To maximize profits when real estate investing, investors must employ the concept of value investing. We often associate value investing with stocks as it maximizes earning potential from real estate projects through price appreciation rather than income production.
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Value Investing Focuses on Property Appreciation
Value investing, made popular by Warren Buffet, refers to the strategy whereby investors search out stocks they believe to be undervalued by the market as a result of the market’s overreaction to various events. They believe these overreactions create a price that does not reflect the fundamental worth of the company.
The same theory applies to real estate value investing, meaing investors look for undervalued properties with hidden growth potential for maximum price appreciation. Value investing leads to the most profit potential as price appreciation far eclipses rental income as a potential source of profit.
Look for High Cap Rates for Value Investing
Of course, finding the undervalued properties or ones with the best growth potential requires knowledge of the market and property management. But we do have a general principle to start the search for a property, which is seeking out properties with higher cap rates and avoiding low cap rate real estate.
Higher cap rates indicate less expensive properties outside of the most in-demand locations. The high cap rate properties give investors the best chance at price appreciation because they feature a lower purchase price and room for improvement. This ability to improve the property creates the potential for significant increase in value, and the improvements can run from renovations to simply more efficient property management.
Ultimately, this means to pursue a value investing strategy, one must avoid the most glamorous, low cap rate buildings that we often consider the most reliable investments because they are unlikely to be undervalued.
Low cap rate properties still have a place in many portfolios, especially those needed low-risk investments for risk diversification.
Methods for Determining Value
In addition to relying on cap rates, investors can apply either the replacement cost method or the net present value method for assigning value in comparison to price.
Using the replacement cost method, only buy a property if the purchase price is less than the replacement cost. Unfortunately, the replacement cost can be hard to calculate. One way is to contact a few reputable developers in your area to provide a price-per-square-foot estimate.
Alternatively, the net present value method calculates a property’s intrinsic value by finding the value of future cash flows over the life of the property. Then, only purchase a property priced at less than the NPV.
High Cap Rate Properties Traditionally Outperform Low Cap Rate Properties
While high cap rates usually indicate a higher level of risk, historical performance data indicates that high cap rate properties actually tend to outperform low cap rate real estate a majority of the time.
Across all sectors – retail, office, multifamily, and industrial – an analysis of the basis points confirms that high cap rate properties outform low cap rate ones, and at a significant rate. Even after adjusting for risk, higher cap rate properties outperform their more expensive counterparts, especially in the multifamily sector.
Tips for Value Investing
Implementing a value investing strategy requires some good decision making because the properties are unlikely to be high occupancy or high end. Consequently, we recommend that investors mitigate their risk using the below strategies when selecting a property under this strategy.
Work in a Market You Know
Identifying the perfect property is the millstone of value investing, and the first step to finding one is narrowing down the search. We recommend that investors limit their search to areas in which they have knowledge rather than putting themselves at the disadvantage of lack of familiarity with a market.
Avoid Areas That Are Already Popular
Value investing is not a strategy where you can chase the market. Property owners quickly know the new value of real estate in a newly discovered or deemed trendy neighborhood. At that point, investors are unlikely to find an undervalued asset.
Instead, turn your attention toward finding the next hidden gem.
Look for Properties in Areas of Opportunity
One way to predict up-and-coming areas is to use economic and population data to spot areas of new demand. Some regions seem to never lose popularity, but on the other hand, others become hot spots out of nowhere. For example, in 2020, Idaho and North Carolina both experienced unprecedented, and unexpected, inbound migration.
Final Thoughts
While value investing is just one real estate investing strategy, it is one that any investor looking for exponential returns should seriously consider.
Life Bridge Capital is a leading real estate syndication company. We offer our investment partners the opportunity to leverage shares of multifamily rental properties into a passive monthly income. Learn More
