Author Topic: speculating on future values of houses vs. future values of company earnings  (Read 1876 times)

clarkfan1979

  • Magnum Stache
  • ******
  • Posts: 3153
  • Age: 43
  • Location: Pueblo West, CO
The value of a stock is based on current earnings and also based on speculating on the potential future earnings of the company, correct? A higher P/E ratio includes more speculating than a lower P/E ratio, correct?

When I look to buy a rental house, I'm looking for a neighborhood that is going to be in better shape in 5 years than today. Rental prices are mostly priced based on the current rental rate. Future potential doesn't seem to factor in. As a result, if one neighborhood has more potential than another neighborhood, it doesn't seem like you have to pay extra for that potential.

Thoughts?

 

SilentC

  • Stubble
  • **
  • Posts: 130
To some degree that sounds right for stocks. I donít think the level of the P/E ratio is directly tied to the level of speculation though.  There is really speculative stuff that trades at 5x earnings (crappy over leveraged financials for example, dying telecoms, etc.) and non-speculative stuff that trades at 30x+ earnings (consumer staples, wide moat enterprise software, etc.).

I think if you buy a house that doesnít cash flow you are betting on rents rising which may or may not be riskier than buying in a neighborhood where you get high cap rates and cash flow right off the bat.  Like price/rent is telling you coastal CA real estate will appreciate faster than real estate in Columbus.  Who knows if that will be true but there is no other reason to accept a lower cap rate or pay a higher price/rent than better future rent growth expectations.

PDXTabs

  • Walrus Stache
  • *******
  • Posts: 5160
  • Age: 40
  • Location: Vancouver, WA, USA
The value of a stock is based on current earnings and also based on speculating on the potential future earnings of the company, correct? A higher P/E ratio includes more speculating than a lower P/E ratio, correct?

I don't know much about professional rental investing, but I would say that equities are priced based on the perception of future profitability compared to the risk free rate of return (which basically means US treasuries).

But I'm not sure why this wouldn't also be true for rental property.

clarkfan1979

  • Magnum Stache
  • ******
  • Posts: 3153
  • Age: 43
  • Location: Pueblo West, CO
The value of a stock is based on current earnings and also based on speculating on the potential future earnings of the company, correct? A higher P/E ratio includes more speculating than a lower P/E ratio, correct?

I don't know much about professional rental investing, but I would say that equities are priced based on the perception of future profitability compared to the risk free rate of return (which basically means US treasuries).

But I'm not sure why this wouldn't also be true for rental property.

The basic idea is that most rental property is purchased with loans, including single family homes and apartments. Even when investors pay cash at closing, they will typically put the property on a loan in the near future. When using leverage, an appraisal is needed. Appraisals go backwards 6 months. This puts a limit on speculating into the future, at least with borrowed money.

I wasn't really thinking of coastal CA vs. Columbus, OH. I was thinking of two similar neighborhoods in the same county. One neighborhood is within the path of progress and the other is not. It would make sense to buy in the neighborhood within the path of progress. The progress is not guaranteed because anything can happen. However, it doesn't seem like you need to pay extra for that speculation.

Even if you do pay a little extra for the speculation, it seems likely that the cost is less than market demand. 

 

Metalcat

  • Senior Mustachian
  • ********
  • Posts: 13703
I bought all 3 of my properties with an eye towards the enormous potential of rents increasing in those areas.

The tricky thing is timelines. How long before your prediction comes true and how profitable is your property in the meantime?

Where my primary home is is a specific neighborhood that has been primed to rapidly gentrify...for 20 years. It's *finally* happening.

The key is to understand what the basis of the potential is and why that hasn't been baked into the house prices yet.

A year ago I bought in an area with the highest growth potential I've ever seen. Like realistically, it could go from the poorest region in the country to one of the most desirable. But it's not like I was the only person who figured that out. It was *the* hottest spot for rental buyers in the country at the time. So very rapidly, the potential was baked into the prices. I was looking for a second property as soon as I closed on the first and I was already priced out and competing against no-condition cash offers over asking on 100+ year old buildings with major repair needs.

In both neighborhoods, by the time anyone was aware of the potential of the area, it drove the house prices up *ahead* of the rents rising.

So in theory I get your idea, but in practice, at least in most of the markets I've looked at, real estate prices rise before rents, so you have to not just find a particular area that has potential, you have to find a particular area that has potential that other extremely savvy real estate investors don't see.

SilentC

  • Stubble
  • **
  • Posts: 130
I bought all 3 of my properties with an eye towards the enormous potential of rents increasing in those areas.

The tricky thing is timelines. How long before your prediction comes true and how profitable is your property in the meantime?

Where my primary home is is a specific neighborhood that has been primed to rapidly gentrify...for 20 years. It's *finally* happening.

The key is to understand what the basis of the potential is and why that hasn't been baked into the house prices yet.

A year ago I bought in an area with the highest growth potential I've ever seen. Like realistically, it could go from the poorest region in the country to one of the most desirable. But it's not like I was the only person who figured that out. It was *the* hottest spot for rental buyers in the country at the time. So very rapidly, the potential was baked into the prices. I was looking for a second property as soon as I closed on the first and I was already priced out and competing against no-condition cash offers over asking on 100+ year old buildings with major repair needs.

In both neighborhoods, by the time anyone was aware of the potential of the area, it drove the house prices up *ahead* of the rents rising.

So in theory I get your idea, but in practice, at least in most of the markets I've looked at, real estate prices rise before rents, so you have to not just find a particular area that has potential, you have to find a particular area that has potential that other extremely savvy real estate investors don't see.

Exactly, if you have great insight you can generate outperformance, but the same is true for any asset class.  If one area clearly has better growth prospects vs another nearby or far away area it will sell for a lower cap rate.  That said maybe you can draw a small circle containing a few neighborhoods and be the best educated investor in that small circle and to you it will look obvious to buy one part of the neighborhood over another because you build experience, but to others the difference wonít stand out.

Metalcat

  • Senior Mustachian
  • ********
  • Posts: 13703
Exactly, if you have great insight you can generate outperformance, but the same is true for any asset class.  If one area clearly has better growth prospects vs another nearby or far away area it will sell for a lower cap rate.  That said maybe you can draw a small circle containing a few neighborhoods and be the best educated investor in that small circle and to you it will look obvious to buy one part of the neighborhood over another because you build experience, but to others the difference wonít stand out.

Yeah. It can get quite granular.

When it comes to rents, in some areas it's block to block, and understanding what impacts those granular values is the key to understanding where factors can/will likely rapidly change.

Are the factors structural? Government funded? Etc? Or are they things that easily change along with the economic evolution of the area, like the profile of the local businesses, which can change rapidly as the commercial real estate values rise.

In particular, places where commercial real estate rents are rising ahead of residential rents can produce pockets of disproportionate growth, because the business profile of a specific block can alter so rapidly. A few blocks can go from ultra sketchy to upscale practically overnight when commercial rents rise quickly.

But a publicly funded, newly built methadone clinic? That's not going anywhere.


Dicey

  • Senior Mustachian
  • ********
  • Posts: 21091
  • Age: 65
  • Location: NorCal
Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.

Metalcat

  • Senior Mustachian
  • ********
  • Posts: 13703
Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.

If you can also become an executive in the company you own shares of and can alter the way business is done. That's a pretty cumbersome way.

Dicey

  • Senior Mustachian
  • ********
  • Posts: 21091
  • Age: 65
  • Location: NorCal
Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.

If you can also become an executive in the company you own shares of and can alter the way business is done. That's a pretty cumbersome way.
Yeah, we can rehab a house a lot faster, with far fewer uncontrollable variables. Becoming an executive sounds like w-o-r-k.

ChpBstrd

  • Walrus Stache
  • *******
  • Posts: 5407
  • Location: A poor and backward Southern state known as minimum wage country
When I look to buy a rental house, I'm looking for a neighborhood that is going to be in better shape in 5 years than today.
How does one go about spotting such a neighborhood? New sidewalks? New jobs coming to the area? Rehab work being done by other landlords? The old trick of following the gays and the artists?

As noted above, you'd need a reliable signal that isn't already obvious to every other local investor.

Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.
You can buy a stock and then sell a covered call to recover some of your purchase price. This effectively lowers your purchase price and increases your ROI in the future, much like remodeling a rental does. Plus you'll never smash your thumb with a hammer this way.

maizefolk

  • Walrus Stache
  • *******
  • Posts: 7092
Rental prices are mostly priced based on the current rental rate. Future potential doesn't seem to factor in.

At least at a macro level, I don't know that this is correct.

In the San Francisco Bay Area rents are increasing rapidly, and many houses sell at prices where a rent won't even cover the mortgage, let alone any side aside for vacancy, maintenance, or profit.

In central Ohio, rents are flat or decreasing and it is (or was) possible to purchase properties that rent for 2+% of their purchase price per month.

SeattleCPA

  • Handlebar Stache
  • *****
  • Posts: 2257
  • Age: 63
  • Location: Redmond, WA
    • Evergreen Small Business
Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.

I think Dicey's point above is really key. You can't do with with index fund. Or your IRA.

And then one other thing I'll mention which I think is relevant and has probably already been mentioned and I missed: Investing in a leverage single rental property entails more risk. So probably riskier than investing in a small company stock?

P.S. Oh another thought... The tax treatment of real estate is also very different. It's very doable to shelter lots of income with real estate. (Recent blog post with explanation: https://evergreensmallbusiness.com/dozen-ways-to-deduct-real-estate-losses/ )

SilentC

  • Stubble
  • **
  • Posts: 130
Not sure if this has been mentioned, but I know how to buy a needy property and add value to it using DIY and mustachian skills to source materials reasonably. If that's possible to do with equities, I haven't the faintest idea how it's done.

I think Dicey's point above is really key. You can't do with with index fund. Or your IRA.

And then one other thing I'll mention which I think is relevant and has probably already been mentioned and I missed: Investing in a leverage single rental property entails more risk. So probably riskier than investing in a small company stock?

P.S. Oh another thought... The tax treatment of real estate is also very different. It's very doable to shelter lots of income with real estate. (Recent blog post with explanation: https://evergreensmallbusiness.com/dozen-ways-to-deduct-real-estate-losses/ )

Agree on tax implications being a huge benefit and stocks often being lower risk that highly levered real estate bets.  I had a good realtor who was a realtor because his leverage house of cards fell apart in Ď09 and he lost ďseveralĒ properties and developments and basically was starting from square 1.5.

I think the idea that the stock market is so efficient you canít apply skill to it is fairly bogus but there is a much steeper learning curve than landlording I would imagine.  I do it and generate alpha and have other friends who do it too.  So one might generate sweat equity in a house the same way as I might buy a lot of illiquid situations people are dumping in late December for tax loss selling and then sell those in late January at a profit for example.  There are corners of the market where there are special situations and being a small fish, just like being a small landlord, letís you pick up plenty of dollars per hour invested.  There is definitely a benefit of certainty in updating a property (you convert a garage to a bedroom and youíll get more rent) but I think you can also add value above an index fund in the same way and get outsized returns.

Swish

  • Stubble
  • **
  • Posts: 147
  • Age: 36
  • Location: Canada
I think the reason it is not factored in is because the neighbourhoods can take a lot longer than five years to improve. Some that were sure things never come to pass and so investors do not consider this a premium. Currently we have a large industrial development going on one side of the city about 10mi away. I am buying as many homes in the neighbourhood closest to it as possible on speculation that they will appreciate because people working there will want a short commute to work. It has been 7 years and the project is still 6mo to a year from completion.

clarkfan1979

  • Magnum Stache
  • ******
  • Posts: 3153
  • Age: 43
  • Location: Pueblo West, CO
I think the reason it is not factored in is because the neighbourhoods can take a lot longer than five years to improve. Some that were sure things never come to pass and so investors do not consider this a premium. Currently we have a large industrial development going on one side of the city about 10mi away. I am buying as many homes in the neighbourhood closest to it as possible on speculation that they will appreciate because people working there will want a short commute to work. It has been 7 years and the project is still 6mo to a year from completion.

This seems to connect with my original thoughts. If one neighborhood is in the path of progress and the other isn't, I think it makes sense to buy the one in the path of progress. The "progress" might not happen, but it doesn't seem like you have to pay for that potential. Because most people buy real estate with loans, comps sales that happened 1-6 months ago are the measuring stick. Not the new development that might happen over the next 5 years.

My in-laws bought a second home in a neighborhood with a very very large community pool. It's actually a 6-acre salt water lagoon. They bought in the Brightwater Community in North Fort Myers, FL. Based on progress of current construction, I'm guessing it will be finished in about 6 months. It will be interesting to see what happens with sales price when the salt water lagoon gets finished. I could compare sales price 6 months before pool was fished to 6 months after pool is finished and compare those numbers to other neighborhoods in close proximity that do not have access to the pool.

 


Metalcat

  • Senior Mustachian
  • ********
  • Posts: 13703
I think the reason it is not factored in is because the neighbourhoods can take a lot longer than five years to improve. Some that were sure things never come to pass and so investors do not consider this a premium. Currently we have a large industrial development going on one side of the city about 10mi away. I am buying as many homes in the neighbourhood closest to it as possible on speculation that they will appreciate because people working there will want a short commute to work. It has been 7 years and the project is still 6mo to a year from completion.

This seems to connect with my original thoughts. If one neighborhood is in the path of progress and the other isn't, I think it makes sense to buy the one in the path of progress. The "progress" might not happen, but it doesn't seem like you have to pay for that potential. Because most people buy real estate with loans, comps sales that happened 1-6 months ago are the measuring stick. Not the new development that might happen over the next 5 years.

My in-laws bought a second home in a neighborhood with a very very large community pool. It's actually a 6-acre salt water lagoon. They bought in the Brightwater Community in North Fort Myers, FL. Based on progress of current construction, I'm guessing it will be finished in about 6 months. It will be interesting to see what happens with sales price when the salt water lagoon gets finished. I could compare sales price 6 months before pool was fished to 6 months after pool is finished and compare those numbers to other neighborhoods in close proximity that do not have access to the pool.

If the houses/locations are essentially equal and the same price, then yeah, of course you would buy the one that has more potential to increase, but that luxury of choice is pretty rare when buying a primary residence.

It's easier when buying an investment property where your search range is huge. I just did this twice last year and when my search area was a third of the country, it was a lot easier to find two nearly identical houses in similar quality locations with obviously different potential.

But your typical primary home buyer usually has a pretty narrow search range and struggles to find even one property that will work for them in their budget.

Also, comps can run up *very* quickly. I was buying investment properties last year and I wanted to buy two in a location that I saw as having massive potential (it does, and way beyond what I expected at the time).

But by the time I had closed on the first property, the comps were already too high to find anything even close to the value that I just bought. A year later the nearest comp is almost double what I paid.

Now, on the flip side, when I was looking at condos in the city in 2019, I was looking at two apartments that were nearly identical except that one was older and bigger. The newer one was in an already expensive area and the older one in an area with potential, but it cost less than half the price. They were less than a mile apart.

I obviously chose the larger, cheaper one in the almost identical location, but very similar local forces have acted on these properties and although mine has doubled in value since 2019, the other has increased by more.

To come back to the original point I made. There were other condos in the city that were about the same size and price as this one, and they were in areas with less potential, but they were areas I would never consider living.

All that to say, yes, it's an obvious concept that if faced with a choice between two equal houses to pick the one that has more potential to go up in value. But in reality, primary house hunting doesn't usually work that way.

And for investment properties, you also have to factor in rental rates, which makes it even trickier because they follow different rules and patterns.

So it's just extremely rare and unlikely that a buyer will have that kind of apples to apples situation. It's a lot trickier to factor in potential in real life buying than it seems on theory.

I now have 3 properties in high potential areas, but my friends who bought very expensive primary homes here in Toronto with no eye for potential have made much larger gains than I likely ever will on all 3 properties combined. But if course they leveraged 4 times what I did.

It's just tricky to predict property values.
« Last Edit: March 19, 2023, 07:07:46 AM by Metalcat »

GilesMM

  • Pencil Stache
  • ****
  • Posts: 640
  • Location: PNW
I think the reason it is not factored in is because the neighbourhoods can take a lot longer than five years to improve. Some that were sure things never come to pass and so investors do not consider this a premium. Currently we have a large industrial development going on one side of the city about 10mi away. I am buying as many homes in the neighbourhood closest to it as possible on speculation that they will appreciate because people working there will want a short commute to work. It has been 7 years and the project is still 6mo to a year from completion.


An acquaintance of mine plays this game fairly well in a huge metro area in the south but with quite a long view. He buys land in the inner city in areas he thinks are under-valued long term.  He is willing to wait 10-15 years for things to improve but usually waits less as he does this full time and has developed a keen sense for how the market will develop.   Then, when the time is perfect to develop, he is also the developer and builds either condos, townhouses or SFH, depending on the local market fit.  He has a huge reputation for quality construction so he can command top dollar.  One of his recent developments is in a prime location on what was formerly a factory site and then superfund cleanup.  Bought the land for nothing, sold half to Walmart and is developing the other half with the proceeds from the Walmart sale. He is doing an entire neighborhood mix of SFH and townhouses. About 50 doors.  Huge margins.