If you make money when you buy, it goes without saying that buying under market value should ensure a big fat profit for you in the future. Jeremy Sheppard explains what you should look out for to ensure you’re buying a genuine gem, not a fine-scented junk...
One thing property investing has over share investing is the opportunity to buy under market value. There is no concept of buying under market value in the stock market since the only purchase you can make is at market value. That doesn’t mean you can’t buy shares at a bargain price. It just means the buyer’s idea of a bargain is different to the market’s idea.
Capitalising on the discrepancy between different valuations of an asset is how one of the richest men in the world made his billions. Warren Buffet performs a valuation on a company and then compares that to the share price. If the share price appears cheap when compared to his valuation, he buys - pretty simple and pretty profitable.
You can employ a similar approach investing in real estate. And you can do one thing Buffet can’t, you can buy under market value. But there are a few “gotchas”.
Defining the concept
Before going any further there are 3 terms I’d like to clarify. They are:
- Buying at a discount
- Buying under market value
- Buying a bargain
Buying “under market value” is often confused with buying at a “discount”. Buying at a discount is buying a property for less than the original asking price. This happens almost all the time. Real estate agents routinely add an extra amount to the expected sale price. This is so buyers like us can feel better about ourselves after successfully haggling the seller down to the price he was going to sell at anyway ;)
Many investors actively pursue heavily discounted properties believing this to be an effective investment strategy. Although there are plenty of success stories with this strategy, there are some issues with the principle in general that makes it either quite tricky to pull off or not as profitable as first thought - more on this later.
Buying a bargain can be different from buying at a discount. It is possible to buy a property at a heavy discount and still pay too much for it. And a bargain is also different from buying under market value. For example, it is possible to pay more than the asking price and still get a bargain if the seller doesn’t know the potential the property really has.
Buying a property under market value, as opposed to buying at a discount, is buying a property for a price that is less than the perceived market value for that property at the time of purchase. The subjective part here is the word “perceived”. In whose eyes is the property really under market value?
Market value
Before a property has been sold, we actually don’t know its market value. And once it has sold, the market value is the price it sold for. So technically, it is impossible to buy under market value. What we mean when we say “under market value” is that the sale price is less than what the property should’ve sold for in someone’s opinion. And there’s the crux of it – opinions.
The usual method for determining market value is to find the sale price of similar properties that have sold recently in the same area. Your lender’s valuer will do exactly this, but they may interpret the data differently to you and will probably be more conservative in their final figure.
So, who has the final say on valuation? How can you determine the true value for a property? It actually depends on the strategy you choose to employ. If you’re looking to buy a bargain, your opinion is the only one that matters. But to the investor looking to profit from buying properties under market value, they should put their own opinion aside. There are only two opinions that count: the opinion of your lender’s valuer or the opinion of the next buyer.
Let me just back up a bit. There are 2 ways to cash in on the equity you have acquired in a property: 1. you can either borrow against the equity or
2. you can sell the property.
To borrow against a property’s equity you need a lender, while to sell a property you need a buyer. How much you can borrow comes down to the opinion of the lender on the value of the property. And how much you can sell for comes down to the next buyer’s opinion about the value of your property. So your lender’s opinion or the next buyer’s opinion is all you should consider when establishing market value for this strategy.
Note that a lender’s valuation may not be the gospel when it comes to market value. It’s pretty accurate in general, but there are some exceptions. For example, when a buyer places an attractive offer on a property, their lender may perform a valuation that comes in at a price lower than the agreed sale price. The buyer will probably use this to haggle the seller down in price. But it is not always the case. Sometimes buyers will simply tip more money into the deal.
For example, a seller may staunchly reject an offer of $400k even after being shown a bank valuation for that amount. But they would sign a contract if the offer was $405k.This doesn’t mean a transaction can’t occur. It simply means the buyer would need to find an extra $5k from their own funds, not from the lender. The buyer may feel this is worthwhile.
This discrepancy between buyer and lender opinion, where the buyer is prepared to pay more, is rare. It would be a game investor who bases an investment strategy’s success on finding a buyer willing to pay more than their lender’s valuation. So the true market value is probably going to be the valuation of the next buyer’s lender for this particular strategy.
You can get an idea of value by asking your own lender. Keep in mind that valuations can differ from one valuer to another. Once you’ve got a good idea of value, the profitability of the strategy comes down to the difference between this independent valuation and the sale price.
Note that many valuers will request the contract price prior to performing their research as a gauge for them to determine the value. If the value they initially come to is above the contract price, they will slide that value down to the contract price to err on the side of caution. So getting an accurate valuation may require not disclosing the contract price to your lender.
How to buy under market value
In most cases the genuine “under market value” opportunity comes from a distressed seller. However, real estate agents and developers will often flaunt a valuation that is above the sale price if one particular valuer happened to over-estimate. Be careful of this ploy and be sure to get your own independent valuation.
A distressed vendor may be a developer who has run into financial difficulty or a home owner who has lost their job. Or maybe the owner has cancer and needs to sell to pay for medical treatment. Maybe it is a deceased estate and the next of kin don’t care what the property sells for, they just want to get rid of it. Or maybe it is a divorce settlement.
These types of deals can be found on the National Mortgagee and Deceased estate database www.NMDdata.com.au. You’ll find that buyer’s agents are also presented with these opportunities by way of their contacts in the industry.
There are no real characteristics of a location you can look for to find a suburb with loads of these opportunities, except perhaps one: over-supply.
Developers have a tendency to focus on demand and ignore supply. They often build in a location with loads of infrastructure projects mentioned in the news without considering if there are already enough properties available for sale. If the developer is having trouble selling, they’ll get desperate. Looking for locations with a large percentage of stock on market (SOM%) will uncover these problem areas.
SOM% is shown in the data section at the back of this magazine. SOM% is just one of the criteria available in ‘Boomtown’ to search by. You can search for these high SOM% suburbs via this online app which is available from www.DSRscore.com.au
Jeremy Sheppard is the inventor of www.DSRScore.com.au (demand-to-supply ratio) and is research director at Redwerks.
