million). To be on the safe side, I would look at a house where my EMI is around 16000 / month (40% of net income)
So based on the above EMI, I can afford a loan of around 16 lacs at an interest of 10% for a 20 year tenure.

Assuming I have to put up 20% of the value of the house, I would look at a maximum investment of 20 lacs (2 million).
For a 16 lacs loan, my personal debt to equity is around 1.6 (16/10). This is higher than what I am comfortable. However it is not too high if you are in your 20s or 30s and have a long career ahead.

The above is a very simplistic approach and may sound conservative. But I prefer to plan for adversity and for a situation where things can go wrong. Buying a house as a first time buyer is less of an investment for me and more of having a roof on my head (in worst possible situation).

Some bad reasons for buying real estate
– Because the price has risen a lot lately or because the broker is predicting a rise.
– Because one can never lose in real estate
– Because your friend is buying it
– Because you can get a loan to buy it
– FII / Institutional investors are investing money – This is really a strange reason. FII/ foreign investors may have a good reason or maybe they are just following the herd. Just because an investor is an FII does not mean they have extra brains. Sometimes they are worse than an ordinary investor

A few links to value real estate
http://en.wikipedia.org/wiki/Real_estate_appraisal
Real estate valuation and analysis – read on the Cap rate which is similar to the P/R ratio
Deepak shenoy’s real estate cash flow calculator – Excellent worksheet to value real estate. Please read his terms.

I think there are several psychological baises working in case of real estate. The first is incentive caused bais. Typically real estate is sold via brokers or by sales agents of the builder. They have an incentive to sell the property and typically earn a commision based on sale price. It is quite obvious that the broker or sales agent would be motivated to sell at as high price as possible. In addition it is likely that he will give you a bullish outlook for the property prices.

The second strong bias is social- proof and deprival super reaction tendency. You see you friend buy a property and make easy money. At the same if you have not invested money and feel deprival super reaction tendency as everyone one else is making easy money.

So these two tendencies work together and motivate us to look for a property. Combine this with the incentive caused bias where the broker is constantly trying to create a scarcity (he will tell you that he has a lot of buyers and even you don’t buy now then the price will go up), lack of information and overoptimism on our part and this creates a combined effect. All these factors add up and can cause the buyer to become irrational.

I personally think the risk of bubbles are higher in real estate for the following reasons
– the common notion that real estate cannot lose value and represent something limited which is land
– High amount of leverage. Typically loans on a property is around 20%
– Lack of transparency and information in this market.
– All the above psychological factors

As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

If like me you believe the basic definition that the intrinsic worth of an asset is the sum total of all the cash flows one would receive out of an asset from now onwards, then real estate could be analysed using the same approach as stocks or bonds.

Using that logic, we can say that there are two components to the cash flow
1. Rent which is equivalent of dividends
2. Final sale price of the asset (real estate) which is the same as the sale price one would get from a stock or bond

Like stocks, it is easy to get the value of rent (or dividend), but difficult to get the final selling price. In case of real estate the final selling price would depend on the state of real estate market, interest rate, economic activity of that area and location of the real estate. This is similar to stocks where the final selling price depends on a large number of factors, most of which cannot be predicted.

Using the same analogy, if it is possible to value a stock roughly, if not with precision, then one should be able to get some idea whether the real estate asset is under valued, over valued or fairly priced.

I recently read an article in fortune on real estate valuation, current pricing and likely future of the same in the US
Real estate : Buy hold or Sell

I have included a few paras from the article which are very relevant for valuing real estate

Many factors determine the value of a house. A family would consider the quality of local schools, the number of bedrooms, the size of the yard. Economists assessing a region look at interest rates, employment, and population growth. But over time the most reliable guide to home values is rents.

In most markets people won’t lay out much more in monthly costs to own a house or condo than they would to rent a similar property unless they expect a huge profit when they sell. Indeed, speculators chasing quick profits did a lot to inflate the recent bubble.

But once the fervor fades, prices must fall to restore their normal, long-term relationship with rents. Rents exercise a kind of inevitable gravitational pull on prices. The ratio of prices to rents “behaves much like price/earnings ratios for stocks,” says Yale economist Robert Shiller. “Like P/Es, price-to-rent ratios are mean-reverting.” In other words, while prices soar from time to time, sending the ratio to exceptional heights, sooner or later the relationship is bound to return to its historical average.

The last para above is very important. Kaushik in his blog has posted several times on the rent for several properties in places like bangalore. Although this is anecdotal evidence, I would not discount it completely.

So based on this evidence if the rent is say 20000 per month, we are talking a valuation of 48 lacs for a 3 bedroom apartment ( 1 lac = 100000)
Rent = 20000/ month = 2.4 lacs p.a. For P/R ( price to rent like PE ratio) of 20, the valuation is 48 lacs.

The only variable in the above equation which can be debated is the P/R ratio. I will discuss about this in more detail in the next post, but think of it this way – the inverse of P/R is the yield on the real estate. For P/R of 20, the yield is around 5%. Globally, most investors demand a yield of 5-7% on an average. So a P/R ratio of 20 is around the average and may not be too low.

Net post : Looking real estate valuation using the ‘invert the problem’ approach.