Real Estate Is the New Dot-Com

Residential real estate is fast becoming the Internet stock craze of this decade. And like the previous mania, house buyers in some parts of the country have thrown logical, fundamental valuation out the window. So if you're thinking about following the crowd by scooping up investment property, you might want to think twice--and first apply sound cash-flow analysis to your decision, similar to a common approach in valuing real estate companies. For that matter, if you're just a homeowner curious about whether you should cash out at current prices, it might be worth conducting this same fundamental analysis.

These two market crazes--Internet stocks and residential real estate--have more in common than many investors would like to admit. In both, speculation was rampant, buyers levered up to new heights to avoid missing out on a "sure thing," meaningless metrics and comparative analysis (price/eyeballs and property appraisals) garnered undue focus, and relevant multiples, such as price/earnings for stocks and the real estate equivalent--price/rent--were ignored.

Fortunately, there's no reason that smart investors need be burned twice by the same mistake--buying at inflated prices when they'd be better off selling. To avoid making poor choices, investors (the 68% of Americans who own homes) can toss out their property appraisal and instead turn to fundamental property valuation. After all, an appraisal in its typical residential real estate form is little more than a comparative analysis conducted by someone with no skin in the game offering little more than confirmation that other lemmings are paying too much for their homes as well.

The Truth Lies in NAV
Within commercial real estate, there is a widespread tool called the net asset value (NAV) model that is applied to a wide range of property classes: office buildings, warehouses, shopping malls, and apartments to name a few. At Morningstar, we currently apply a similar valuation methodology--though with a few more bells and whistles--to estimate the intrinsic worth of the dozens of real estate investment trusts (REITs) that we cover. With some minor modifications, any real estate investor can readily estimate the intrinsic worth of his or her home, valuing the property on a cash-flow basis, just as if it were a stock or any other financial asset.

In its simplest form, the NAV requires just four major inputs: annual rent over the past year, average maintenance costs per year, an average long-term growth rate in rent or property value, and a discount rate (called the cap rate in real estate). Without getting into the guts of the theory behind this model (plenty of explanations exist in finance texts and on the Internet), the NAV formula looks like this:

NAV = ((Rent - Maintenance Costs) * (1 + Growth)) / Cap Rate

If you're dealing with your own home--owner-occupied real estate--you can simply estimate the rent component by comparing your house to comparable rental homes in your area.

Next, to estimate the average annual costs required to maintain the property in its present state--no better and no worse--consider the two major costs: property taxes (net of the income tax benefit) and home maintenance such as periodically replacing appliances, fixing leaky roofs, and so on. For reference, most apartment REITs have costs equal to about 30%-40% of the rental income, and this seems a reasonable proxy for single-family homes as well. Next, you need a long-term growth rate estimate. This is a bit subjective--and will vary by region--but can be arrived at via CPI estimates (4.2% per annum going back to 1980) or by using home price data (which averaged 4.4% annually since 1980 if you ignore the past 5 anomalous years). Finally, the cap rate. Because real estate is a low-risk asset class, the cap rate can be derived by adding a couple of percentage points to the current long-term Treasury rate. Historically, apartment real estate has carried a cap rate of about 7%, and, given the current interest-rate environment, professional investors have been able to justify a cap rate of about 6%-6.5% in some recent cases.

Once this calculation is done, investors will also probably need to tack on a control premium. This is the value assessed for the net benefit of controlling the residence rather than being at the mercy of a landlord. Similar methodology has commonly been employed in the stock market, most frequently during merger analysis, and the premium has typically averaged about 20%-30%.

Now that you've calculated the intrinsic value of your home, you can compare it to what similar properties are going for. If sale prices are far above what you came up with on an intrinsic basis--enough to justify the realtor's commission and moving costs--it might be time to pack your bags. The key in conducting your own fundamental real estate analysis is to use reasonable estimates. No one besides you is going to be hurt if you use aggressive assumptions. You're the one who will overpay for a house or miss out on the option of cashing out of an overvalued property. When conducting your analysis, the most aggressive case that you'll probably want to run would include setting your cap rate equal to a long-term Treasury bond, currently about 4.4%, and the growth rate of about 10%--assumptions so high they made my REIT colleagues nervous. After all, even assuming real estate is as riskless as Treasuries (it's not) and that national price appreciation follows long-term trend lines similar to the past five years (it won't), many buyers in hot markets such as California--the current hub of real estate frenzy--will find that there's no way they can justify the current market price of their homes.

Consider one city I investigated: San Diego, which has been one of the nation's hottest markets, with a median home having appreciated a whopping 107% from 1999 through 2004. While every regional property market is unique--and no two houses are perfectly comparable--we can make some reasonable estimates of fair property values. In my searches of numerous rental house listings in San Diego, it seemed possible to rent attractive four-bedroom homes in good neighborhoods for about $2,000 per month. Using extremely aggressive assumptions--a 4.4% cap rate and 10% growth--I arrived at a maximum fair value of about $546,000 for a house of this type. Yet, the median price of an existing home in San Diego County was $593,600 in April, according to the California Association of Realtors, and homes comparable to the rentals I found were listing for $600,000 to $700,000!

Price/Rent Ratio
It's worth noting for investors conducting an NAV analysis of their home that this exercise really boils down to one easy-to-understand multiple--price/rent--just as the price/earnings ratio is shorthand for the value derived from a discounted-cash-flow model. This price/rent ratio can be thought of as the intrinsic value (price) of the house relative to the rent you'd receive from it.

In my own analysis, I found that a reasonable range of price/rent multiples--no matter where the property is located--ranges from about 9 at the low end to 23 on the absolute high end. To arrive at these multiples, I assumed two scenarios. In the aggressive case, I assumed a cap rate of 4.4% (the Treasury rate), an NOI margin of 70%, a growth rate of 10%, and a control premium of 30%. In the conservative case, I assumed a cap rate of 7%, an NOI margin of 60%, no growth, and no control premium.

Interestingly, U.S. homeowners already seem to have an implicit understanding of the importance of the price/rent ratio. The Federal Reserve Bank of San Francisco published a fascinating research study last fall analyzing the fundamental pricing of houses. Using government data, Federal Reserve researchers compared U.S. housing prices to rents going back to 1982, and found that they've generally risen hand in hand--until recently, when home prices rocketed to all-time highs compared with rents. However, what's curious is that the rent component of their study focused on Consumer Price Index data, and this data is estimated at least partially through surveys of homeowners asked to assess what their house would rent for on the open market. So while the debate currently rages in the news media over whether homes are overvalued, U.S. homeowners have already tacitly admitted that homes are overpriced--even if they haven't said it in so many words.

For what it's worth, my one predicted difference between the Internet era and the Real Estate era is that the latter won't end nearly as badly as the former. Unlike the Internet mania that propelled worthless stocks like eToys, Pets.com, and WebVan into the stratosphere, residential real estate certainly has a lot of intrinsic value. It's just that some people are paying too dearly for home sweet home right now.