Mistaking price for value
Originally published at https://www.realyse.com on June 30, 2020.
Anna Clare Harper, Co-Founder at Anglo Residential, looks at how investors in residential property can avoid the trap of confusing price and value.
How many times have you heard, “We negotiated 10% off the asking price”, followed shortly by, “we’re delighted!”?
People often assume that if the price of a property is discounted, it will be a better deal. The truth is, a price discount doesn’t always mean a property will prove more valuable.
As investment idol Warren Buffet puts it,
‘price is what you pay; value is what you get’. What is value?
There’s plenty of different ways to think about ‘value’. The Royal Institution of Chartered Surveyors describes it as:
‘the estimated amount for which a property should exchange on the date of valuation between a willing buyer and a willing seller in an arms length transaction after proper marketing, wherein the parties had acted knowledgably,prudently and without compulsion.’
This makes a lot of sense, in theory. The trouble is, in practice, it’s quite common to have two different RICS surveyors who have trained for years to be experts in valuation, using the same underlying assumptions and methods, and coming up with different ‘values’.
So it’s no surprise that investors often find themselves unsure.
Often, there is no ‘right answer’. In many ways, ‘value’ is determined by what investors are looking for. For example, if I’m looking for a quick way to achieve a strong rental income, then I’m not going to see much value in a field with planning permission. That’s not to say it wouldn’t be valuable for a local developer wanting to build houses.
In relation to real estate opportunities, the idea of ‘value investing’ is, simply put, about focusing on assets that will continue to deliver value for many years, and are well-priced today.
Regardless of which concept of ‘value’ you are thinking about — the RICS definition, the ‘goal-oriented’ definition, or the idea of ‘value investing’ that is so commonly associated with Warren Buffet, Charlie Munger et al, there’s one common issue that underlies them all, and causes investors to fall into traps.
This is mistaking price for value. Working out what a property is actually worth can be hard. Finding out what the asking price is, and negotiating a discount, is much easier. This can easily lead investors to mistake value for price.
In practice, mistaking price for value often happens because of what economists call ‘asymmetric information’. By this I mean, the person selling generally knows far more than the person buying. The trouble is, the person selling sets the price, and it does not always reflect value.
Real life example: mistaking price for value
Let’s take an example. An investor I know — let’s call him Ben — wanted to buy a portfolio of student properties near the University of Oxford. Ben is very busy, and highly intelligent: he’s a Partner at a leading London law firm. He wanted to set aside some money that would earn an income, which he planned to use to fund his children’s education.
Ben’s colleague mentioned she was investing in a stunning new student housing development in Oxford, which he had loved since his university days. Ben did not want to miss out. He spoke to the sales agent. He looked over the brochure. It showed a stunning, seemingly ‘hassle free’ opportunity he could happily live in. The Computer Generated Images were seductive. The opportunity promised a guaranteed ‘6% return’ for two years. Ben felt secure, knowing a building warranty was in place.
There were only a handful left. He was able to negotiate a ‘discount’ for buying more than one property, off plan. Ben bought six apartments, for £2,000,000, and he was delighted to have achieved this discount.
The first mistake Ben made was being driven by a fear of missing out. He felt that if his colleague could do it, so could he. The second mistake was believing it would be best to invest in properties he could envisage himself living in. The third mistake was relying on marketing materials and incentives like the guaranteed rent, ‘discount’, ‘building guarantee’, and CGI images of perfection which in his eyes, made the opportunity seem both perfect, and easy. Perhaps the biggest mistake Ben made was thinking that the price the developer was asking for signified the value of the investment. As a result, he thought that by negotiating a discount, he had got himself a great deal.
He trusted the agent and developer, as both had strong international reputations. In the end, it turned out that he had misunderstood the property value, as well as the ‘market rent’ and costs.
On value vs price: the ‘discount’ he was sold on was not really a discount. The marketing price of each unit was over-inflated for the area it was in, to £400,000. Ben had negotiated a £400,000 discount from the ‘off plan, below market value’ list price, getting six properties for £2,000,000. What he didn’t consider was that the prices were created by the developer, not the market. They included a ‘developers’ margin’, and as such, like a new car, would lose value off the forecourt. Classic techniques for marketing include ‘off plan’ and ‘bulk’ discounts and ‘below market value’ descriptions based on over-egged prices, especially for new build properties.
Ben’s goal was to achieve a strong, safe income to fund his childrens’ education. Let’s talk about the realities of his returns, and costs, which directly affect value to him as the investor. The forecast return was described as 6% and guaranteed for 2 years. Unfortunately for Ben, the return on investment figures were artificially inflated due to the guaranteed rents above market rent levels, and unrealistic cost assumptions.
A classic marketing technique used in real estate is to present inflated returns, based on a developer’s dreams rather than market demand. For properties with no precedent, marketed prices and rents may not reflect what ‘customers’ (tenants) in the area can afford. Market value is defined by demand and supply, not just supply. Especially on larger schemes, developers can quickly dominate a local market. They do not always reflect what other people are willing and able to pay — for rent or resale.
Another marketing technique is presenting a false sense of security. For Ben, the guarantee felt valuable in itself. Ben didn’t know that ‘guaranteed rents’ are generally offered as a marketing tool. Guarantees of all persuasions can be misleading in the property world.
In practice, rents are often guaranteed at levels above the market rent, rather than reflecting true market rent, in order to give buyers confidence. Once the guarantee period is up, it can be impossible to rent at the same rate, as the market is flooded with 100s of identical properties marketed at levels higher than local tenants could afford: the market rent.
When he was assessing the opportunity, Ben had compared rents and prices with what he could get in London. He felt the property was cheap by comparison. In fact, the ‘market rents’ were very expensive for the local area. Only a small percentage could afford to live there. And that small proportion of locals had 100+ identical properties to choose from. The local market was flooded with competition. It was the opposite of ‘safety in numbers’. This emphasises the point that relying on recent sales and rental data to assess value is not enough. It is also important to look at what is happening in the local market.
Another common marketing ploy used in property is to quote unrealistically low costs. It’s important to consider costs in an assessment of ‘value’. The figures provided to Ben did not account fully for transaction costs, such as stamp duty or conveyancing. They assumed minimal maintenance costs.
The agent told Ben that new build properties had lower maintenance costs. They did not include a realistic assessment of the building’s service charge and ground rent, or a realistic figure for wear and tear. It’s true that the cost of getting the property to the right standard should be minimal up front for a new build. However maintenance costs relate to usage not just when a property was refurbished or developed. Wear and tear happened because a property is lived in. There’s also plenty of costs and issues that won’t be covered by snags, Building Guarantee or Warranty. NHBC cover is the best known guarantee. It primarily covers structural problems, and does not apply immediately. It excludes most internal costs. Further, the hassle of getting the developer to resolve snags can be more costly in an investor’s time than it is worth on some schemes.
Before investing, Ben had assumed older properties would be expensive and more hassle, therefore less valuable. This was reiterated by his agent. It turned out not to be true, either within his flat or within the building. The service charge for the building and costs of repairs in his flats quickly ate his profit margins.
For Ben, costs ended up closer to the residential property sector average of 30% of his rent each year, rather than the ambitious 15% for management and maintenance quoted in the marketing literature.
Ultimately, the rental returns after the guaranteed rent period elapsed turned out to be minimal. The deal was not worth the hassle. Since then, Ben has moved on to a portfolio of indirect investments including joint ventures and shares in property funds, closely targeting the goal of income for his childrens’ education. This is a much better fit for meeting his goals, and continues to perform well, offering genuine ‘value’, in line with his goals.
How to avoid mistake price for value?
- Run your own numbers, don’t accept other people’s — especially if they have a vested interest. This applies to assumptions and calculations. I can’t stress enough the importance of making sure you have access to quality data. There’s so many ways to do this. Our process involves using data tools, including REalyse, to quickly aggregate specific and relevant data that can be analysed in house, as well as ‘triangulating’ this data with other qualitative and quantitative data and sources, including local expert opinions. Seek independent sources to verify and provide their input. Ideally, you want 3+ opinions to match up.
- If you’re considering investing directly, for yourself, it’s worth taking the time to understand what is happening in the property market generally, as well as specifically in the location you are interested in, and what values are in this context. This is about protecting the downside, as well as optimising returns. What you can buy and sell for in one market is not the same in another area, or time; and the price you achieve may not be the same as value.
- Get to know the local market, not your local market, and what drives it. Compare apples with apples. Being ‘cheap compared to London’ is irrelevant. Benchmark the rent and capital values against local properties. In some markets, people prefer older houses to new build flats; others are dominated by internationally-funded buyers. Consider what is really driving demand for rent or resale in the chosen area.
- For new, unproven schemes, consider what will happen to the local market. Will the scheme flood the local market with a large number of over-priced properties? This affects supply, not demand.
- Be cynical: if you’re getting something that sounds perfect, like a discount or guarantee, ask why, and be totally clear on what is covered and what is not.
- Make sure you do thorough research on each opportunity and look for the downside as well as the upsides. Remember that if something looks too good to be true it probably is.
- Use as much hard data, for example recent sales and rental comparables and local expert opinions as possible, and remember that no investor is infallible: it’s hard to assess value, and it’s also crucial for avoiding the common pitfall of mistaking price for value.
About the author
Anna Clare Harper is a property investment strategist, entrepreneur, TEDx speaker and Author of Amazon real estate and investing Best Seller, Strategic Property Investing. After graduating with a RICS-accredited property degree from the University of Cambridge, she worked as a professional strategy consultant at Deloitte. Most recently, she co-founded and developed the strategy for Anglo Residential, a UK property fund that has secured seed capital to build a £150m housing portfolio. Anna hosts a leading property investment podcast, The Return: Property & Investment Podcast, and was recently named one of Bisnow’s ‘Women Leading Real Estate’.