By this point, it should be abundantly clear that quality decisions are the goal. The reason for this is because decisions are the only part of the investing process that are within our control. We do not control the property managers, we don’t control the tenants, we don’t control the weather, and we don’t control the local economy. The only thing that is within our sphere of control is the decisions we make.
These include deciding what type of property to buy, deciding where to buy the property, deciding when to buy the property, deciding what terms to offer prospective tenants, deciding when to evict tenants (if necessary), and deciding when to sell. In each of these decisions, the ultimate result is outside of our control. We can influence the results we achieve with our decisions, but we cannot control them.
What value-based analysis does is help us to increase the quality of our decisions by increasing the amount of solid fundamentals that are behind the decisions we make. In stock investing, this is referred to as the “margin of safety” or the amount by which we can be wrong and still come out ahead. When dealing with income property, the “margin of safety” represents the degree to which we are buying a quality asset at a low price, and are likely to be protected against significant adverse market developments. This protection does not come form a third party “guarantee” … it is the result of our superior research, superior knowledge, and superior decisions.
One of the things that we can do to generate this “margin of safety” is starting with a thorugh analysis of the characteristics of investment properties that are available in the area where we are considering investing. The reason why this analysis is so important is because it will tell us what is “normal” for a particular area, and by extension will enable us to determine whether we are purchasing a property with investment characteristics that are better, worse, or on-par with “normal” for the area.
For example, let’s say that you are looking at investing in a particular area with the following average characteristics for properties:
- Replacement Cost $80 per square foot
- Rent to Value Ration: 0.90%
- Metropolitan Area Population Analysis: Net Population Growth 0.5% per year, with large amounts of land available for new construction.
To continue the illustration, let’s say that you’re looking at a property for purchase with these characteristics:
- Purchase Price: $90 per square foot (including land)
- Rent to Value Ratio: 1.01%
- Property is located on the outer ring of the metropolitan area, near a large amount of new construction.
By conducting a brief value analysis, we quickly see that the purchase price exceeds the replacement cost of the property, the rental rate exceeds the area average, and the property is located in an area where new inventory can come onto the market quickly.
What this tells us is that the property is situated in a place where it can generate good income, but that we should not expect to see rapid price escalation in the near-term. The reason for this is because the purchase price was in-line with replacement cost when accounting for the cost of purchasing the land, and that the property is located in an area where new inventory can come onto the market to absorb increases in demand and curb price growth.
None of this is to say that the property necessarily represents a definitively ‘good’ or ‘bad’ deal … it is simply to say that the property’s investment characteristics have a certain profile. In this case, the profile is one of a property that should held as a play to produce cash flow. This is not to say that appreciation cannot happen, but the market conditions are structured to create resistance against price escalation by new construction that generates additional inventory to modulate supply in response to additional demand. In this situation, significant price appreciation will require an escalation in market demand that exceeds the ability of builders to generate new inventory.
This analysis helps us to make higher quality decisions, because it provides additional depth to the “what if” questions. For example, we may ask: “What if the market for property purchases dries up and it creates pressure on rents as home owners turn into tenants?”
The answer to this is that the pressure on rents may come, but there is a “margin of safety” from the above-market Rent to Value Ratio to absorb it. Furthermore, the decrease in homeowner purchases will slow down or possibly stop construction. From this point, prices are likely to stay relatively flat until demand for purchases picks up again. However, this additional demand will meet a static supply, since there is a significant time requirement to bring new housing inventory into the market. During this time lag, existing housing will escalate in price as the new buyers bid up the prices.
By conducting analysis of this type, we can enable ourselves to make higher quality decisions. The reason for these deicsions will not be blind faith in the projections of a market prognosticator or a broker who is trying to sell us a product or property. The decisions will come from our knowledge of a market, and our ability to see how the property we are looking to buy fits into that market.
The idea that we end on is exactly where we began … the part of our success we can control is the decisions we make. There are many things outside of our control, and worrying about them is ultimately futile. We should be investing our mental effort into the part of the process that we can control, which is the quality of our decisions.
By increasing the quality of our decisions, we can influence but not control the quality of our outcomes. In the next section of this report, we will be examining the relationship between decisions and outcomes, as it relates to our careers as income property investors.
