How to Spot Undervalued and Overvalued Real Estate Markets

Former Fed Chairman Alan Greenspan has gone from genius to goat in recent months. Pundits wonder whether his ultra-easy-money policies were responsible for the meltdown in sub-prime mortgages and the collapse of formerly hot real estate markets.

The answer is yes, he is responsible. But he’s not alone.

Greenspan kept the bar open, but Americans drank themselves silly. They ran negative personal savings rates, turned the equity in their homes into ATM machines, borrowed on all sorts of “time-bomb” terms – from adjustable to negative-amortization, interest-only, short balloons, and more.

Then they used this cheap and seemingly endless supply of money to buy properties – pushing prices to points that simply no longer made any fundamental sense.

That’s what this article is about. The fundamentals. The kind that can save you a lot of pain and make you a lot of money – in any kind of real estate market.

There are simple rules of logic that can steer you away from trouble in bubble markets and toward profits in value and growth markets. Learn these, and you can spot the next bubbles as they develop. Better yet, you can use the same rules to identify some of the strongest investment opportunities in today’s real estate markets.

Even Kids Can Identify a Bubble

In testimony before Congress a few years ago, Greenspan said you can’t identify a bubble until after it bursts. Baloney!

Public companies typically sell for about one times sales and 15 times earnings. You might pay 30 to 40 percent more or less, depending on the industry, the company, how fast it’s growing, and where you are in the economic cycle. Yet, eight years ago, we had hundreds of companies sell for dozens, even hundreds of times sales… and hundreds and thousands of times earnings. Many of the fastest rising stocks, in fact, had negative earnings!

And behind it all, savings were falling while personal and corporate debt was skyrocketing. Cheap money was chasing tech and spec stocks, and pushing prices far beyond the economic fundamentals of sales and earnings.

That was a bubble. Stock prices no longer had any fundamental connection to sales or earnings.

In residential real estate, it’s even easier to identify a bubble. One big telltale sign is that homeowners can no longer afford to buy their own homes.

I know a mechanic, for instance, who bought his home for $150,000 10 years ago. Today, it’s worth $500,000. His house has gone up by 233 percent, yet his income is up only about 40 percent. He could not afford to buy the same house today.

In fact, even if he sold his house and went to buy another house for the same $500,000, he’d still have a tough time doing it because his new taxes and insurance would be based on $500,000 instead of being anchored to $150,000.

My friend is no longer a potential buyer for the same kind of home he bought 10 years ago. And most of his longtime neighbors are in the same boat.

Fact is, large groups of people are being priced out of their own neighborhoods. If, for example, you’re trying to sell a typical median-priced home in Los Angeles today, your market of potential buyers is 90 percent smaller than it was six years ago. In 2001, one out of every 2.4 households was a potential buyer for your home. Today, only 1 in 33 is.

You didn’t have to be a genius or have a crystal ball or wait till “after the bubble burst” to recognize that bubble. When the median-priced home is not even remotely affordable to the median-income household, something’s gotta give.

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That something has been prices. And prices are likely to continue to give way in the bubble markets until properties or money or both become cheap enough that the median-priced home is once again affordable to people earning the median income.

Investors Can Get Priced Out of a Market Too

Another irrefutable sign of a bubble is when investors can’t find properties at prices that cash flow. When people pay $350,000 for triplexes that generate $25,000 a year in gross rents, they’re no longer “investing”… they’re speculating.

The rents are not enough to cover a traditional mortgage and expenses. The only reason people pay those prices is they expect someone else to come along and pay an even higher price. Why? Simply because… well, because that’s what’s been happening so far.

So you end up with a market where homeowners no longer provide buying support because they’ve been priced out. Investors no longer provide buying support because they’ve been priced out. And only a few last speculators, armed with self-detonating loans, push prices up the last few dollars until the cheap money stops. And “pop” goes the bubble!

The Flip Side of Bubble Markets: Great Opportunities in Value & Growth Markets

The same criteria used to identify bubble markets can be used to spot value markets. And to find strong investment opportunities, you only need to look for value markets that also are showing strong signs of growth.

First, let’s take a look at the value criteria…

For the last two years, I’ve had my research staff pull together data on over 130 U.S. metropolitan markets. I’ve used this research – plus travels throughout the U.S. – to identify value and growth markets.

I’ve formed limited partnerships and have invested in some of these markets myself. This has allowed us to continue to make significant profits even though many of my passive investors and I live in South Florida, perhaps the worst bubble market in the country.

For value, we consider how the typical house is priced relative to rents and relative to household income. Here are some examples:

In the U.S. right now, the typical house trades for about 21 times annual rents. That means if a house would rent out for $12,000 a year (or $1,000 a month), it’s selling for about 21 times that amount – or about $252,000. At these ratios, the rents won’t come close to covering your typical mortgage and expenses. In bubble markets, it’s even worse.

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We’ve put together a Bubble Index that shows key value and growth criteria for some of the most overvalued markets – from Los Angeles to Miami to Boston. In these markets, the typical house sells for almost 29 times gross annual rents!

So, in most markets, to get cash flow in small residential properties, you have to (1) focus on special situations and find motivated sellers so you an buy deeply under value; (2) buy small multi-unit properties (2 to 4 units); (3) buy in a market outside your home area where properties do cash flow; or (4) some combination of these things.

Another key value criterion is the price of the typical house compared to the typical household income. Nationally, the median-priced home tends to sell for just over four times the median household income in the area. Historically, this is a little high, but still affordable. But not in the bubble markets…

In Los Angeles, the median-priced home is $586,500, while the median household income is just $56,200. That’s the kind of ridiculous situation that prices homeowners out of their own neighborhoods. In other words, at current prices there is almost no market for median-priced homes in LA.

By contrast, Houston has a higher median household income, at $60,900. And the median-priced home is just $148,600. That’s extremely affordable – which means you have a market for a home you’re selling in that city.

But don’t forget the growth factor. Value alone is not enough.

Growth Counts Too

If you just looked at value, you might conclude that Pittsburgh and Detroit are great buys right now. After all, their median-priced homes trade at only about two times household income and 10 and 13.6 times annual rent, respectively. Trouble is, their economies are struggling. Both these areas have had negative population growth in recent years. Pittsburgh has had anemic job growth and Detroit has been losing jobs as well as people.

So to look for the best investment opportunities, you want to look for value and growth. You also want to look at markets with diversified economies. They shouldn’t be overly dependent on one industry, as Detroit was with automobiles and Houston was with oil when they went through their major real estate crashes.

My favorite value and growth markets tend to have the following characteristics:

1. The median home is priced well relative to household income. (Typically three times or less.)

2. The median home is priced well relative to gross annual rents. (Typically 15 times or less.)

3. The market has experienced appreciation in the past few years, but at a sustainable pace, in line with the long-term average or slightly below it.

4. Population and jobs have been growing faster than the national average.

5. The economy is diversified. (One of my favorite markets has five strong sectors in the economy: a state capital, a major university, a tech corridor, music industry, and local industry.)

6. It has lively emerging or re-emerging downtown areas with a diversity of cultural activities.

Once you find your new target market, focus on buying undervalued, cash-flow properties in that market. Then fix your interest rate and make sure you have the right management in place.

Investing is a forward-looking process, and no one can claim to know the future. Yet you can get a pretty good look at the present. So don’t believe Alan Greenspan and bubble-boosting brokers. The fact is, yes, you can identify bubbles.

Likewise, you can identify value and growth markets. And when you consistently put your money to work in undervalued properties in these markets, you can make a fortune.

It ain’t rocket science. It’s common sense. But that’s a commodity that is rarer than cash flow in today’s marketplace.

“Success is more a function of consistent common sense than it is of genius.” – An Wang