Property's secret: buy at bargain levels
04-11-2004
The big secret when buying an asset is to pay less than its fundamental value. When the general price level of an asset such as residential property increases above its fundamental value, it loses its attraction as an investment.
The fundamental value of fixed property is the cost of replacing it — and that, of course, is a combination of the cost of the stand as well as the cost of putting up the building. Valuers call this the replacement cost, said Rode CEO Erwin Rode in a Finance Week article last week.
The replacement cost is the long-term driver of house prices (and other products). That means prices in the short term could be above or below the trend of the replacement value; but eventually prices must return to the long-term trend.
The reason for that is explained by the substitution theory. In the long term, consumers aren’t stupid. For example, why would someone buy a fairly new second-hand house for R110 if he can get a brand new one directly from the builder for R100? Fully-priced houses on the market for R110 will therefore in the end trade for about R100 — perhaps not while buyers are in the midst of an irrational buying spree, but certainly eventually.
However — just to complicate things slightly — remember that in a strong sellers’ market, developers aren’t going to miss any opportunities and in the irrational phase these houses may well trade at R105, though the developer would normally have been happy with R100.
"My definition of a bubble — which always goes hand in hand with an irrational buying spree — is therefore when prices rise above the underlying replacement value. With 'underlying' I mean that enormous profits, such as those being earned by builders at present, are left out of account because in a normal market the profit margin will shrink again.
"However, in determining whether the market is in a bubble, you must be careful not to compare old lamps with new ones. The reason for this is that in due course houses, like lamps, depreciate in relation to new ones," Rode said.
The rule of thumb is that houses depreciate by 1% per year relative to new houses. One would therefore expect a 25-year-old house to be about 25% cheaper than a new one. That discount develops despite regular maintenance, because the fittings and fixtures become old-fashioned and worn.
The ratio of price to replacement value can be calculated in two ways. First, prices in actual transactions can be compared with the replacement value (the cross-sectional approach). Second, the movement of prices versus building costs can be compared in the long term. The latter is called the time-series method and is the one that we’ll use here.
This method can be represented in two ways. The first, which is easier for the layman to follow, is to show the price trend separate from the building costs trend, with prices that typically oscillate around building costs. Otherwise prices can be deflated by building costs (the price time-series divided by the building costs time-series) to calculate real prices.
The latter shows that real prices in upmarket neighbourhoods are very high at the moment compared with historical peaks in the early 1970s and in 1984. When prices are so high, they attract a growing number of developers and investors, who oversupply the market, restore equilibrium between supply and demand and force prices down to the replacement costs’ trend line.
The “forcing-down to replacement costs” occurs in two ways: either by implosion (typically because, for whatever reason, interest rates are suddenly increased drastically); or a gradual forcing-down. Given SA’s current stable macroeconomic environment, the gradual scenario looks more likely.
"One could well ask: What about the cyclical (short-term) drivers of house prices, such as (low) interest rates, the strong growth in the economy, along with growing disposable income and the consumer’s capacity for more debt? Not to mention the additional demand created by the black middle-class entering the market.
"These factors drive demand and have pushed prices up to their current levels. However, as long as we’re prepared to accept that the supply is reasonably elastic — as reflected by the already sharp increase in building plans approved — prices will be forced down to replacement costs. It’s merely a question of time."
Note, however, that the supply in certain upmarket neighbourhoods is not elastic. The best example is the Atlantic seaboard surrounding Cape Town, where land for development doesn’t exist, Rode wrote. As the graph shows, upmarket neighbourhoods are extremely expensive and at their highest level since the early 1970s. But low-priced neighbourhoods (less than R500 000) are still cheap, with considerable room for growth, provided the demand factors remain strong. However, that doesn’t include Cape Town, where all price classes are expensive.
