Price vs Value(or why not to read the news)

Markets are fleeting. One minute they are new and edgy giving you a status boost to the stratosphere , the next they have you left with a hefty bill, little liquidity,and a feeling of pessimism that makes you shiver at the thought of taking another chance. But they do create the chance for profit and that opportunity is a window that is eventually going to close because prices are based on perceptions not necessarily value(as anyone who lived through the dotcom boom will remember) and perception and value eventually start to come closer together.

Value is something that is underlying and fundamental to a product. It is based on more tangible and often numerical variables that and can be analyzed. Take for instance a bottle of wine. There is always a value to wine, the value you get from drinking it, but the price of a wine can change due to many underlying variables that flucuate like tastes and also I was intrigued to learn , the weather.

Orley Ashenfelter is a Princeton economist  who came up with a model for predicting the prices of bourdeux wines that was based on four important factors. His paper titled Predicting the Quality and Prices of Bordeaux Wines is available here(I'd really recommend glancing through it). The variables that he used were the vintage of the wine(year and maker), winter rainfall, summer temperatures, and harvest rainfall. Using these variables he was able to make predictions about what the best years would be(in terms of price) about what wines would fetch at the time of their maturity.His analysis was met in the wine community with harsh criticism from the tasters and magazines like the Wine Spectator, who ended up disallowing his private journal to advertise. There was an obvious clash with those who felt that their expertise was threatened if someone could essentially do more(predict with greater accuracy) while doing less(not having to sit and taste the wine every year). I bring this example up because I think it provides a really good analogy to starting to analyze the housing market and the difference between looking for factors that will help predict price movements before they happen(like Ashenfelter did) versus looking at what the housing market is doing now(like the tasters do with wine).

This post initially started as a thought I had after reading this article titled "Twin cities home values still skidding downwards" . I immediately disagreed with the title of the article because the analysis has nothing to do with home values, but everything to do with home prices. I felt like I was reading an article by a taster, not an investor. The article creates for me at least a feeling of pessimism about the housing market. I would of course have to agree with the premise of the article that  prices are going down, but that may actually increase the value of the home to a buyer(like myself).But the other thing that is tricky with markets is timing.  A taster can not taste what isn't there yet. If there is a population of people who are getting jobs now(and won't be eligible for a mortgage for 1 year) and rental prices are going to go up(but haven't gone up yet) then a "tasting" of current prices is unlikely to be seen in current housing prices(meaning there may be some future value). Information is often revealed non-linearly, which is why all markets when graphed share a characteristic self similarity. They look squiggly and have jumps like this.

So what I would like to do is find a set of adaptive variables that I can use to model future home values at rate that is better than what I can get by watching or reading the news.  I don't expect to perfectly predict the future(that would be hubris).  However like the wine in the bottle there may be shifting underlying dynamics that are based on a set of initial conditions(like the weather) that end up making the rise in home prices more predictable. I also don't intend to try to predict anything too big(like the total US housing market), but instead will try to focus on localized commutable areas like the southern twin cities using these factors. The data I will use will focus on modeling next years prices in a local area based on these factors from the previous year.

winter rental prices(makes buying more attractive to renters)
summer job market(increases number of buyers)
harvest weather(cheaper food prices)
gas /transportation prices(changes costs to buyers)

Like wine in a bottle the time to maturity may be longer than 1 year but my attempt is to use this to influence my wife and my sense of urgency to buy(if we need to have one).

What should I offer? -The buyer's dilemma

It is a rare occurrence in America for a price to be negotiable, at least it is when you take into account the frequency at which we trade for things. I go to the shopping mall to buy pants and all the prices are already listed. I can't exactly go up to the cashier and say "34.99 for these pants! How about 28.50?" I would most likely be met with strange looks and perhaps an offer to sign up for a store charge card, which  I do not want. Yet when it comes to the really big things we buy or sell in our lives: houses, cars, or even ourselves when we negotiate prices for our services the bartering system is often in play. Yet I find myself often out of practice because it seems like I am often being asked to shoot a 3 pointer from half court for a 100,000 dollars, when I've not even practiced hitting layups or jump shots. I would wager that a trained shooter would be at least twice as likely to hit the shot as an untrained one.

So I have come up with  few tools based on both the advice of friends and family, my experiences in more barter friendly countries like Greece, and historical price data from Robert Shiller's excellent book Irrational Exuberence.

Offering to individuals

Making an offer to an individual is a far different prospect than making an offer to a bank. An individual is more likely to be offended by an extremely low ball offer, or a perceived attempt by the buyer or seller to squeeze every penny they can out of the opposing party( see carmelo anthony to nets negotiations).

So you are in a situation where you would like to get a good deal, don't want the negotiations to drag out, and don't want it to appear like you are trying to squeeze someone.

So if offering on a personal house the first thing you want to know is how much a person bought the property for. This will hugely effect what you can offer, not only because they will have a loan out for that amount on the house, but that they will be anchored on that number. Next I would learn what I could about the real estate market from that time, was it overpriced or underpriced?

When you look at historical trends in home prices, as Robert Shiller did, he found that real homes prices in the US since 1890 rose only .4% a year through 2004*. Moreover most of the increases occurred in two brief periods, the first directly following WWII in the baby boom and the second being the response to the 1990's stock boom. So how can I use this in placing an offer on an individuals home? I can use the 1997 or earlier value of their home(the real boom started in 1998) and then appreciate the price at .4% per year. For instance one family home I researched came up with initial purchase in 1996 of $133,000

Family Home 1 - $133000(1996) >>>(2011) 133000 *(1.004^15) =  $141, 207

I call this the historical average offer(HAO). So a good initial starting point for my wife and my first offer would be this.  Other factors may also come into play like, the new houses that have been added since then, whether the house is in good condition and has been updated, and the schools and the community the house is in. This house is on the market for a medium amount more than this so I don't think we will make an offer, mainly because it isn't an ideal house for us and there are so many other bank owned properties to offer on.

When dealing with an owner property I would also want to meet the owners and  try and pickup anything I can about their attachment to the house-is the mortgage already mostly paid or is there a point where they are going to owe more than the house is worth. 

Offering to banks

I much prefer to deal with banks because, they have far different incentives than an individual owner.
A house sitting there to a bank is just an expense, and depending on the bank and the time of year may be making their earnings look bad, so with a bank I have the social ability to make an offensive offer. It may be a long term bad proposition for them to take but it may make individual employee's within that company look good for the quarter or year. So I'm definitely going to offer below my owner based HAO. I'm also going to deal mostly from my own perspective. I do not mind putting in 10 offers on bank owned houses and getting turned down on every one.  Although I would say that with a bank you also want to offer the prospect of quick negotiations and closing. Don't drag things out if itdoesn't go right within a week just quit. When the money you are putting down is big take a lesson from Russian billionaire Mikhail Prokhorov and be patient.

So getting down to it I would use something I call turnaround sell value break even point(TSVBP or tis-vap). Which I included in the table of my previous post, but didn't really discuss.  Basically seller agents and buyers agents get 6% of any house offer, so if you to buy a house then sell a house then you would be charged 6% on the price each time. For simplification purposes I use the current list price of a house and multiply it by .94(1-.06) twice**. With a bank you could go further. Come up with a price that you think you get for a house in a year(with updating and a different market perspective) then multiply it by .94 twice and you have a good starting offer for a bank.  For my owner house this would have yielded an offer of $20,000 less than the HAO price, so I wouldn't offer this to an individual(unless you wanted to offend them of course).

So say you think you can sell a house for 140,000 but it is owned by a bank. Offer 123,700, you can only be turned down, which costs you nothing but a little bit of time.

If there are other offers you may want to know how much a house may be costing them and factor it in, but with the current market conditions I think just making 10+ low offers would probably yield the best long term results. I remember traveling in Greece and my good friend making a offer on a chess set for 1/3 of the asking price, being turned down, then walking out of the shop only too be chased down by the shop assistant saying yes they would accept the offer, if he paid in cash. The walkout strategy must always be employed in order to maximize results in bartering!

 *Irrational Exuberence. Shiller, pg 20.
** for a more accurate break even result you would want to reverse engineer the process because if you get a house for a low ball offer you will be paying less on the initial sale, but this just helps you to get a reasonable point from the list price 

Irrational Exuberance to Irrational Pessimism

I was going to go to a few stores to gather some $ per gram food stats to add to my continuing tables but went house hunting with my wife this weekend. Since about 2006 my view of houses has been that I don't want to buy one and that taking on the debt wouldn't be worth it. I use all of my ready available cash at higher edge anyway so it never really made much sense for me to buy. In addition I had read Robert Shiller's excellent book Irrational Exuberance in 2006 and agreed very much with his views(that basically the housing market was overpriced). This was rather funny at the time because my wife worked for Barret Homes(a huge property developer)in London. I remember her telling me about their model for purchasing land(which was made for them by Pricewaterhouse Cooper). When she described most of the assumptions I laughed because I believed it failed to capture the crux of the home builder’s dilemma, which is that at some point you're going to build too many houses. They moved into the FTSE100 that year as Britain's biggest home builder. Later of course when the bubble burst they nearly went bankrupt.


So when my wife decided to start looking for houses this year I always found myself playing the skeptic to her "I want a nice house with a garden for our daughter to play in" enthusiasm. So I went along and expected very much to play the skeptic again. Surprisingly this is not what ended up happening. The houses that I looked at seem undervalued and in some cases even the monthly payments seemed to offer a very large edge. Of course my wife ended up being pessimistic about all of them because they weren't ideal but I was seeing something different and something in my head switched. When I came back to our apartment I was the optimist and she the pessimist. I even started crunching the numbers. It helped to my form my new view that individual houses if evaluated correctly can be great buys right now, especially if you can get a short sale/foreclosure from a bank. Certain niche houses within the overall market are in recovery. They are those that capture the shifting dynamics between a very old choice which has additional factors that you can read about in a recent Star Tribune article about the local rental market here. So without further adieu her is my take:

Rent or Buy the home buyers dilemma


                 P     EMP MOP FF RHC VORH % Edge

House 1 86700 656   360  100 1300  544    196.43%
              99700 710   360  100 1300  490   176.93%

House 2 154900 998 360   70   1350  282     65.54%
              128000 998 360   70   1350  282     79.31%

House 3 240000 1512 360  70   1000 -582    -87.30%

House 4 398000 2735 360 140 2013  -862    -77.97%


P = Price
Expected Monthly payment(via a mortgage calculator)
Months of Payment = 360 for a 30 year mortgage
Fudge Factor(inc Electric/heat/association fees etc)-extra expenses above current expenses
Replace housing cost(i.e. Rent)- How much is it to rent a similar place which brings us to
Value Over Replacement Housing(VORH) = Rental price-Mortgage payment
% Edge = (VORH*360) / Price


                TG       YV     TSVBP   CRPD CD   T $/gal to NE EEW

House 1 663840 22128  88094.92   50     20     13.6             2027
              644400 21480
House 2 587520 19584 136869.64  50     20      7.05             2019
              587520 19584 113100.8    50     20      7.05

House 3 150480 5016    212064     50      20       N/A             N/A


House 4 414360 13812   351672.8  50     20        N/A             N/A

Total Gain(TG)= Monthly Edge +Savings Value

yearly value(YV)- Total gain/30

Turnaround Sell Value Breakeven Point(YSVBP)- price you'd have to get it for to buy it and turnaround and sell it for the list price to breakeven Price*.94*.94(seller’s commission)

Commute range per day- distance to metro area

Commuting Days/month = 20

Transport $/gal to negate edge= what would gas prices have to be for it to more profitable for tenants to live in a closer commuter town?

expect edge window-gas prices were half their current price 8 years ago so I expect them to double in another 8 years(this is probably the worst part of the model)

So how does this explain why my views have shifted?

House 1 and 2 we both toured this weekend

House 3 I lived in 3 years ago

House 4 was a higher priced home currently on the market I used to illustrate that there is not a full recovery.

So the numbers tell me that Houses 1 and 2 are offering not only saving advantages(as houses have always done) but are offering monthly cost savings. Needless to say I presented this all to my wife and pushed hard for house 1 but alas our closing date appears too far out for the bank to accept. We may take a shot at house 2 or wait for something better. In this market who knows. Hopefully there will be some more and I can use my model again to evaluate.

I think it was warren buffet who said it best "The most common cause of low prices is pessimism - some times pervasive, some times specific to a company or industry. We want to do business in such an environment, not because we like pessimism but because we like the prices it produces. It's optimism that is the enemy of the rational buyer."