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”.
Before going any further there are 3 terms I’d like to clarify.
- 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 a great deal.
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?
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 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: you can either borrow against the equity or 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, not the opinion of the next buyer themselves.
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.
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 available for free from DSRdata.com.au for markets right across Australia.
As a general rule I avoid heavily discounted or under market value properties.
Not to put you off the strategy, but I’ll just give you a “heads up” on some of the issues so you’re better prepared.
Personally, I have an ethical problem buying under market value knowing the seller is distressed.
I don’t feel comfortable kicking someone in the teeth when they’re already on their knees.
Personally I don’t like someone trying to badger another dollar out of my pocket simply to line there’s with it.
Good negotiating is about finding a win-win not who has the worst case of hepa-tight-arse.
Some would argue that if the vendor signs a contract, they were “agreeable” and you may even be helping them out of a tight spot.
And some will consider mercy ill-placed if the vendor is a developer – they are the enemy after all.
If it does make you a bit squirmish but you want to pursue a distressed sale, you can always employ the services of a buyer’s agent to palm off these ‘awkward’ jobs.
How do you know the vendor is actually distressed anyway?
Did they provide you with their balance sheet or was it just a marketing ploy by the real estate agent?
What’s worse than kicking a distressed vendor in the teeth is discovering they weren’t distressed at all and instead they were licking their lips right from your first offer.
You’re so lucky
A question you should ask yourself is why you were able to snap up this bargain and not someone else.
If you didn’t have your finger on the pulse of the market or you weren’t quick to make an offer, how come you got it for below market value rather than someone else?
Is nobody else looking?
If so, then you need to question demand for property in this market.
Inexperienced investors will find recognising a genuine opportunity difficult and the timing challenging.
Obviously, if an excellent deal does come on the market, you’ll need to identify it straight away and move fast with confidence.
But rushing into a deal worth hundreds of thousands of dollars is not something you should do when you’re new to the game.
This is where industry professionals can come in very handy for young investors.
No such thing as discount flip
Another problem with the strategy is that once you’ve bought at below market value, the new market value of the property you just purchased is the purchase price.
The next buyer will see a record of the sale and will know the real value of the property.
You could try to on-sell before the information about your sale appears in various databases available to the buyer.
But your timing has to be spot on or you won’t get away with it.
And there is no way you can approach your lender straight after settlement and ask for a top-up based on the so-called equity you now have.
The new valuation will be the price you just paid.
And the lender will have undeniable evidence to support this claim.
They’ll say in a sarcastic tone that a property exactly the same as yours, in the exact same location and condition sold only the other day for this amount.
They’ll act all surprised that you didn’t know this given that you were the one who just bought it!
You may have heard of the renovation flip strategy.
But there’s no such thing as a discount flip strategy.
What you just paid for the property is its new value.
Many lenders won’t consider a revaluation until at least 6 months have passed.
If the market hasn’t collapsed in that time, then you may be able to cash-in on your strategy.
And why would the market collapse?
Well, the stronger the market, the less likely you’ll find a distressed seller.
In a hot market, demand exceeds supply.
Sellers have no problem selling so they don’t get distressed.
Sellers get distressed when they really need to sell but the market is so weak they can’t.
Sometimes real estate agents will promise the vendor a sale at an unreasonable price just to secure the contract to sell.
They then talk the vendor down to something more reasonable.
If this is done by a large number of agents in the one suburb, the discount could be skewed higher than normal.
But not all agents employ this technique and the extent of their influence is limited.
The greatest discounts and the greatest number of distressed sellers are in the worst locations for capital growth.
But if you’re hell-bent on this strategy, see table 1 for a list of Australia’s highest discounted markets as at the end of August 2015.
Table 1: Highest 3 discounted markets by state as at end of August 2015
Note the DSR in the right column.
This is a score out of 100 representing the demand relative to supply.
The average DSR country-wide is over 50 currently.
Very few markets have a DSR less than 45.
But the list in table one shows very few markets with a DSR above 50.
As you can see from the data there is a correlation between markets with low demand to supply ratios (i.e. weak markets) and high discounting.
When demand is weak with respect to supply, a vendor will find little interest from buyers and too much competition from other sellers.
But when demand is high and supply short, there are very few distressed vendors – they pop their property on the market and away it goes for close to the asking price.
If you bought from a developer in a new complex, your cheap purchase will guide the prices of future purchases.
This could potentially drag down the values.
If there are enough sales of the same value, you can give up on getting a higher value from your lender 6 months down the track.
Another problem with the strategy is that it can distract investors from more important and lucrative aspects of the property such as the capital growth, renovation or development potential.
If your sole strategy is to buy under market value, then once you’ve bought, you’ve locked in your profit.
The clever part of your plan has ended for the rest of the life of ownership of that property.
Unless there is something else going for the property like capital growth potential or renovation potential, there could be little further profit to be made.
That 10% discount will seem pretty inconsequential after you’ve been holding a stagnant property for 3 years of zero growth.
If there are loads of similar properties, it is easier to get an accurate idea of market value.
But then your property will be the same as many others and you lose the uniqueness factor.
But the strategy becomes harder to get right if the target property is unique because of the inability to accurately determine market value.
Entry & Exit costs
Another problem is that finding a true property under market value by a significant amount can be difficult.
By significant I mean enough to buy, sell, pay tax and make a profit.
Remember there are entry and exit costs such as stamp duty, legal fees, building and pest inspections, valuation, loan establishment fees, sales agent commission and more legal fees on the sale, plus your own time and capital gains tax.
Unless you’re buying for around 15% or more below true market value, you’ll find it hard to buy and sell and make a worthwhile profit after tax.
Remember that if you sell within 12 months you won’t get the 50% CGT discount.
At best you can buy in a company name and pay 30% of your profits to the ATO.
As I said earlier, there’s no such thing as a discount flip.
And if you buy and hold rather than sell, then you’ll need to ensure there is adequate upward pressure on prices forecast for the future to make the holding costs worth it.
This research will be more time-consuming than researching market value.
But if you get that right, the upside on profit is much more rewarding.
Trash vs treasure
Another potential trouble-spot for novice investors with this strategy is the lure of fine scented rubbish.
If a tin of rubbish was for sale at half price, would you offer to buy the whole crate to maximise your savings?
Are you able to do enough research to know it truly is a bargain and not just a cheap rubbish dump?
Recognising the difference between trash and treasure will often come down to the state of the market.
Once again, if the market is hot, there won’t be too many distressed vendors and therefore not much under market value opportunities.
I prefer to pay above market value to secure a great property in a top location.
I’m not saying you can’t make a profit from buying “under market value”.
I’m not saying genuine deals don’t exist.
I’m just presenting my dislikes of the strategy and therefore my preference for others.
I would rather pay top dollar to secure a property with loads of potential than scrounge around looking for a seller who has all but given up trying to offload their problem in an ordinary market.