High Prices, Bad Neighborhoods, and Good Investing

Forbes magazine published an article last week naming the world’s most overpriced real estate markets (as attached here). The author goes through a convoluted calculation to come up with a price-to-earnings ratio for each market that he says is comparable to a stock P/E.

 

The calculations used to arrive at the P/E are complex and include things like transaction costs, both coming and going. When buying, for example, you have to consider transfer taxes, registration fees, and sometimes agent commissions. Selling, you need to factor in agent commissions and capital gains taxes at a minimum, depending on the market.

 

What Does "Momentum" Mean To You?

The chance to get early-in prices at an established, fully operational beach resort in Panama!

 

To produce its overpriced market index, Forbes selected prime city-center locations, then determined the cost of an apartment in each, as well as the respective rental yields; however, the origins of and the figuring for the rental yield figures are a little murky. It isn’t clear if the yields are for long-term or short-term rentals, for example, or what size property is being considered in each case. A notation is made explaining that the property sizes are equivalent city to city.

 

Typically, the higher the value of a long-term rental property, the lower the rental yield. For short-term rentals, the bigger the property, the lower the yield.

 

I can agree that the city at the top of Forbes list, Monaco, is home to some of the world’s most expensive real estate. I’ll be there to see for myself in October. Rome, Paris, and Los Angeles make the Forbes top rankings, as well. No argument that these are also expensive markets, but that doesn’t mean you can’t find good investment opportunities in all of them.

 

Last week, I told you about a “cheap” property for sale in York, Pennsylvania. I made the point that, though the price tag might seem a bargain ($299,000 for an historic and well-renovated 5,500-square-foot home), the place didn’t make sense as an investment. The price was low, but there was little evidence to persuade me to believe the market (York, Pennsylvania) would see any real appreciation any time soon.

 

So, in fact, maybe that $299,000 price tag was high…and maybe you could make an argument for York being an overvalued real estate market.

 

Considering the opposite end of the spectrum, you can’t write off an expensive property as a bad investment just because the absolute price is high. A $1 million property might be a better investment than a $50,000 one. You’re putting more money at risk, but that is a diversification question rather than an issue of investment quality.

 

The Forbes index gives Bangalore a low P/E, and the accompanying article, therefore, names this city as a good market for investment. However, the article doesn’t explain that it is almost impossible for foreigners to buy real estate in India. In other words, don’t waste your time trying to track down an agent in this booming Indian town.

 

A good real estate investment can be found in almost any market. You have to look closely and know what you’re looking for. Don’t buy cheap property, just because it is cheap. Don’t avoid expensive markets just because they are “expensive.” As the old saying goes, it can be better to own the worst house in a great neighborhood than to own the best house in a bad neighborhood.

Your scout…trying to make sense of the numbers,

 

Housing Trends
World's Most Overpriced Real Estate Markets
Matt Woolsey, 08.24.07, 6:00 PM ET

Buy a home in Monaco and you'll enjoy iconic beaches, glamorous casinos, a renowned arts and music scene, pulsating nightlife and boutique-packed boulevards.

You'll also pay for it.

That's because the Mediterranean principality tops our list of the world's most overpriced real estate markets. The rankings were compiled by calculating an effective annualized rate of return on a property based on annual cash flows derived from renting and adjusted for capital gains tax, transaction fees, operating costs and maintenance, appreciation and inflation. We then flipped the return rate to resemble the more familiar price-to-earnings (P/E) measure.

In Pictures: World's Most Overpriced Real Estate Markets

Monaco's housing market earned a P/E ratio of 74.07. What's more, the well-earned moniker of "tax haven" apparently doesn't apply to transaction costs, which rack up to a 20% premium when buying and selling a property.

 

Rome landed at No. 2 with a P/E of 50.51; it's a slow growth market, which remains very expensive. Representing North America in the world's top 10 were Los Angeles (5th place at 26.88) and Vancouver (6th at 26.81). For a list of America's most overpriced real estate markets, click here.

 

The relationship between rental yields and housing costs matters because a low rental yield is a good indication of a stretched market--one that has a bubble--since these markets are more likely to face downward price pressures or grow at a slower rate. Possible higher returns attracts more buyers and pushes up prices. India's disparate markets illustrate this. Bangalore has a 9.7% rental yield helping it to an 8.74 P/E, a good sign the market has room to grow. Last year prices climbed there by 16.5%. Mumbai, which posted a P/E of 17.21%, saw prices grow 6.6%.

 

Behind The Numbers

To arrive at our numbers, we inverted the effective annualized rate of return so each figure resembled a price-to-earnings measure that was easier to read. Think about each market like you would a stock: the higher the price-to-earnings figure, the more you have to pay to get one dollar of return. Many of the world's most expensive markets, such as London and New York, didn't make the top 10, and were beaten out by less expensive markets that had lower yields and smaller rates of appreciation.

 

We measured 50 financial capitals in every continent except Antarctica. For the most part this meant one city from each country--London for Great Britain, Bangkok for Thailand, Warsaw for Poland--but for countries like India, China, the U.S., Australia, Canada and Switzerland where there were multiple, distinct financial centers we measured a variety of cities: Geneva and Zurich in Switzerland and Shanghai and Beijing in China, for example.

 

Our valuations were based on data from GlobalPropertyGuide.com, an international real estate research firm. For each market, it assumed no debt financing; a constant cost of capital as the buyer wouldn't shift funds based on where they buy; a 10-year hold of the property and that the property would be a nonprimary residence.

 

Pricing data were based on city center properties of equivalent size. An investor looking to buy in Rio de Janeiro likely doesn't consider Rio's favelas viable options, so data skewed by that cut of the housing stock isn't useful. In basing the numbers on the prime cut of housing markets from Kiev to Manhattan, the resultant valuations are more comparable as investment options.

 

Purchase costs included transaction costs. In Geneva, that represents an effective 0.36% hike on the paid price, while in Seoul, buyers pay 20.88% above the property's base. Here, for example, transaction fees include housing bonds, legal fees, registration tax, acquisition tax, estate agent's commission, education tax, stamp duty and a special tax for rural development. Suddenly, a $500,000 apartment has a real cost of $604,400.

 

Yearly operating costs and maintenance were valued at 10% of rental yields across markets, a standard estimation in pricing calculations. Projections for the future value of the home were calculated by annually compounding the original capital value based on each respective country's five-year average trailing gross domestic product growth rate and inflation, as calculated by the International Monetary Fund, which has a good rate of correlation to housing price growth.

 

Cash flows were predicted by the annual rental yield minus operating costs and maintenance. Bangalore had the highest rental yield. There, landlords can command a 9.7% return per year on the value of their property something that undoubtedly stokes the jealousy of countrymen in Mumbai, where the strict rent controls of the local Maharashtra Rent Act beat rental yields down to 3.27%.

 

After 10 years, when it came time to sell, we tacked on capital gains taxes and sellers' costs--something that's a serious headache in Moscow, where sellers' costs amount to 18% of the sales price; far better to live west of Russia in Latvia, where sellers' costs are 3% and capital gains nil.

As N.Y.U. Stern School of Business finance professors Anjolein Schmeits and Stijn Van Nieuwerburgh point out, this system of calculation doesn't discount for risk and volatility. For the purposes of this article we decided not to adjust for these elements in part because many of the markets have undergone such dramatic transformations in the last 10 years that calculating a beta rating--what an economist would use to measure an asset's volatility against the market--wouldn't accurately represent the housing markets of rapidly developing countries like India or Latvia, for example.

 

© iStock

Monaco

P/E: 74.07

Monaco is one big luxury good. The principality famous for its "tax haven" status attracts international figures from around the world looking to bask in the Mediterranean sun. only two miles long, Monaco's real estate market has nowhere to grow but up--or up. Monaco's current plan to expand into the sea by building an artificial peninsula should take off some price pressures.