The End of Easy Money

July 1, 2006

Dear Investor:

With the Fed Funds Target Rate at 5%, the easy money is gone. No longer can anyone buy a home with a 3% adjustable rate mortgage or cash out half their home equity for kicks. Mortgage rates are closing in on 7% and look to move higher. Some of the results are in: The real estate market is entering a secular bear market. The stock market has corrected nearly 10% from its 52 week highs, as bond yields begin to compete for investor attention. So are both asset classes, real estate and stocks, doomed for the foreseeable future? Signs point to yes for real estate but no for stocks—the different prognosis is due to different intrinsic values.

Value investing is based on the premise that the price of any asset—be it car, diamond, house or bond—will revert to its intrinsic value over time. Behavioral finance teaches us that during periods of euphoria (i.e. real estate) or fear (i.e. stocks), people bid the price of assets way above or below their intrinsic value. By buying an asset at a price which sits below its intrinsic value (also known as fair value), an investor can make good money as the price rises to fair value over time. But by buying an asset at a price above fair value, an investor is destined to lose money—even if they make some in the short run (i.e. Internet stocks in 1999). The obvious question is, then, how an investor determines the intrinsic value of an asset.

There are many techniques for determining intrinsic value. The one made famous by Warren Buffet and employed by most successful value investors is a discounted cash flow valuation. This is based on the premise that the intrinsic value of any asset is the sum of its future projected cash flows, discounted back to the present to account for the time value of money. For example, the intrinsic value of Coca-Cola stock is quite literally the discounted value of its future cash flows per share. Morningstar uses this method to estimate that the current fair value of Coca-Cola stock is $54/share, way above its current price of $42. Obviously, this method is dependent on the projections an investor makes about future cash flows, estimates which are inherently difficult. That caveat aside, we estimate that the Dow is currently trading at least 18% below its intrinsic value based on future cash flow projections. This implies a fair value on the Dow around 13,000, far above its current 11,000.

Today, real estate looks far more dismal with an intrinsic value approach. Estimating fair value for a piece of real estate is different from a stock, though it still operates on the same premise, that the value of any asset is based on its projected cash flows. The median price for a two-bedroom apartment in Soho (New York’s priciest neighborhood as of the first quarter, according to the New York Times) is $2,025,000. This would run approximately $12,468/month in carrying costs, assuming a jumbo mortgage and a $1,500/month common charge. If investors were to purchase this apartment to lease out at the market rate, they could expect to get roughly $7,495/month in rent (i.e. cash flow). If we compare the rental income to the total purchase cost in monthly terms, we see that there’s a wide disparity, with the purchase carrying cost 66% above the rental cash flow. Even after adjusting for tax benefits, annual increases in rent and yearly capital appreciation of the property, the carrying cost exceeds the expected future rental cash flow by a wide margin. This implies that the fair value of a Soho apartment is way below its current market price. There are only two ways this can get resolved over time: by falling prices or rising rents, or probably both, with the emphasis on the former.

The bottom line is that stocks, especially large-cap multinationals, look as cheap as they have in twenty years while real estate, especially speculative property, looks more expensive than ever. If you wish to avoid buying high and selling low, favor stocks over real estate for the foreseeable future.