The notion of “value investing” was first made popular by Ben Graham, and later by Warren Buffett. At its core, value investing is about knowing the fundamentals or “intrinsic value” of an asset. What this ultimately means, is that investors should seek to learn what a given asset is “really” worth. While most value investing literature is primarily directed at stocks, the underlying principals can be applied to any type of investment. One area that very few have chosen to apply value investing principals to is income property.
Once the investor knows the “real” value of the assets that are being analyzed, they will have the ability to become value investors. The reason for this is because the market price of assets changes much more rapidly than the underlying fundamentals of those same assets. Ben Graham referred to this phenomenon as a fictional person named “Mr. Market” who will offer to buy or sell assets on any given day at rapidly fluctuating prices. Sometimes “Mr. Market” is willing to buy and sell at very high prices, and other times he is only interested in very low prices.
Generally speaking, the market price tends to fluctuate around the “fair value” of an asset. Over time, the price of an asset tends to regress toward the fair value of that asset. What this means is that when assets become significantly over-priced or under-priced, a reversion to vair value is very likely to occur in the future. As value investors, we should seek to purchase when market fluctuations have pushed the price below fair value and sell when market sentiment escalates the price above fair value.
Of course, one of the important things to understand in this whole process is that prices can remain disconnected from fair value for a very long time. Bubbles can escalate prices to levels that seem to be complete nonsense, and then keep pushing them higher. Crashes can compress prices to levels that seem unbelievably low, and then keep pounding them lower. The path from any given point in the life cycle of an asset toward fair value is very rarely a straight line. Typically, the asset will go through a period of becoming more overvalued or more undervalued before it regresses toward being fairly valued.
The way that this principal is used by stock and bond investors is to conduct financial analysis on the companies and countries issuing the financial assets in question, and determine what the “fair value” of the equity ownership or debt obligation should be. From this point, the investor waits until the market value of these assets fall below their fair value, at which point they begin to buy. As the price escalates through, and beyond fair value, the stock and bond investors will pay close attention to the trend of price changes to pinpoint an opportune time to sell.
As income property investors, we can place these same principals to work in our favor. By knowing the fundamentals of what creates value in income properties, we can learn the fair value of any property that we are looking to buy. Once we know the fair value of a given income property, we can know whether it is being offered at an attractive or expensive price. When market prices escalate above fair value, our analysis will tell us to both avoid buying new assets, and to sell assets we already own, since the risk of loss is increasing, while the probability of additional gains is decreasing. Conversely, when market prices are significantly below fair value, our analysis will tell us to buy aggressively. The reason for this is because over the long-term, prices regress toward fair value. By purchasing below fair value, we will be able to lock-in expected equity appreciation as the price of the property reverts toward its real value. Ultimately, value investing is about buying when the risk is low and the potential rewards are high, and selling when the potential rewards have dwindled and the risk has escalated.
Thus, the fundamental underpinning of applying value investing principals to income property investing is to understand how we can determine the “fair value” of an income property. Once we know this critical piece of information, it will lay the foundation of many intelligent business decisions.