“Is the real estate market currently overvalued?” Many active investors and entrepreneurs are asking this question, and you probably are as well. The housing sector is strong despite the fact that the U.S. is officially in a recession. Home prices and rental rates are jumping in many metro markets. During unpredictable times, wise investors take cues from historical patterns. Market analytics expert Stefan Tsvetkov talks with Joe Fairless on The Best Ever Show about the power of quantitative analysis to help you find undervalued opportunities. As with other markets, your best bet is often to focus on value rather than attempting to time cycles.
About Stefan Tsvetkov
Stefan owns the data analytics firm Envvy Analytics, which specializes in business and market analysis. Its mission is to help real estate investors find exceptional opportunities and leverage market inefficiencies. Stefan brings ten years of experience in financial engineering, a field that develops and applies quantitative techniques to tackle financial problems. Stefan is passionate about using data analytics to help investors make better decisions.
Stefan has three years of personal experience as an active investor. He has privately purchased multifamily properties and knows firsthand the impact of current market trends on individual owners and businesspeople. His portfolio includes a New Jersey triplex and fourplex and a New York duplex.
Stefan found early inspiration for an analytical approach to real estate in the work of hedge fund manager John Hussman. Hussman developed a predictive metric for stock market drops by determining whether the stock market was overvalued. Stefan contrasts this valuation measure with the typical Wall Street emphasis on price-to-earnings ratio. He determined that Hussman’s metric outperformed the price-to-earnings ratio, which further motivated him to deep dive into market valuation analysis.
Look Beyond Demographics
When considering a potential real estate market, you probably look at job and population trends. You’re in good company, as commercial investing advisers stress demographics when evaluating opportunities. However, Stefan advises people to focus on market valuation. Why? For one thing, he notes, real estate markets are inefficient. It’s challenging to get a qualitative read on values for a given market.
Another compelling reason is that historical market cycles are best analyzed quantitatively. Data analytics finds patterns that qualitative analysis might overlook, allowing financial engineers such as Stefan to develop predictive models. Critically, data analysis can validate models for robustness. When you use a metric such as the one Stefan recommends below, you know its performance history. You are not guessing.
A Gold Standard Metric
Stefan’s research has yielded one metric he considers the gold standard for valuing markets. The ballpark measurement to start with is the historical ratio of housing prices to income in a given market. You then determine the current ratio and calculate its deviation from the historical norm. Typically, the metrics refer to household income and the price of single-family homes rather than commercial properties.
As an example, let’s assume that the historical housing price-to-income ratio in Texas has averaged 5. If today it is 8, you should consider whether that market is overvalued. If it is 4, perhaps the market is now undervalued. You would then consider other potential factors such as housing shortages, employer flight, or other socioeconomic influences.
Does Stefan’s metric hold true for larger investors? Whether your interest in commercial properties is via active investing or passive investing, the good news is his measure still applies. Stefan explains that the price-income formula is about 95% accurate for multifamily units. Over time, differences in appraising and returns even out. Household income still drives valuation, however, and so the metric best suits commercial investing in one-to-four-unit properties.
Lessons from the Great Recession
Stefan’s interest in quantitative real estate valuation was partly inspired by a seeming prophet of the big crash, Ingo Winzer. As early as 2005, Winzer declared on CNN that specific markets were significantly overvalued. A year later, he reiterated his belief that certain metro areas were dangerously overpriced.
By 2007, the most overvalued U.S. real estate markets were Arizona, California, Florida, and Nevada. These states ranged from being 49% to 68% overvalued. Stefan estimates that the subsequent market falls correlated 83% with these markets’ deviations from their historical price-to-income ratios. Their prices plummeted 45% to 56% after being overvalued and held steady when their values aligned with historical norms.
According to Stefan, the median market deviation from historical ratios preceding the crash was 26%. A 22% price plunge followed this peak in value. In contrast, real estate markets with variations under 10% could be considered fairly valued. Price drops in these areas averaged only 11%. A clear correlation seems drawn between the percent deviation of a given market from its historical price-to-income ratio and its percent drop in a recession.
Overlooked and Undervalued
The Great Recession has lessons for investors seeking quality undervalued markets. Stefan emphasizes that it’s easy to forget that some state markets were undervalued during this time. About 12 states, including Texas, experienced price drops in line with their undervaluation. Texas was undervalued by 5% in 2007 and dropped only 4%, in contrast to the historic losses experienced in many other regions.
In parallel, national income declined 4%. This loss of household spending power hit over-leveraged homeowners particularly hard. However, the story isn’t as bleak for undervalued states. When considered with single-family home prices, income and homeownership costs kept pace in many regions.
Stefan believes these historical patterns still apply, and today’s markets offer opportunity. Regardless of whether the overall market peaks next year or in five, undervalued markets should resist the steep losses of a correction.
Scaling Market Peaks
How do you identify a market peak, especially in today’s volatile landscape? Stefan insists that you can’t. He explains that a market peak is when prices top out and then drop significantly. Prices can plunge quickly or bottom out over two to five years. We identify market peaks in hindsight. We can’t predict them, and even an active investor shouldn’t hinge a strategy on timing.
Quantitative market valuation offers tools to navigate cycles in the absence of timing peaks. In consideration of complex housing markets in certain metro regions, Stefan is refining the price-to-income metric. He cites San Francisco as an example of a complex housing market. San Francisco housing is expensive due to supply and demand and thus should not be assumed to be overvalued. Prices there are driven by a housing shortage.
People often discuss historical market peaks as singular events. In reality, market cycles vary regionally. During the Great Recession, some areas peaked in 2005 while others topped out in late 2007.
Does this uncertainty mean that you should stay out of hot markets? Not necessarily. Large, strong markets in areas such as Texas tend to hold their value across cycles. Stefan believes that large states with robust economic activity offer the best opportunities. What you need to watch for is significant overvaluation that could signal a powerful forthcoming correction.
How to Find Undervalued Opportunities
According to historical performance numbers, undervalued markets are less likely to drop substantially in a downturn following a peak. If you want to invest cautiously, focus on identifying undervalued markets. You can work with a financial expert like Stefan or do your research based on Stefan’s guidelines.
Your investor profile matters when deciding on potential markets. If active investing, you have more control over responding agilely to changes in markets or investing goals. If passive investing, you generally have little say in the timing of market exits. You want an undervalued but strong market that lets you sleep soundly at night.
Your investing scope matters as well. Buying a triplex in a residential neighborhood differs from investing in retail shopping centers.
Along those lines, Stefan notes that we should distinguish between metro and state scope. Though an undervalued state such as Texas may hold reasonably steady, specific communities may fluctuate more widely. Factors such as employment and migration affect individual cities and counties.
The key is to find strong markets that are undervalued and weigh their strengths against weaknesses. Many U.S. states are undervalued by Stefan’s criteria, but not all of them offer equal opportunity. Currently, Stefan names the most undervalued states as being Arkansas, Connecticut, and Illinois. However, Connecticut has issues that make it unattractive to investors.
In contrast, Indiana is 6% undervalued and up 27% from its 2007 peak. If you are an investor starting small, you would most likely consider Indiana over Connecticut. Larger investors looking at retail shopping centers or other commercial investing should consider big markets.
The Bottom Line
When overarching factors such as the current pandemic muddle qualitative analysis, a quantitative view brings objectivity and historical context. Rather than try to guess the market’s peak, focus on identifying undervalued yet strong markets. If you’re a larger investor, choose big metro regions. Accurate market valuation supports portfolio growth while buffering against plunges. It outlasts rollercoaster cycles, and so can you.
Disclaimer: The views and opinions expressed in this blog post are provided for informational purposes only, and should not be construed as an offer to buy or sell any securities or to make or consider any investment or course of action.