Understanding Single-Family Home Property Values

I recently attended a party with some of my wife’s new friends with whom I had never previously met. Almost every time this happens … no each and every time this happens at any social gathering, the wives disappear to a separate room to have what I’m told is “real conversation” as opposed to the allegedly superficial “guy talk” that supposedly goes on after their departure. Incidentally, there is nothing shallow about sports!

But then it happens, I am asked the inevitable ice breaking question, “So what do you do?” Of course I mention that I am in real estate, as an educator, agent, and radio show host but I am primarily a real estate investor. The questioner universally reacts with a dramatic and painful facial expression while simultaneously exclaiming how he would never do such a thing.

So naturally I ask, “Why not?”

What usually follows is some string of excuses ranging from fear of tenants or the lack of tenants, that it’s not the right time “for me”, or competition. Whichever of these or other ‘reasons’ are given it is a conclusion that I would suggest is based on false information. It used to be that the most common issue for folks is they heard somewhere that managing real estate investments is nothing but a hassle. It isn’t, and I explain why it isn’t in my article on property management in the Lifestyles Unlimited® article archive.

But more recently the most common fear that is expressed is a concern over the real estate market—of ending up with a property in which a market turn caused loss in value. There is much to digest here because the media coverage of real estate prices significantly falling in some markets around the country has compounded this fear. Recent legislation regarding appraisal rules has had an effect as well. While many have just given in to these stories and chosen to ignore real estate as a viable place to invest, others recognize the significant opportunity at hand but at the end of the day just don’t have enough confidence to follow through with actually purchasing an investment property.

Once you have completed your core real estate investor training, it is time to begin your Action Plan. Property evaluation is the 3rd step of your Action Plan; there are actually 2 others that precede it, but …

Property evaluation is the most important duty of any real estate purchaser; both the real estate investor and consumer alike.

Obviously there are other components to a proper property evaluation than just determining a correct value; revenue items like rents and repair fees (yes, repairs that you administer for which your tenant is responsible should actually be a profit center), and expense items like taxes and insurance are important, too. But our scope today will focus on determining a dependable figure for a property’s value. This next statement might be one that is difficult to accept, but it is true nevertheless. There are many types of valuation models, used by different parties, which are used to achieve a specific, predetermined result. In fact, my copy of Texas Real Estate Practice, 9th Edition, lists 8 kinds of value, and explains that each can be interpreted differently. Is it any surprise that the taxing district values your property more highly than your insurance adjuster? Is it any wonder that the Harris County Flood Control District will not accept the appraisal from the Harris County Appraisal District to determine property value in it’s buyout program? It is for this reason that I encourage you, no I urge you to obtain access to accurate and reliable data with which to make your real estate investing decisions.

I would like to make one point on valuation models before getting into the meat of the material, and for my own fun I think it might to throw you off just a little. The interpretations of data that you will encounter as a real estate buyer are varied. Market value is not always the best model to use for determining the “real value” of a property. Whatttt???????? If calculated market value exceeds replacement value, and it can during a strong expansion phase of a market cycle, then use replacement value (the lower of the two). This is how much it would cost to purchase a lot and build an identical structure in place of the one that is there now. Because of the scarcity of land, cost of labor and materials, and the weakening US dollar, the trend for this curve is almost always an incline; after all, it represents inflation. This wrinkle is a more complex idea that also has some extremely fascinating timing and financing considerations as well. I encourage you to attend Del Walmsley’s Financial Freedom Program Seminar, where I learned them, for the specifics, but the basic illustration for replacement value looks like this:

Figure 1: Replacement Value (Solid black line)

coins

Market value is what we usually think of as a property’s value, which is commonly illustrated by the supply and demand curve. It is defined in Barron’s Dictionary of Real Estate Terms as “the theoretical highest price a buyer, willing but not compelled to buy, would pay, and the lowest price a seller, willing but not compelled to sell, would accept.” And in the example of market value that my copy of the dictionary uses there are phrases like “normally active market” and “allowed to stay on the market for a reasonable time.” Now based on this definition of value is it appropriate to include foreclosures as comparable sales in your analysis? At none of the three stages where you’ll find foreclosure properties does a foreclosure property qualify as comparable to your subject property. These houses or sellers do not pass the compelled to sell and several other tests to meet the standard. On the other hand, the nonforeclosure sales activity already reflects the presence of foreclosures in the marketplace. Remember, those properties are actual sales—that means they are comparable. When we add this kind of value curve to our illustration it looks like:

Figure 2: Market Value (Dashed Blue Line)

coins

It would be expected then, since a real estate appraisal is an estimate of value that the formal appraisal report that is required by lender underwriters would reflect comparable sales where the principals were not under duress. Unfortunately this is not true and appraised value is calculated differently for several reasons. A prominent one is that legislation regarding appraisal rules has changed the way appraisers even approach the value of a home, reduces the amount of time available to conduct an appraisal, and regrettably has diminished the quality and accuracy of the reports in many cases. Namely, industry professionals are reporting several problems with the new HVCC (Home Valuation Code of Conduct). In fact, the Texas Association of Realtors has gone so far as publishing an article on their website that makes a distinction between two interpretations of value titled, “Market Value Versus Appraised Value.” Recognize that the appraiser’s charge is to prove to the lender that a subject property represents sufficient collateral so that in the event of a foreclosure the lender isn’t likely take much of a loss, if any. In order to ensure that their evaluation is on the conservative side, they are including foreclosures in their analysis even though these sales do not reflect true market value. Conversely, during the expansion phase of a market cycle these conservative restrictions vanish and appraisal reports many times over-estimate a property’s value. Let’s add this curve to our graph:

Figure 3: Appraised Value (Dotted Red Line)

coins

So what then is a reliable method of evaluation? Should you just use the assessed value from the tax appraisal district? Ha, hahaha, ha, Hahahahahahahaha, hahahahahahahaha, hahaha, ahem, ahem, hahahahahaha. Please remember from the discussion earlier our example that the Harris County Flood Control District will not accept the appraisal from the Harris County Appraisal District to determine property value in its buyout program. There are two reasons that the Flood Control District requires an independent appraiser. First, it helps create an appearance of non-collusion. Second, the district is well aware that the current system of appraisals with negotiated protests favors the informed and skilled homeowner and creates inequities in valuations of comparable and even identical properties.

Trent Yeo’s article on this website details this process and explains why. Please do not even consider using the tax assessed values in any part of your valuation analysis. This is so ridiculous a concept that it would ruin our pretty graph with its inclusion.

I suggest that you perform your own property evaluations to determine the investor value. Remember, property evaluation is your most important responsibility as a real estate buyer. For this reason you’ll have to gain access to real historical property sales data. That is, find out what properties like yours—those with similar amenities in the same neighborhood—actually sold for. Real estate brokers and agents have access to this data and can provide it to their customers, but when you are an investor buyer who must act quickly, you’ll need access directly. Plus, some unscrupulous agents can manipulate the data to achieve a desired result. When you calculate your subject property’s market value, exclude foreclosures from your list of comparables. However, remain cognizant that neither your lender nor your lender’s appraiser will perform their evaluation in this manner. Therefore to calculate your rates of return you’ll need to complete a blended analysis that uses both methods. Damon Janis, the developer of Lifestyles Quest, which is an evaluation tool available by subscription to Lifestyles members that also helps to obtain comparable sales, teaches this blended approach at a Lifestyles Property Evaluation Class every month. Take a look at the figure below and consider, after adding investor value to our graph, the relationships between value types. We’ve found that, true to Pareto’s Principle, 80% of our investment properties are on this curve. Please note that in some cases the bank appraisal will actually understate the value so much that it comes in even below the investor’s price.

Figure 4: Investor Value (Green Line; alternating dashes and dots)

coins

Now for one last bit of fun, let’s take a look at adding rents to the picture. The reason I find this so interesting is because of the inverse relationship in the pricing direction between the two. It is often the case that the direction of rent prices has an inverse relationship with home values. One example: many homeowners decide how expensive a home to purchase based on the payment they can afford. So when interest rates rise faster than incomes, families cannot afford the same home as before and many decide to wait to buy. So they rent, resulting in increased demand for rental homes and subsequently an increase in those rental rates. Therefore, a landlord’s income rises during the contraction phase of a market cycle, while acquiring more substantial equity positions at the same time. Those equity positions are then realized through a sale or refinance and re-leveraged during the recovery and expansion phases of the cycle, and the process repeats. Adding rents to our graph looks like this:

Figure 5: Rent to Value Relationship (Rents = orange dashed line)

coins

When a real estate buyer, investor or otherwise, is armed with accurate, reliable, credible data, then he can move forward with confidence and speed. Please evaluate where you think we are in the market cycle, and which approach will offer you your greatest opportunity. As you take steps toward your next real estate purchase, whether that means attending a workshop or seminar, or signing on the dotted line, I hope to hear your success stories at the next Lifestyles event … while we also talk about last night’s big game.

By Jeff Smith, Real Estate Agent with Lifestyles Realty

Comments

  1. Great article. Note that when mastered, you can determine your investor value in about 5 minutes with a tool like Lifestyles Quest.

    I remember when I first started investing, running my comps, verifying with my mentor and writing offers less than 30 minutes after hearing about a property.

  2. Bill Edwards says:

    The information contained in this article is just another reason why I have added Jeff Smith to my list of personal mentors. I marvel at the depth of understanding Jeff has for this business and this market.

  3. Brian Carter says:

    How can I get access to Lifestyles Quest?

  4. Jeff Smith says:

    Thanks for the encouraging words fellas … I’m kinda turnin’ red, Bill.

  5. Carl Lentz says:

    Lifestyle Quest is well worth the cost and is invaluable in determining comps. You can cancel whenever you want.

    This is a great article on valuation. It’s tough to figure out real value with all of the foreclosures, short sales, and damaged properties

  6. Bryan Phillips says:

    Jeff,
    I am not yet a member, but I’ve listened to your show a long time. I have run across a VERY EXCITING way you and your members can have their mortgages paid off. It’s too complicated to go into in this little box. Don’t worry I’m not selling anything it’s just something I ran across and I’ve seen it work with a friend of mine and his $83,000 mortgage was paid in full. Feel free to email me and I’ll forward you the detail for you to check out for yourself.

  7. William McGowen says:

    Not yet a member, and don’t have any obscure message as above, but I was wondering if Lifestyles Quest was specifically targeted to Texas, or if it can be used anywhere in America?

  8. Jeff Smith says:

    William, Quest is currently TX specific.

    Bryan, most growth stage investors are more interested in investing in additional properties with their cashflows rather than a using them to pay off the mortgage faster, but adding a new layer to the graphs above that shows principle reduction occuring with relationship to any of the valuation models is intriguing.

  9. @Jeff

    Excellent post! I’ll be using some of your points in my next Single Property Evaluation class next week.

    @William

    Quest has the MLS rights to the Austin, DFW, Houston and San Antonio markets right now. These are the only markets that we can access to our members to pull the historical MLS sold comps.

  10. Doug Freeman says:

    Jeff,
    Great Information! This makes it very evident that historical and accurate sales data on the subject property is THE key to determining real value as an investor. B. Batson in the DFW office taught the SFPE class this past week ( my third time attending-I learn something new every time)and while doing the evaluation included a foreclosure in his analysis. This in effect gives the “blended” evaluation you talked about in your post correct?

  11. Jeff Smith says:

    Not exactly. The mv of the house is the cma w/o distressed sales (unless the subdivision is all or mostly foreclosures), bc those are actual sales. The equity based on that figure is real whether the lender agrees or not. But if your loan is a fnma product you’ll need an additional analysis for financing that includes foreclosures, like the one that Bryan did.

  12. It is all about understanding real estate valuers in any market blog summary..which is really good & very useful to all real estate persons..thanks to share it .

Leave a Reply to Steve Cancel reply

*