Sunday, December 16, 2012

A new approach to housing valuation:


What a dog with a stick can teach us about house prices
              
Some innate behaviors traverse species
Every weekend I take my dog; Butters out for a nice long stroll at a local off-leash dog park in Ottawa. She is a husky so she loves to run and be chased. Over her short life span of 3 years, Butters has learned that getting a chasing buddy doesn’t come easy and requires some enticing. She has figured out that if she picks up a tree branch from the acres of land with trees and fallen branches, inevitably she is going to draw attention of another dog. The other dogs almost always place a great deal of value in this random stick, resulting in Butters perceiving it as of great value to her. In fact, when she picks up a random stick, dozens of dogs come barreling down towards her, wanting to chase her and play with the stick. A stick that just five minutes ago laid on the ground with no apparent worth suddenly has a dozen dogs vying for it. In this dog society, as fast as the value of this stick goes up, it tumbles down. Being that huskies are borderline ADHD, after getting her chase on, she get distracted and moves on to other important things in life like rolling around in dirt. The stick she leaves behind has no takers, no salvage value, and it lays there until at some random moment another dog decides to pick it up. 

Butters at Bruce Pit, Ottawa
I have learned from dog experts that a dog’s intelligence plateaus at a level similar to a 2 year old human.  Often to the dismay of many parents, I compare things Butters does to their two year old. But I can’t help it; at an age up to 2, dogs and kids are so darn similar. We all have seen kids that want what the other kid has. If a kid picks up a random toy from a heap of toys, the other kid must have it. We all like to think that over time, this innate human behavior leaves us, that somehow we have evolved out of it but the truth can’t be further from that. As adults, we want to dress like those that dress like what we want to be. If our income permits (or in some cases event if it doesn’t) we aspire to drive the cars and live in the homes like the ones that our idols drive and live in. I love my dog, but I am glad that her impulses do not have a huge bearing on major economic decisions in my life. On the other hand, human impulses have implicated not just me but many others over the years. It is these impulses that have mired our history with valuation bubbles.  

Human history is mired with valuation bubbles
The readers of financial history are well aware of the fads that have preceded our time. Human history is mired with valuation bubbles. When one studies the financial bubbles, it appears that humans have indiscriminately chosen a random “stick” to value. From the earliest recorded asset bubble known as Tulip Mania to the recent examples of overly zealous valuation of internet companies, art work, classic cars, specialty tea and coffee, residential mortgages, student loans, it appears that our ADHD is almost on par with the dogs.

The fallacy in real-estate pricing approach
While the real-estate values vary depending on the location, the pricing approach to real estate is uniform globally: based on the approach of relative valuation. An individual that has engaged in real-estate transactions at any point in his/her life will recall that their realtor shows them a list of comparable homes in the neighborhood and based on that recommends a price point. This relative price comparison approach forms the basis of valuation for close to 500,000 home on average that change hands in a given year in Canada and millions in the US. This type of approach is not unique to the retail real-estate market but is in fact mainstream in the non-real-estate world as well. Wallsteet and Baystreet analysts persistently employ relative price valuation to price a host of assets.
In the context of the housing market, the problem with relative pricing approach is that the impulse of another individual to pay a certain amount for a house will for a long duration change the house prices in a given neighborhood.  Because a house is heterogeneous enough (location, features etc.) the lack of comparables mean that the price is not corrected fast enough.  The exuberance of one individual impacts many others in the market for quite some time. When it comes to housing, the dynamics are quite different and it isn’t until we encroach on some key fundamentals – which provide a common sense check -that we realize that the market needs to be corrected.

An alternative to relative price valuation
The next time you are thinking about purchasing a home, think about whether you are chasing after the proverbial stick that Butters has. Reflect back on the moment that first instigated the notion of home ownership in your mind. If you come to the realization that the decision is based on someone else’s decision to purchase a home, stop and think again. In case you made the decision independently and were not inspired by someone else, make sure you do your homework and are willing to treat the stick as a baton in a relay race that can be passed on to the next person with high credibility. Below are some alternative approaches that you should utilize the next time you make the decision to purchase a home.

  • Mortgage affordability based on normalized expected income: Make sure your five year projected income can support the mortgage and base it on the interest rate on a five-year fixed term. Instead of looking at your current gross household income, look at the expected income which takes into account the probability of unemployment and use that to calculate the mortgage affordability. In the example presented in the table below, the normalized annual household income is equal to $60,464 versus the current income of $75,580.

Key elements to determine
Value
Explanation
Median current household income (Toronto)
$ 75, 580
This is a gross annual household income. Be conservative and do not include expected bonuses, but this should include reasonable year-over-year pay raises in line with inflation adjustments.  
Probability of unemployment assigned to each earner
0.20
The 0.20 implies that both household earners expect to be unemployed for duration of one year in the next 5 year period. The 5 year period is used because in most cases offloading a house in less than 5 years results in less equity being built than paid off in real-estate commission, interest and other related expenses. Your situation may vary greatly. Hint: if you have been laid off from a job, think about how often that has happened in the last five years and how long did it take you to find a comparable position. You can rely on some publicly available statistics to come up with a value but your own assessment will likely be most accurate (see: http://www.bls.gov/news.release/empsit.t14.htm)
Normalized expected household income

= [(median current household income  x  5) x (1-probability of unemployment)] / 5 = [($75,580 x 5)x (0.8)]/5 = $60, 464


  • Evaluate the house price using property tax multiple: buying a house should not be an impulse decision. For many it is the largest purchase of their lives, so ample research should be done. Ideally, you should allot one-year to research. Many of the readers may find this to be a ludicrous restraint but there are many benefits to this approach. Firstly, it prevents you from making an impulse purchase. Secondly, it ensures that you have done enough research that when the right house in the right price range comes up, you will have no hesitation in pulling the trigger. Finally, in the one year you may start to notice valuation swings that you are not ready for.

A property tax multiple is the new approach to housing valuation that is proposed here. It is a very useful measure for pricing your house. In the year that you are doing your research, make sure that you retain a realtor and have her send you as much data as possible on the houses being sold in the neighborhood of your choice. From the data provided to you, extract the values of property taxes and the price paid by the buyer. As an example, if the property taxes for the house are $12,000 and the house sold for $1.2 million, the property tax multiple will be 100 i.e. $1,200,000/$12,000. Collect this multiple on as many properties sold in your neighborhood as possible. Get as much historical data as possible. Once you have collected the multiples, arrange them in an ascending order. Exhibit 1 below illustrates a hypothetical outcome from this exercise. It shows multiples from 32 hypothetical property sales. The outcome from your exercise will look different. In order to ensure that you are not overpaying for your home, make sure that the price you are willing to pay falls below the median multiple. In the case illustrated in exhibit 1, that multiple will be in the range from 114-119. Of course, nothing stops you from going even lower but you do not want to be in the upper range of the property tax multiple. At the upper-end range you will be risking your ability to “pass the baton” or sell the home when the time comes. 

Exhibit 1 Property Tax Multiple Approach to Valuation
Since property tax value information is available before the sale – often times provided by the realtor in the property summary document at an open house – prospective buyers can apply the multiple to determine the fair value of the house before closing date. For example, if the property tax assessment shows a value of $5,000, the multiple in the range of 114-119 should result in the fair value in the range between $570,000 to $595,000 (i,e. $5,000 x 114 to $5,000 x 119). The main advantage of the property tax multiple approach is that it does not experience the swings that can typically be experienced through relative price valuation. This is because the property tax assessments are done by a third-party, usually the municipal government and are based on fundamental factors like the location, lot size, property type, age, amenities etc. More importantly, it prevents you from being a victim of someone else’s impulse who either decided to pay a higher multiple themselves and is now unloading the property on you or who is demanding a premium over comparable homes in the neighborhood.

  • Balance life style needs: Ensure that the decision does not come at the expense of your other wants. It is stating the obvious but the decision to purchase a home should not come at the expense of your other needs and wants. If you want to spend your disposable income on travelling, eating out, or on a hobby, weigh that against the decision of buying a house and how it may hinder you from doing things that you love.