We all smile when someone reminds us that the three most important things about real estate are "location, location and location." It seems to mean "forget it - real estate is too complicated to understand." Textboodks don't explain the saying or provide significant theories about the role of location - how to define it, measure it or predict its conse quences. One of the "locations" in the saying is the community - a preoperty's city or metropolitan area. If we had a system for measuring the robustness of a local economy then this would tell us something important about properties within it. But this works in reverse, too; property value within a market tell us about the life expectancy of that market - about the local economy. The problem has been that local economies seem to be idiosyncratic - each follows its own set of rules. Whatever is going on in Phoenix is independent of trends in Sacramento. We do not have a theory which explains local economic diversity.
We do, however, have theories about prediction which are not only intuitively appealing but also useful in a most practical way - that is quantifiable. Most business related forecasting is extrapolation - extending a data series from the past into the future. Everything rides on the bet that the line won't break. Statistical and econometric forecasting models are fundamentally subjective exptrapolations even though they can appear "scientific."
There are three common prediction concepts which do not involve extrapolation - forward rates, price-earnings ratios and real estate "cap" rates. By applying these concepts to real estate data we now have a way to predict the course of individual local economies.
A forward rate is the relationship of spot rates in the yield curve - the set of yield rates and bond maturities which is published every trading day. If today's yield for a five year bond is 6% and that of a six year bond is 7% we can say with certainty that people today expect that the one year rate five years from now will be 12%. The forward rate is in this case 1.07 to the sixth power, divided by 1.06 to the fifth power, minus one. If today's one-year rate is only 4% then people in the market believe there is going to be a big jump in rates, i.e. inflation, during the next five years.
We do not have a crystal ball or tomorrow's newspaper, but we are able to say what investors today think the interest rates will be at some point in the future. And that, after all, is what we really need to know - expectations.
A P/E ratio of 5 means that people are paying for a particular stock five times the present level of earnings. If a second stock sells for 20 times earnings this tells us that investors expect that company to do much better in the future than the first. Investors expect a rise in price, not just earnings. Again, price relationships today tell us what the market expects to happen in the near future.
A real estate cap rate is quite similar - essentially the inverse of the P/E ratio. Cap equals present net income divided by the price paid today for the property. A property which sells for a five cap is expected to appreciate faster than a property that sells on 10. The basic real estate cap rate, therefore, also equals cost of capital minus expected annual appreciation. Cost of cpaital for a leveraged investment equals the weighted average of loan and equity rates. If the expected cap rate is .1122 on this basis, and the observed cap rate is .09, then appreciation of .022 is expected over the investment period. This must be annualized by a sinking fund factor. Again, expectations are part of the observed ratio.
So we have the makings of a theory. Market data to which the theory can be applied is published regularly by the Wall Street Journal for fifty market areas.
Expectations about local economies differ widely. The following data represents these expectations as "months to meltdown". At the bottom of the list is New Orleans with a rating of 69.8 months. The data and theory tell us that investors in the New Orleans area see the present economic base dwindling away in a little under six years with no reviving forces in sight. New Jersey engenders the greatest optimism, ten or eleven years. San Francisco is a lovely town, but is 93.7 months from meltdown. Silicon Valley is right down there with a rating of 89.6 months, IPO's, multi -millionaires and all. The market expects the glitter to stop on this round with no more on the horizon. Things could change, but the market isn't buying it. Los Angeles, by contrast, is right up with New Jersey at 122.7 months.
These conclusions involve judgmental applications of realistic theory, and data which may have important flaws. Its main function is to point toward probable weakness in local economic situations and to indicate clearly that a high level of economic activity and outstanding current data can be very misleading.
Author of Visible Investments