Real estate: an old fashioned rent-based view |

Real estate: an old fashioned rent-based view

As a fundamental value investor, I am constantly searching for undervalued assets. By undervalued, I mean assets that cost less than the discounted cashflows they might produce. There are a lot of assumptions, caveats, personal biases that go into that calculation and it is never clean, no matter how simple some snake-oil salesmen make it out to be.

As we’ve discussed in previous posts, real estate (whether it be physical land or capacity on a fiber optic network) tends to siphon off excess profits. Not suprisingly, when excess profits are high, real estate generates outsized returns. As margins are squeezed, and excess profits are slumping, real estate will follow. As a value investor, I try to analyze real estate based on the cashflows expected (accounting for wrong assumptions by trying to build in certain cushions).

So are we at a bottom in real estate prices? Here’s a link to a WSJ article on the recent decline in housing prices around the country.

http://blogs.wsj.com/economics/2009/05/12/home-prices-and-jobless-rates-by-metro-area/

This article did a better job than most in pointing out the unemployment rate associated with the different regions. The questions we should be asking ourselves is not whether real estate can fall further, because it definitely can. The question is whether cashflows, income available to pay rent, population growth, and job security have stabilized or are increasing on the income side and taxes, mortgage payments, construction costs, etc. on the expenses side are stable and/or falling. Let’s make a little check list:

Income available to pay rent: stable? I don’t think so. The commercial side is facing declining margins from retailers that are already troubled, office space (in almost every class building) is on the rise as are subleases from shrinking firms looking to offload some space, and consumers are not seeing any rise in disposable income that they are putting towards rent.
Job security: still negative.
Population growth: if the unions have their way, anemic immigration will become even slower and our 2.1 birth rate will not allow for significant long term increases.
On the expenses side, mortgage payments: not going any lower, might be rising.
Taxes: not going any lower, might be rising (already rising on local level to make up for budget gaps).
Construction costs: were coming down, now, not so much. Everything from copper to heating oil is up and doesn’t look like it’s going down in the near future.

Where does that leave us? The only real estate that would make sense in this environment is on the low end, which is where I’ve been looking. Rentable low-end properties with stable residential leases. Cap rates were down to below treasury yield, but have now doubled, or tripled and are back up to respectable levels (if you can hold on and come with the equity).

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