This post first appeared in the June edition of: Cirios Trends: Finding Real Estate Opportunities.

“Mow much should I pay?” is about the most common question we get here at Cirios. Unfortunately (or fortunately), the answer to this question is never black and white. Depending on a buyer’s desired use for a property, there are many ways to determine value and what the right price to pay is.

An investor looking to rehab and sell a home quickly may put a different value on it than an investor looking to buy and rent for several years. Since each investor has different profit targets and time horizons, formulas that determine what price the investor would pay nearly always differ.

Still different is the price a regular home buyer would be willing to pay after accounting for mortgage payments, tax breaks, upkeep expenses, etc.

This piece covers a couple different methods for valuing a property, and is at best a cursory examination of these topics. Each one contains many further levels of complexities and nuance.

Many investors that purchase and hold income generating properties use the Income Method of valuation to determine an attractive purchase price. If an investor wants to earn, say 6% on his money, he would use the annual operating cash flow generated by the property to calculate what purchase price would achieve that level of return.

This type of investor often uses the concept of a “Cap Rate” to figure out how much properties are worth. A Cap Rate (short for Capitalization Rate) is the rate of return generated by net cash flows – that is, rental income minus all operating expenses associated with owning the property. For example, if a 6-unit apartment building bought for $400,000 generated $30,000 in net operating income, the Cap Rate would be 7.5% ($30,000 / $400,000).

If a nearby 6-unit building generated $45,000 of income, applying the same Cap Rate you would arrive at a value of $600,000 ($45,000 / .075). In general, as markets improve and property values go up, Cap Rates go down. This makes sense: When times are good, there are usually more buyers than sellers, so sellers can demand high prices which push down rates of return.

The reverse is true when prices fall and markets tighten up. Investors demand a higher rate of return for taking the risk of buying a property in a hard environment, which drives down the prices they are willing to pay and thus pushes the Cap Rate up.

For home buyers, the decision of what price to pay is determined by two primary factors. First, the buyer’s ability and willingness to pay. Monthly income and savings will often dictate how much a buyer can pay, then more emotional factors kick in to determine how much he or she is willing to pay. The confluence of hard numbers and soft feelings creates a price range where the buyer can be satisfied both economically and emotionally.

Second, recent sales, other listings and general market conditions will determine what a fair price for a given home is. Subjectivity plays a huge factor in comparing like properties, so valuing single family homes is much more an art than a science.

Often, relative affordability between different cities is evaluated using a “Rent Ratio.” A Rent Ratio is exactly what it sounds like, a ratio between the cost to buy and the cost to rent. If a $200,000 home would cost around $16,000 per year to rent, the Rent Ratio is 12.5 ($200,000 / $16,000). According to Rent.com, which compiles rental data nationwide, a Rent Ratio around 15 means the buying and renting are roughly equivalent options. Below 15 and buying may be the best route, while above 15 and it may be best to hold off.

According to the most recent data, San Francisco is actually ranked as the best city to rent, with a whopping Rent Ratio of 37. That’s higher than New York at 21 and Honolulu at 24.

So, does that mean it’s a terrible idea to buy a home in San Francisco? Far from it. There may be plenty of valid reasons not to buy in San Francisco, but a broad metric like this doesn’t tell the story of individual neighborhoods.

What this high ratio does tell you, is that if you are lucky enough to find a property in San Francisco where buying and renting cost roughly the same, you are probably getting a pretty good deal.

By RYAN TAYLOR

The National Association of Home Builders, or NAHB, released its confidence numbers for February this morning and the reading unexpectedly rose to 9, up from 8 in January. 8 is the lowest level the index has ever reached.

This surprise increase is not exactly a reason to start popping champagne and celebrating the bottom of the market for new homes: Sentiment is not deemed positive until it climbs over 50, so we have a long way to go before it is time to be optimistic.

“The market for new single-family homes remains very weak at this time,” NAHB Chairman Joe Robson said.

While the NAHB is rarely as misleading as the National Association of Realtors, these comments are far from reassuring. The basic reasons for the increase in the sentiment were increases buyers traffic and the blind hope that the $789 billion stimulus package would help turn the economy around.

“Looking forward, we are certainly hopeful that the newly passed economic stimulus bill, which includes some favorable elements for first-time home buyers and small businesses, will have a positive impact that will help get housing and the economy back on track,” said Robson.

In a more muted recessionary environment, we believe the $8,000 tax credit offered to first-time home buyers would have a significantly positive affect on demand. However, the economy remains quite weak and we believe most first-time home buyers are going to have a hard time buying homes since so many either A) no longer have a job or B) have seen their wages curtailed.

Finally, new home sales will continue to be hurt by the ever growing prevalence of REOs on the market. Given the fact that numerous banks are keeping many of their REO properties off the market, we do not foresee competition from REO properties being eliminated in the foreseeable future.

Buying a new home remains a risky proposition.

By RYAN TAYLOR

Looking at real estate from the perspective of an investor, it’s easy to forget that behind each transaction is an intensely emotional decision – often one that is life changing for the buyer. Not only do people want to buy a home to grow their wealth but they also want a place to raise children, be close to friends and enjoy the nuances that make a home special to them.

And while we use many different tools (Google Earth, Realty Trac, Trulia etc.) to value a home, it’s nearly impossible to know what intangible aspects of a house adds value to you, the buyer. The concept of your own personal preferences when it comes to a residence is “Your Value”.

One of the main reasons real estate will always be an imperfect market is because of Your Value’s influence on the market. It is impossible for the rest of the world to know when a house that’s for sale is next door to YOUR best friend or within walking distance of YOUR job. In both these cases, because of the intangible benefit that creates an increase in Your Value, you may be willing to pay more than the typical buyer for that particular home. As well you should.

In a declining market, Your Value becomes more important because the decision to buy a home is so much riskier from a financial standpoint. Buying a house is a big decision at all points in time but it is never more profound than in a market where your new home is likely to be worth less than you paid in a short period of time.

Now, more than ever, you should be uncompromising as a buyer. The home you are looking for should be well defined –

TOO Broad: A 3 bedroom single family residence in San Mateo
TOO Narrow: 1234 Main St, San Mateo, CA
Perfect: A 3 bedroom home with a large backyard and updated kitchen between the 101 freeway and the 280 freeway.

Think about it this way – if you had $500,000 cash and you were going to spend it all on something, wouldn’t you require it to be perfect or close to it!? Well, that is exactly what you are doing when you buy a house — you just get a bit of help from the bank on the cash part.

The reality is that you should always be willing to pay up for the house that fits your parameters. As any good real estate agent will tell you, you should never purchase a home that you do not see yourself living in for at least 5 years (in this market, preferably 10 or more). With this thought in your mind, having a clear understanding of what constitutes Your Value is critical when looking to buy a home.

While we continue to believe it is a risky time to buy a house, we understand that there are certain properties that meet or exceed your every expectation. It’s very possible this home will not be available when market conditions have improved and risk has fallen. When the home is affordable for your situation and Your Value is reached, it might just be time to buy.

And while that doesn’t mean you should rush out and start bidding on properties that you convince yourself are “perfect,” it does mean finding the right property, at the right price, even in this market, is certainly possible.

But before you hit the Saturday open houses with your neighborhood Realtor, ask yourself this very important question: Do You Have a Friend in the Real Estate Business?

By AUSTIN NELSON

How many times have you read a statistic like this one: “57% of Americans believe that the economy will do X in the next Y years”? Ever wondered how in the heck they can say something like that? Do they poll every American and ask them what they think?

The answer, of course, is no.

Through a series of statistical tricks, it is usually perfectly acceptable to make statements like the one above using only a small sample size. For national poll results, usually between 1000-2000 people suffice. Scientifically speaking, much can be inferred from such a sample, and its accuracy can be evaluated mathematically (hence the ubiquitous +/- 3% info that follows all poll data).

The goal of polling any sample is to get enough people to gather a representative group, without going overboard and designing polls that would take months to perform. The problem — and this is where one can get into trouble with polls and other studies using small samples to evaluate a large population — is in the process of sampling itself. For instance, in “nationwide” polls like one that could get the datum described above, polls are often conducted by phone, with pollsters “randomly” selecting people to poll and collecting the results.

But what does “random” mean? Presumably, these pollsters have a method akin to pulling a name out of a hat filled with every name in the phone book. There are a few problems with this assumption of “randomness.”  The first is that not everyone is in the phone book. The second, and more significant problem with this methodology, is that it takes a very specific kind of person to a) actually answer the phone when someone calls from a number they don’t know and b) actually stay on the line when the person on the other end announces they just need “a few minutes.” By choosing to interview people by phone, the pollsters have actually thrown random out the window and left a large portion of America out of their study entirely.

Now, Im not saying that every national poll is worthless. Far from it. In fact, polls can be very informative as to trends in public opinion because you can accurately compare the results of the same poll over time. But it should never be assumed, not even for one moment, that if the poll says 57% of Americans do whatever, that 57% of Americans in real life actually do that (even including the stated error range).

Sampling is a big issue in any area of scientific inquiry. The assumptions that underlie any statistical analysis are very specific as to the requirements for sampling. Outside of the physics laboratory, these assumptions are almost never met. However, through careful design and data acquisition, one can make a reasonable stab at satisfying their requirements.

One good example of this is the Case-Shiller home price index, or CSHPI. As described previously by Andrew Jeffery, the index uses paired-sale comparisons to evaluate current trends in housing markets. Their methodology is opaquely complex but freely available for the world to see.

Some argue against the method, saying that by only sampling homes that have repeat sales within a given time period, you leave out a huge chunk of homes whose sales could give you insight into home values in its area. This is true, and the CSHPI is far from perfect as a result, but there is simply no way one can achieve perfection in an undertaking like modeling home prices.

The important thing to keep in mind is that with the CSHPI, you know what exactly what you are getting — and what you’re not.

Is the index a perfect indicator for what is going on in Brentwood, CA or Mesa, AZ? Absolutely not, and anyone who tells you otherwise is selling you something you don’t want to buy. But it is a painstakingly accurate and admirably well-designed method for tracking trends on a large scale level. That it leaves a large chunk of the market out of its samples is an inevitable aspect of proper experimental design.

Only by controlling as many variables as possible (in this case, by only comparing one house to itself rather than every other house that has sold within a given time frame) can one hope to do any meaningful analysis of a market as complex as residential real estate.

Because of the way it is constructed, the index itself is really only valuable as a tracker of large scale trends. If the index goes down by 10%, you can’t reasonably say that any given property has declined by 10% or even use it to reliably estimate the price change of a specific property. But if the index has shown a 25% drop from its peak (as it has), you can reliably infer that things are not going well in US housing. By tracking the rate of that decline or the difference in trends between the individual indices of one metro area versus another (there are indices available for 20 metropolitan areas), one can gain valuable and reliable insight about the performance of those markets and make inferences about future trends.

In conclusion, sampling is one of the most important but least appreciated aspects of modern data analysis. In order to correctly interpret any given data, it is absolutely essential to know how that data was sampled and how that sample fits into the area of study. Be wary of data where the data collection and analysis methodology are not freely available. And understand that where samples are involved, usually the most valuable way to use that data is to monitor changes over time rather than making inferences about how any given time period’s data relates to whatever phenomenon you are interested in.

This is especially true when it comes to home values, where there is absolutely no single data model that can tell you how much your house is worth or how much to pay for that new house you’ve got your eye on. However, there is enough data currently available that with careful scrutiny (and the help of trained professionals like the friendly folks at Cirios Real Estate) you can confidently make those assessments.

Unlike Santa Ana, where last week we learned there is strong demand for attractively priced properties, Sunnyvale has seen sales volume decrease over the past 3 months. This is concerning, particularly as other, distressed areas experience pops in sales activity and the broader economy continues to weaken. Sunnyvale is in the heart of Silicon Valley which has been relatively immune to the downturn in the economy…so far. However, we see properties like this one experiencing significant value drops over the past few months.

Since the property did not sell in the last week, we are providing you with our value. Thanks to Lisa Friedrichs who is the only one who guessed (and got darn close by the way!!). The envelope please …

Address: 809 Muender Ave. Sunnyvale, CA 94086
List Date: 11/13/09
List Price: $509,900
Cirios Value: $390,000
List Price v. Cirios Value: 23.5% over-listed

The housing crisis has affected the entire country but certain markets have fallen faster earlier while others are only now seeing declines. The Sunnyvale market (and the Silicon Valley in general) has only experienced slight declines compared to some of the more distressed markets, which has a lot to do with the strong job market through the 3Q of 2008. As the job market has slowed down, the values of homes have begun to feel the pressure. The first homes to see declines are the ones that have a high level of negative obsolescence.

We believe a former “Old Fashioned Doll House” that is bank owned and backs up to a auto body shop is a prime example of a property that is going to see a significant decrease in value. This home sold for $605,000 in 2005 and to think it has only decreased in value by $95,100 or 16% since that time seems optimistic to us.

Beyond this property, we feel very strongly that properties like this one in formerly strong markets have severe downside risks associated with them. If you only take one thing away from this HOTW, it should be that “entry” level homes on the San Francisco Peninsula should not be viewed as properties that have very little risk.

As always, if you are looking for a property on the Peninsula and want to know what is the real value of the property, please do not hesitate to contact us.

Cirios Real Estate: Educating home buyers since 2008.

By RYAN TAYLOR

The National Association of Realtors announced yesterday that the median home price in the US fell by 12% from a year earlier. Not surprisingly, the fall in prices was driven by the ever increasing number of foreclosure sales which accounted for 45 percent of all transactions.

The pressure on prices is only increasing as job losses mount around the country. The US lost 2.6 million jobs in 2008 and has lost more than 600,000 already in 2009.

While we may sound like a broken record, we continue to believe that buying a house right now is a risky proposition. Unless Washington comes up with a plan where they make housing payments for unemployed workers (not terribly far fetched given the announcement yesterday to subsidize mortgage payments), the housing market will decline because job losses equal a decline in home prices.

The reality is that the pent-up demand often cited by homebuilders and Realtors is fading due the increased uncertainty in the broader economy. A trend being seen in previously strong markets throughout California is that potential buyers are holding back to due to uncertainty about their jobs. Even those with steady jobs are content to wait — houses will almost certainly be cheaper next month, and the month after — why buy now?

Furthermore, most of the homes on the market today are listed at prices that reflect an environment where demand remains strong. By in large, it’s not strong. Sellers will be forced to recognize this and slash prices — but this takes time.

Of course, the government will be working around the clock to speed up the demand process and you can trust that Cirios Real Estate will keep you informed on the latest developments in the market.

This week’s House of the Week, a 3bed, 2 bath home in Santa Ana, CA is evidence that even in a market as weak as the one we’re one, people are still buying houses. This may seem like simplistic concept, but the way the media reports it, it’s as if home buying has stopped altogether.

To be sure, its brutal out there, hard to get a loan, prices are falling, but people still need somewhere to live — and no matter how mad it gets that will not change. And with that, the drum roll please . . .

Address: 602 East Camile St, Santa Ana, CA
List Date: 11/27/2008
Sold Date: 12/23/2008
List Price: $294,000
Sale Price: $310,000

Not only did it sell, it sold above list!

Now, does that mean everyone should run out and put their homes on the market because suddenly the buyers are back and bidding wars will once again become the norm? Far from it.

If asked to value this property prior to its sale, we probably would have placed it somewhere between $270,000 and $280,000. One of the most attractive features about the subject is its oversized lot at >9,000 square feet. As for comps, 1275 South Hickory Street, a fairly comparable property sold for $285,000 a few weeks before the subject. Interestingly, this house sold also above list.

In neighborhoods where sellers are undercutting each other to attract buyers (like this one), we are starting to see more and more buyers come in and bid up the properties to above list. House prices have fallen so far from the peak, that even though they are likely to keep falling for a while, buyers see a previous sale of, say, $600,000 and a list price under $300,000 and can’t resist.

For 602 East Camile specifically, we would argue the buyer would have been better off waiting a bit. There are some properties on the market now in the $260,000 – $280,000 range that offer a nice alternative. Also, prices remain in a downward trajectory and it’s reasonable to expect them to fall closer to $250,000 by the summer.

This post first appeared in the February 2009 edition of Cirios Trends.

This being the inaugural edition of Cirios Trends, we’re giving our loyal readers two houses for the price of one. Let’s travel about 30 minutes south from San Francisco to Google Park – err, Menlo Park – where the tree-lined streets are paved with Internet gold.

The two houses below are on Hermosa Way, across the street from one another. We believe both owners are a touch too optimistic about finding a buyer at their current asking prices. The homes were listed during the same week back in September, and now appear engaged in a my-overpriced-house-is-less-overpriced-than-your-overpriced-house price war. Hard to imagine either owner is going across the street to borrow a cup of sugar. Here we have a microcosm of the current housing market – too much supply, each seller trying to undercut his neighbor.

Neighborhood Overview: Menlo Park is a very desirable location because of its great schools and proximity to major Silicon Valley job centers (including Google’s massive campus in nearby Mountain view). These factors, coupled with its mild climate, have ushered in an era of unprecedented prosperity for this once middle class town.

Property values began to falter in 2001 as the dotcom bubble burst, but the emergence of Google almost single handedly reversed the market’s fortune. Many freshly made millionaires bought older homes, tore them down and erected McMansions of their own. Now, with many residents seeing their paper wealth evaporating on Wall Street, Menlo Park property values are starting to come back to earth.

House #1: 800 Hermosa Way, Menlo Park, CA 94025

Original List Price: $4,250,000
List Date: 9/7/08
Current List Price: $3,675,000
Previous Sale: $2,900,000
Previous Sale Date: 3/12/2004
Estimated Down Payment: $735,000
Estimated Monthly Payment: $22,622*
Bedrooms: 5; Bathrooms: 4+
Liv. Area: 5,350 sqft; Lot Size: 21,816 sqft (0.5 acres)
Positives:
+ Large house, more living area than most comps
+ Upgrades nearly throughout (except kitchen)
+ Close to all amenities, schools, shopping, freeways
Negatives:
- No sales >$3 million in the area in the last 3 months
- Many high end homes listed, lots of competition
- 5,000 square may be too much house for some buyers
Value Analysis:
The world of potential buyers for this house is very limited, he or she would need to have the income and job security to afford a $22,000 monthly payment. Many comparable, if not quite as large, homes are available for as much as $1million less. The comp sale below is inferior, but a better indication of demand in the area.

HOUSE #1 CIRIOS VALUE: $2,950,000
Over-listed Amount: $725,000 (24.6%)
—-
Comparable Sale: 345 Vine St, Menlo Park, CA 94025
Sale Price: $2,420,000
Sale Date: 12/16/2008
Bedrooms: 5; Bathrooms: 4
Liv. Area: 3,220 sqft; Lot Size: 8,350 sqft (0.2 acres)
Comparison to Subject: Inferior

House #2: 777 Hermosa Way, Menlo Park, CA 94025

Original List Price: $4,495,000
List Date: 9/5/08
Current List Price: $3,975,000
Previous Sale: $2,295,000
Previous Sale Date: 6/19/2002
Estimated Down Payment: $795,000
Estimated Monthly Payment: $24,469*
Bedrooms: 4; Bathrooms: 3;
Liv. Area: 3,302 sqft; Lot Size: 21,708 sqft (0.5 acres)
Positives:
+ Excellent condition, inside and out
+ Updated kitchen
+ Reasonably sized home that conforms to the area
Negatives:
- No sales >$3 million in the area in the last 3 months
- No exceptional features, except the kitchen and lot
- Significantly over-listed, smaller than its listed neighbor
Value Analysis:
The world of potential buyers for this house is also very limited. House #1 is larger and newly upgraded, and should sell for more than the subject. The subject’s conformity and smaller size could attract more buyers looking for an easier home to maintain. The comp sale is inferior, but more similar to the subject than House #1.

HOUSE #2 CIRIOS VALUE: $2,700,000
Over-listed Amount: $1,275,000 (47.2%)
—-
OVERALL COMMENTS:
Both owners are faced with a similar dilemma: Do I lower my asking price until I get an offer, or take my home off the market and hope for a rebound? Ultimately, both sellers need to be more realistic with their expectations of how much their homes are worth.

* Mortgage payments are based on the house being bought at the list price with 20% down and a 7.0% 30yr fixed loan, monthly tax cost included.

By ANDREW JEFFERY

In contrast to the silver lining of higher-than-expected home sales tallied in yesterday’s release of Existing Home Sales, this morning’s Case-Shiller November Home Price Index registered the worst year-over-year performance on record.

Property values in November 2008 tumbled 18.2% from the prior year and 2.2% from the previous month. As measured by the Case-Shiller’s 20-city index, home prices have retreated 25% from their mid-2006 peak and now sit close to levels not seen since 2004.

Like a CD stuck on repeat in the guy down the hall’s dorm room while he is away at class (you try listening to Chumbawumba’s Tubthumping for 3-hours straight and not being driven to drink at 3pm), annual price declines were the worst in Phoenix and Las Vegas, followed by San Francisco, Miami, Los Angeles and San Diego.

News that home prices are falling, however, isn’t exactly news. So let’s look at what this Case-Shiller Home Price Index is anyway, and how it differs from the less murky Median Home Price data released every month by our friends at the National Association of Realtors (the NAR).

As Cirios statistics’ wizard Austin Nelson explained last week, the median home price is simply the middle price in a list of sales. So, the NAR grabs data on all home sales in a given month and picks out the one with the same number of sales on either side. The logic behind using this measure, rather than the more commonly understood average, is that it reduces the effect of outliers, or sale prices that are either much higher or much lower than the prevailing trend.

Case-Shiller, on the other hand, uses what are known as “paired sales” to evaluate home prices. By examining sales in a given month, then looking back to find the most recent sale price and date for each house, statisticians are able to back into an annual rate of decline.

For example, if house A sold in November ’07 for $250,000 and again in November ’08 for $200,000, Case-Shiller would say the annual home price decline was 20%. By limiting the search only to sales that have a relevant pair (ie, previous sale), the methodology limits sample size, potentially leaving margin for sampling errors. Sample size is something I’ll let Professor Nelson explain in further detail at a later date.

So, which method is better, paired sales or median price? As is typical with such economic questions, the answer is a resounding neither.

Median Home Price measurements provide good information about the distribution of sales, and in the current environment reflect that since Jumbo mortgages are nigh impossible to get and foreclosure sales are driving most markets, cheaper houses are selling far more often than more expensive ones.

Case-Shiller, on the other hand, represents a more accurate level of home price declines for specific homes — far more important to the average homeowners. Of course, a number slapped on a metro area is fairly meaningless when it comes to an individual property, but it’s still more useful than a bucket of houses being sold for different reasons by different sellers in different neighborhoods.

With Case-Shiller a month behind the NAR data, keep an eye out next month to see if the silver lining found in December’s median home sales data is reflected in the paired sales analysis. If it is, you can be sure calls for a bottom in housing will once again abound.