The Great American Real Estate Giveaway

As the media reminds us on an almost daily basis, many sectors of the real estate market are in the midst of one of worst adjustments since the Great Depression. This is evidenced by the most recent California Association of Realtors (CAR) publication on existing home sales which reported a price decline in the median selling price of 35.3% from a year earlier. During the worst 12 month period during the Great Depression U.S. housing prices fell by a less dramatic 10.5%. For investors with high tolerance for risk, it may now be time to embrace the timeless proverb “buy low – sell high” and start sifting through the wreckage for bargains. And while bargains exist, they are not available universally across all locations or property types. Investors must know where to look, have proper guidance and understand the proper methods for valuation. The sectors with the most opportunity are single family residential properties (SFRs) in class B or B-minus locations of suburbs outside major metropolitan areas. Properties in many metropolitan markets have adjusted very little, while towns in extended metropolitan areas (MSAs) have deteriorated acutely.

Using the San Francisco MSA as an example, CAR statistics released for June 2008 indicate a year over year decline of 4.3% for San Francisco proper. Comparatively, the median selling price in Vallejo, California, a suburb about 30 miles outside of San Francisco, has decreased a much more dramatic 37.3% year over year. Vallejo is still accessible to San Francisco via public transportation including frequent commuter bus routes, Ferry access, casual car-pool access and BART access from the Richmond, California station. Furthermore the statistics do not fully reflect the willingness of banks and distressed sellers to negotiate on a case by case basis in these markets. As an example, one of our investors is currently purchasing a SFR in Vallejo for 4,500. In this instance the property is being acquired for a 65% discount relative to the implied valuation on June of 2007 (based on comparable sales from First American Title Company). Although this 65% discount is tantalizing it should not be a deciding factor in the decision to purchase the property.

Using a discount to market value approach is a fools approach to valuation at this point in the current environment, because it assumes that historical prices were rational. A discount to market value won’t pay the mortgage and it doesn’t ensure that the home will be affordable to prospective buyers when an investor is ready to sell. Investors should alternatively use an income approach or an affordability approach to valuation.

For example, consider the Vallejo property discussed previously. From an income approach (assuming a 30% down-payment), the cash on cash return is about 11.6% per year and the cap rate is 9.54%. From an income standpoint this is an attractive cash yield. It handily exceeds the national average money market rate of 2.99% annual percentage rate and the 2.90% average dividend yield for S&P 500 non-zero dividend stocks. This additional return offers substantial compensation for the additional risk and management responsibilities required for this investment.

From an affordability standpoint the medium household income in the zip code is ,030 per year. Most lender underwriting guidelines consider that 28-33% of household income is an allowable limit for housing related expenses (rent or mortgage plus taxes and insurance). Using this guideline as a benchmark, the average household in this zip code can afford ,000 per year (,250 per month) toward housing related expenses. The mortgage payment for the Vallejo property will be approximately 0 plus monthly expenses of 0 (taxes, insurance, and repairs/maintenance) which is comfortably below the affordability implied limit of ,250 per month. Assuming a 90% loan to purchase price and a 7.0% fixed rate mortgage, this property could be purchase by the median household for up to 2,000. This represents a 70% premium to the purchase price of 4,500. As a cautionary note, valuation based on affordability won’t guide market values until the mortgage market returns historical underwriting guidelines. Further details of this transaction are posted on our website www.unitedinvestors.com >> education center >> sample property.