I think most of us can agree that real estate agent, as a profession, lacks “street cred”. The reputation for our industry is not high and I say this despite the reputable people I meet here and elsewhere. Two ways to effect a change in that perception are: raise the bar of competition and adopt a better model. Sometimes we can do both.
In a recent post called It Takes More than Comps to Beat the Competition, I introduced a pricing model based on how assets are valued in the securities industry. As a former stock broker and options trader, I can tell you that the methods employed in the real estate world for valuing assets and advising clients are rudimentary. A more thorough understanding of what a property is worth and a framework for better understanding what that knowledge suggests would not only help us to do our job better, but it would separate those that use the tools from those that do not. Adopting a better model de facto raises the bar of competition.
A Quick Primer
From a securities standpoint, price is rarely the sole motivation behind a buy or sell. We are usually trading volatility or time or both. An asset’s value then, is affected by these two items. This is evident in real estate too. Good agents take these factors into account when they do comps, but we are generally lacking the common language and function for applying them. By adopting a better model, we gain these tools.
Volatility
Let’s use options as an example: an options contract is valued in relation to the underlying stock. This valuation is called its delta. On a scale of 1-100, a delta of 100 means the options contract might as well be stock. It is traded, hedged and valued as if it were the underlying stock. A delta of 20, on the other hand, means the options contract is very unlikely to approach the value of its underlying stock. It has only a 20 percent chance of holding value. I would therefore trade, hedge and value it quite differently. Now a delta of 50 suggests the potential for the contract to eventually carry the full value of the underlying stock at 50/50. Here’s the important thing to remember: as volatility increases, deltas move toward 50. What does that mean? It means that the more volatile the market, the less sure I am what the outcome will be. At a very high volatility, virtually all possibilities move away from the extremes of “sure thing” and “long shot” to become 50/50.
As the real estate market started to scream upward, property values skyrocketed and equity became more and more of a “sure thing” (in trading lingo we were “in the money”). Yet in reality the delta of these homes was dropping. The steeper and more frenzied the rate of appreciation, the less sure we could be of our homes true value in the future. By the end of the run-up, deltas had to be approaching 50. As chinks in the credit and lending armor began to appear, deltas would have dropped below 50! The only way to capture this equity was to close out the position: i.e. sell your home. The real estate market is liquid, but not that liquid. If you had not planned on selling your home (and at any given time the majority of people do not), there should have been little confidence in the paper equity that had built up.
Time
The time frame our clients are looking at obviously affects the valuation of a home. From a buyer’s perspective, the longer they plan on staying in a home the less concerned we become with temporary price fluctuations in the market and the more concerned we become with proper financing. Real estate, for the most part, is a cyclical, appreciating investment. Time works in our favor to “heal all wounds”. The cost of money, however, is not so forgiving. Time compounds our debt-based mistakes in the same way that compounding interest corrects them.
From a seller’s perspective, their short term and long term goals affect their decision making as to whether to sell and the length of time they can afford to be on the market impacts their pricing.
Bring it All Together
In preparation for meeting a client, begin by assessing and understanding all four values of a property: the BREAK-UP VALUE, the INTRINSIC VALUE, the FUNDAMENTAL VALUE and the UTILITARIAN VALUE (go back to the post referenced above for more on these concepts). Once a snapshot of pricing has been provided (and that’s all it really is, whether using a more comprehensive four-value view or basic “comps”) there is one more step: provide an analysis for the prices – put them in a framework. What is the volatility of the current market and what is the time expectation of your clients?
When volatility is high in an appreciating market, home values are increasing but the delta is dropping. Obviously it is a great time to sell. But it is your understanding of how low delta is getting that dictates how aggressive your pricing should be. If volatility is high in a depreciating market, values are dropping but at some point deltas begin to rise indicating a good time to buy. How fast delta is rising dictates how aggressive to be on your offers. Low volatility leads to balance and a high degree of confidence in the outcome of buying or selling. Combine this with your clients’ time expectations. The further out in time we go, the lower the overall volatility. An assets true delta becomes clearer and therefore the decisions easier.
Once you have done the four valuations and assessed the two factors, your buying clients will make informed, rational decisions (even while missing out on some of the run-ups) that should leave them little chance of a foreclosure. Your selling clients will know when prices are out of line and how aggressive they should be in their marketing and price reductions. You will even create arbitrage opportunities: is the volatility in one area greater or less than than the volatility in another? This is an obvious benefit to your investor clients but it goes a long way to helping home buyers make a rational decision too. If you are creative enough, it should impact your listing side marketing too. Think about it…
Whether your client is interested in buying or selling is secondary. The purpose of that meeting… that job interview, is to get hired. When all is said and done, sitting down with such a thorough analysis gives you an edge in advising your clients. Not every client will understand all that you present, but you might be surprised. Dumbing down real estate makes us look foolish. Many of your clients are having these exact conversations already with their financial planner, stock broker, HR rep or even the neighbor next door. More importantly, they are hiring you because you understand it. That is called job security.
Providing thorough expertise on what home prices are, why they are moving and how your client should react will not change the market value of a property – but it will most assuredly change your value.
Dave says:
Sean,
Thank you for a very insightful post. I liked it much better than part one.
Whether your client is interested in buying or selling is secondary. The purpose of that meeting… that job interview, is to get hired.
That is perfectly said. True professionals are seeking to begin or maintain a relationship with every meeting. The relationship should be solidified with a “giving” attitude.
Well done.
August 19, 2008 — 11:09 am
Brian Brady says:
Were you planning on using Delta for range pricing?
How are you going to measure time and translate it to pricing? Discounted cost-of-funds?
August 19, 2008 — 2:15 pm
Michael Cook says:
Well thought out post, but I wonder how many people buying a house would be able to follow all of the logic.
A quick aside: To pay for my wedding I got a second job at a jewelry store. As someone who is intellectually curious, I wanted to know everything about what I was selling. Eventually I became a certified diamondologist and knew more about diamonds than anyone in the store, yet I was always the number two or three salesperson. After about a month or so, I figured out my mistake. People really dont care about the 4 c’s or any of the other crap that I knew, they just wanted me to tell them that the they looked like a movie star in their new jewelry. When I ditched all the book stuff, I became the top sales person.
Dumbing down real estate does not make agents look foolish, not being able to answer basic questions makes them look foolish and not being able to come up to the level of their buyers/sellers makes them look foolish.
That being said, as a very analytical investor I love the thinking. I do have a question, however. You mention volatility in real estate. With an asset class that does not trade often and that has so much uniqueness to it, how can you determine price volatility? Sometimes volitality can just be two knuckleheads that didnt know how to price their house or a couple that lost their job and had to move right away, right?
The trouble I have found with arbitrage and real estate is the require hold time. Two years is consider a short hold time in real estate, unfortunately the rest of the world moves a mile a minute. Economies tank, companies move, an unexplaining shooting happens in a good neighborhood. All these things add up to a very nervous two years even when buying under the best conditions. Unlike options, real estate does price very inefficiently, but combined with the infrequent transactions, it can simply be very tough to call a market.
August 19, 2008 — 2:39 pm
Sean Purcell says:
Dave,
Thank you. I’m happy you liked it… batting .500 ain’t too bad. 🙂
August 19, 2008 — 2:48 pm
Brian Brady says:
I was waiting for you to jump in, Michael.
I love what you said about “looking like a movie star”. Even in securities brokerage, Mrs. Smith would buy 200 shares of First Peoples Bank of NJ because they gave her a 16% CD, back in 1983. Faulty logic but it got the job done.
“With an asset class that does not trade often and that has so much uniqueness to it, how can you determine price volatility?”
I think increased information leads to greater liquidity. I’m thinking about how spreads narrowed when Milken relinquished his stronghhold (with the aid of a federal prosecutor) on the high-yield bond market info or when Bear Stearns stopped controlling the derivatives market.
I’m coming from the idea that we’ll somehow figure this out, Michael and eagerly anticipate your contribution.
August 19, 2008 — 2:55 pm
Sean Purcell says:
Brian,
Thought provoking questions. …delta for a price range is a novel way to incorporate the relationship between volatility and pricing. It would have to be an inverse relationship wouldn’t it? As the deltas increase you become more and more sure what the house’s value is and more importantly what the transactional price will be so the range can (and should) decrease.
Which suggests that as deltas drop below 50 the range can increase to a point that becomes absurd. This makes sense though because as deltas drop below 50 what you are really saying is that you are priced out of the market. Whether measured by deltas or by the need to have an incredible spread in the price range – the message is the same: you should not take that listing.
As for time, I use a risk aversion scale of my own design so it does not translate into discounted money. But that would surely work. It could even be seen as a future value calculation.
August 19, 2008 — 3:03 pm
John Kalinowski says:
I used to dabble with options so this is very interesting. Unfortunately, though, most sellers can’t even grasp the concept of price per square foot, so I don’t see how this helps in real-world real estate.
August 19, 2008 — 7:17 pm
Mortgage Samson says:
The four valuation and assessment factor is a much more analytical means than I have presently been using. Adopting it doesn’t necessarily translate into informed rational descisions, but I suppose one out of two is better than none out of two.
August 19, 2008 — 7:20 pm
Mortgage Samson says:
The four valuation and assessment factor is a much more analytical means than I have presently been using. Adopting it doesn’t necessarily translate into informed rational decisions, but I suppose one out of two is better than none out of two.
August 19, 2008 — 7:21 pm
Sean Purcell says:
Michael,
Had to think about your questions some. Real estate is not very liquid on a single property scale. But as you add data the numbers become clearer. Volatility itself is a reference that makes more and more sense over time. There is a potential problem though: if you work in a small area geographically, you may not have enough data to create valid results. If you correct this by increasing the size of your net, your results become unreliable. Either way, it can be a problem.
As for the speed at which events happen, I have to agree with Brian’s comment. Generally speaking, information increases liquidity and tightens markets. This should lead to increased efficiency.
August 19, 2008 — 7:43 pm
Sean Purcell says:
John,
most sellers can’t even grasp the concept of price per square foot
You’re killin’ me.
Seriously, I think you may be underselling the folks in Ohio. Most people are discussing aspects of this in their retirement planning, just not with as much detail. That’s OK. Some will not get it and they do not have to, they just have to trust that you get it.
As for how it helps… anything I can do to differentiate myself with unique expertise is going to help me get hired. It might even help me give more informed advice. 🙂
August 19, 2008 — 7:50 pm
Sean Purcell says:
Mortgage,
one out of two is better than none out of two
I don’t follow…
August 19, 2008 — 7:57 pm
Paul Francis, CRS says:
Sean,
Interesting concepts that I suppose can make an agent look brilliant as long as they sound like they know what they are talking about.
Unfortunately, we still have to contend with the masters of overpricing to get the listing..
And as the Diamond Sales comparison comment shows.. (Loved that by the way), people just seem to like to hear what they want to and not what they need to.
Probably why you’ll see more real estate agents in a Sales seminar then a CRS 204 or Intro. to CCIM class..
People love hearing Terrific.. 🙂 .. and 20% appreciation rates, real estate is a great investment, etc..etc..
August 20, 2008 — 6:26 am
Michael Cook says:
“Information increases liquidity and tightens markets.” I agree with this point, but I do not know if this will increase liquidity or transaction frequency in real estate.
A major difference between real estate and options is transaction costs. I can go on etrade and buy $50,000 in options for less than $20 a trade. Every time I buy and sell a house I have tons of transaction costs. Even if I know a house is underpriced by $20,000, I cant act on it because there are $10,000 of transaction costs, plus holding costs while I wait for the market to agree with me.
Extending that logic a bit and talking more about volitality in real estate you have several issues. Volatility implies major price swings up and down over a short period of time. Real estate fails on both of those accounts. Even in the hottest markets, prices dont go up or down 20% a year for 5 years. 90% of market (Mike’s guess, not factual) probably increase or decrease +/- 5% a year.
All of this brings me back to the buy decision. As an investor any tool that can help you better analyze an investment is positive, so this kind of thinking is very helpful.
On the other hand, as a home buyer this really should not factor in at all. The value add here is very minimal because of the factors above, in my humble opinion. Factors like schools, proximity to work, and personal preference would trump this analysis for me every time because the difference would be so marginal. Add to all of this the uniqueness of every home and it just seems like a lot of brain damage for one house.
Last, if you were buying 50 houses, this analysis would be spot on because you would remove a lot of the things mentioned above. Homebuilders and large investors should be employing all of these technique to evaluate neighborhood investments.
August 20, 2008 — 9:01 am
David Shafer says:
Interesting post. However, I wonder if it really makes sense to use an option metric to try to predict variability? Also your take on time is a little convoluted for me. The transaction costs and the lack of liquidity demands that real estate be a long term investment (5 years is probably a good starting point). Mortgage debt is another reason time is on your side. Given positive inflation, mortgage debt becomes less expensive as time moves on because it is fixed. So with long time horizons you flatten out variability and drive your expenses down. As to the general price of real estate it is always tied to household income (ok you got me with the lax underwriting of 2003-2007) over the long run. So any analysis of real estate pricing over the long run needs to be applied to area jobs, incomes and current rents. I don’t think this helps the average realtor because in any given area the rents paid might not convert to a buy decision. In my area you can now rent a 3/2 for $1200/month, but were you to buy that same house it would cost you double that!
My experience with home buyers is more akin to M Cook’s diamond selling experience. People buy homes and structure their mortgages for emotional reasons. If you didn’t have that strong emotional push, and really started to do rational analysis, you would find much less home buying!
Keep it simple, buy a home that you want to live in for a long time, let the long term appreciation (5%??), leverage, and inflation do its job. When the home no longer works for you, repeat!
August 20, 2008 — 9:12 am
Michael Cook says:
One correction to the above that might add a bit of support to Sean’s point. Considering most real estate investments are levered at 80% loan to value, a 5% swing could mean a 20% increase in value to a levered investor. Additionally, in super hot markets a 20% swing could be an astounding 100% return, so I retract my price changing statements above.
This does lend support to Sean’s perspective and would certainly make this analysis much more valuable to an investor. I still cant wrap my arms around how to actually determine the volitality of a single asset or even three or four.
The hyper local aspect of real estae really challenges this. Additionally, the lack of buyer knowledge and different buyer motivations, even though information is increasing still make determining the right price challenging. As you increase the number of homes purchased this decreases and perhaps an investor who specialized in several neighborhoods could use this to determine where to focus his/her efforts.
August 20, 2008 — 9:33 am
Sean Purcell says:
Paul
people just seem to like to hear what they want to and not what they need to
I could not agree with you more. I just don’t want the listings where my clients are not going to listen to what they have to hear from me. If all the client wants is a monkey to put a sign in their yard, their are plenty of agents out there who will work for bananas. 🙂
August 20, 2008 — 11:44 am
Sean Purcell says:
Michael,
You raise a lot of interesting questions about an idea that is developing. The pricing models of my previous post I use now, but it is this new way of looking at values that intrigues me.
You are right, of course, about the liquidity and cost of transaction issues. But that view is focussed on buying and selling a single property. We can not “trade” single properties. But using this type of concept to understand what is happening across a broader scope has a few applications.
The obvious one you and others have already mentioned: this can be a very powerful tool for investors if it is constructed properly. But I think there may be other uses as well. Not all buyers, for instance, are set on an area. Some buyers are looking to make the “right” financial decision between a few different choices. Knowing which area is a better value based on the homes volatility, delta and so on would be beneficial. In the end it may not make the decision for them, but it should help clarify their options.
This type of information might also be helpful to an agent deciding which area to farm or specialize in and has definite marketing implications.
Finally, Brian Brady mentioned something that gets less attention than it deserves: the negotiation of a contract. Our clients may not always understand the things we are talking about, but having a deeper, clearer view of values can be used as a big hammer in negotiations with another agent. 🙂
August 20, 2008 — 12:12 pm
Sean Purcell says:
David,
Your criticisms are well recieved. There are issues with this idea, no doubt. I am not putting it out as some polished gem or “black pearl,” but rather a work in progress. There are aspects of the options metric that will not work and their is much to figure out about how to even measure volatility. The process would be based on the desired outcome and the comments here have helped define some of those outcomes.
Home buying is, as you said, linked to income and I envision the mathematical model here involving some type of reversion to the mean concept. It may measure price vs. hypothetical mean, it could be a moving average or it might be based on some standard defined as 1. Lots of ideas in my head and lots of mistakes still to be made.
Your take on rents and mortgages is interesting. I think Brian Brady has a pretty specific theory for defining what I call the Utilitarian value as a basis. I will just have to wait like everyone else to see how it works.
I do agree with you that real estate is an emotion based transaction. But that does not mean more information is bad. If anything, more information is desired when someone is making a large financial investment and allowing emotions to take a large role. We should remember that most other investment worlds use a system much closer to what I am playing with. Not many base valuations on “comps”. We may not be trading houses, but it is still a very large investment and deserves a thorough analysis.
Plus, this industry is a competition for jobs based mostly on perception. Like a carpenter showing up with the most tools and the coolest truck is often perceived as the guy who knows how to get things fixed; knowing a homes’ delta or where it falls on a volatility scale certainly makes my tool box bigger.
August 20, 2008 — 12:31 pm
Dave says:
Interesting concepts that I suppose can make an agent look brilliant as long as they sound like they know what they are talking about.
Can we all agree that if you really don’t know what you are talking about, it’s best to say nothing?
August 20, 2008 — 12:45 pm
David Shafer says:
Some good ideas in there. Like the reversion to the mean idea. Maybe taking some of Buffett’s ideas about investing and put it to real estate might be more fruitful than an options metric?
But, I just can’t get over the fact that houses are homes first, not investments. It is only because people are so bad at investing that their home ends up being where they have most of their wealth.
Starting from this unintended consequence (home equity being a majority of individual net worth) of home ownership, we then go down a very questionable road when we start to treat home ownership in the same ways we treat investments. Trying to market time for example or looking to predict the homes with the greatest appreciation potential.
Finance guys like myself and Brian attempt to show people how to turn their home into an investment with mortgage financing, however, I think we will always be dealing with the outliers who can appreciate these strategies. Most people just want a home that works for them and their family. Appreciation happens despite their lack of rational thought to this. I think the realtor can do best by making sure the home buyer gets into a home which will keep them happy for at least 5 to 10 years. Maybe this is where I am going with all this. Buffett thinks you should invest with the idea the stock market is closed for the next 5 years, real estate should be sold with the same idea. Bring that thought to your home buyers and you will do much good and prove the worth of your advice much better than attempting to predict future pricing!
August 20, 2008 — 1:35 pm
Dave says:
Starting from this unintended consequence (home equity being a majority of individual net worth) of home ownership, we then go down a very questionable road when we start to treat home ownership in the same ways we treat investments.
David that is perfectly said and impeccably timed. And on that note, if no one has noticed, but Fannie and Freddie may not survive on their own through the week:
http://ap.google.com/article/ALeqM5gPfdSGL82ufTASVrfgCbKslcCYPgD92M5Q200
August 20, 2008 — 1:40 pm
Keith says:
I like what you have to say, and I can’t say I disagree. As an MBA with an absolute geek attitude, I perform regression analysis every quarter on various neighborhoods in my community to determine where the strength of the town really is. Watching a median price go up and down and claiming that shows what the market is doing is somewhat absurd.
However, while my analysis is part of why people hire me, selling and pricing their house is much easier. Why base a price on imperical data alone when many realtors are simply going to see what the tax assessment is and base their offer on that.
I use my analysis to justify my recommendations, but when it comes down to it, you need to make offers and counteroffers based on how the other party is thinking… and that is frequently not based on good evidence.
August 22, 2008 — 7:48 am