Like stocks, real estate has proven to be an excellent way of building wealth. If you're hunting for your dream home or an investment property, here are three value investing principles to embrace.
Don't take your cues from Mr Market
In Benjamin Graham's book The Intelligent Investor, he asks the reader to imagine a business with two owners – you and your business partner, named Mr Market. Every day Mr Market comes to you and offers you a price at which he is happy to buy your share or to sell you his. Mr Market, however, is emotionally unstable; his offer price can swing wildly depending on whether he's in an optimistic or pessimistic mood.
Whether you're dealing with shares on the stock exchange or houses in your local suburb, the principle is the same – the public can be emotional, excited, overly-pessimistic, and often irrational. Investing, however, is always at your option, so it pays to stay patient and wait for a deal that suits you.
Smart property investors know that trying to time the market is a losing game. Buying or selling because you think Mr Market is going to do this or that over the next year is a great way to lose money – what matters is whether the specific property you're considering is undervalued or overvalued.
Look for moats
Warren Buffett popularised the idea that some businesses have ‘moats' – sustainable competitive advantages. These, he argued, would protect investors by ensuring long-term profits that aren't eroded by competition. The same goes for certain properties.
‘Location, location, location,' as the saying goes. Buying property in a prime location doesn't guarantee success – which also depends on the price you pay – but it can save you a lot of financial pain. A prime location isn't necessarily somewhere like Double Bay or Toorak – by ‘prime' we mean somewhere with favourable and sustainable fundamentals.
Focus on two factors: supply and demand. It's a good idea to target areas where there's increasing demand due to a growing population or employment opportunities. Proximity to parks, schools or trendy shopping districts also enhances a property's 'moat'.
Demand, however, isn't enough; you also need barriers to supply – a lack of available land, restrictive zoning laws, and limited nearby development opportunities. The fewer the cranes on the skyline, the better.
Plus, stick to properties less likely to become ‘architecturally obsolete'. You may love that hot pink house with purple gargoyles, but it could limit the number of future tenants or buyers.
Demand a margin of safety
The Margin of Safety concept was promoted by Benjamin Graham as being key to investing success. If a bridge is capable of supporting 10,000kg, you don't want to drive a 9,999kg truck over it. Likewise, when buying property, you want to leave a generous gap between the price you pay and the property's underlying value to leave room for valuation errors, cognitive biases, and unfavourable events.
There are three main ways to value a property – the ‘discounted cash flow' model (a fancy cousin of the income capitalisation approach), replacement cost, or similar sales comparison. The former is technically the most accurate but it's prone to forecasting error. Replacement cost and sales comparisons, on the other hand, are easy valuation tools for the present market – and are the most commonly used – but they only describe whether a house is undervalued relative to those around it, not whether it will actually earn you a decent return on investment over the long term.
Whichever method you use (ideally all three) the important point is that you want to factor a margin of safety into your offer price to allow for error. In fact, try to be conservative at every step of the investment process – for example, by not taking on more debt than you could afford if interest rates were materially higher, or by focusing on specific suburbs so that you become a 'local expert', which will make it easier to spot opportunities.
Whether you're buying stocks or property, most investing principles are the same – do your homework, ignore the crowd, and look for assets that deliver more value than you're paying for.