My friend Dylan was in Hyde Park, London on a Sunday. He had wandered over to the speaker’s corner, an infamous place where anybody with a soap box can stand up and argue for or against whatever it is they feel like arguing.
Dylan has a particular interest in debates and couldn’t resist the urge of wandering over to the man holding the picture of an Ape and a Ferrari. The man could not believe we were related to an Ape. A human is complex (“like a Ferrari”, he said. ) and a Ferrari has a designer and was created, therefore a human has a designer and was created. But Dylan of course was not sold.
“How was the Ferrari designed?” he asked.
“Well by an engineer,” the man replied. Unknowingly he had stepped into Dylan’s trap.
“One engineer all my himself?” Dylan asked.
“No probably several.” the man replied.
“And they just one day drew a Ferrari on paper, built it the next, and it ran smoothly the next day, with fuel, fuel stations and roads conveniently located for it to go anywhere.”
“Well no,” the man replied. “Some of those things were there before and I’m sure they used trial and error in their designs.”
“And the designers of the Ferrari invented the combustion engine, which worked smoothly right away, and in all environments?" Dylan asked.
“No they used existing designs for some of the things.”
“Ah so there was public knowledge already available of them, and they used this.”
“Of course,” the man replied.
“So when they finally got one that worked and sold it to customers, they never needed any repair shops, to listen to customer complaints, or to go back to the shop and redesign.”
“No they’re always coming out with new models.” The man replied.
“So the original designer I’m sure does all the tinkering, and comes up with all these new ideas. I’m sure Ferrari would never take the suggestions of their customers and include it in future designs for testing.”
“Oh I’m sure they would,” replied the man.
“Every suggestion?” Dylan asked.
“No not everyone”
“Would it be fair to say that they take the ones that the majority of their customers agree with, test them, and keep the ones that allow them to survive financially.”
“…you could say that.”
Looking down at his watch he noticed he was late for meeting a friend. “Thanks for your time but I must be going,” Dylan replied. He decided he didn’t feel like debating evolution, and liked talking about Ferrari’s much better.
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).
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
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