The idea of analyzing the value from an income standpoint is nowhere near new. I do it all the time when I’m appraising income properties such as apartments or office buildings or multi-tenant retail properties. Breaking the “income” down by net proceeds of the rent and net proceeds of the eventual sale and adjusting for the effects of inflation to render a current “value” indicator are also common valuation tools being used by appraisers every day. I don’t really see why the economics community is deeming this “new” other than the fact that Income is seldom considered to be the driving factor for properties that are primarily purchased by owner-users rather than income-oriented investors.
As has been alluded to above, when looking at an investment with a long term cash flow analysis, the assumptions used are critical. The article made light of “quibbling” about the assumptions, but when the holding period stretches on for more than a couple years it takes only very minor variances on those assumptions to completely dork the results. The reason for this is because of the effects of compounding. That is, an assumption of 6% average annual increase over 5 years will result in a 33% increase in the value. If you knock that assumption down to even 5% it reduces the increase to only 27%. So the difference between a 6% average increase over the next 5 or 10 years is going to be DRAMATICALLY different than an average increase of only 2%.
The other problem with their methodology is that they’re applying that average rate of increase based on the current price, not on the historical average upon which that increase is based. The historical average over the last 60 years is about 2% – 2.5% depending on which index is being used. But that 2.5% is based on the trendline itself, not any specific point that contributes to the trendline. The trick in doing Net Present Value (NPV) analysis is to reasonably forecast what’s going to actually happen during the next few years. If we’re on the down side of the trend we can reasonably project a higher-than-average rate of increase for the period starting low and going high. Conversely, if we’re at a high(er) point in the trend it would make sense to project a loss – not a gain – during the period from the high to the low.
So, if you think we’re in the New Paradigm where the old trendline no longer applies and the values will stabilize more or less where they are now, an assumption of a 2% average annual increase over the next 10 years would be reasonable. If you think we’re at the bottom end of a big increase then the 6% assumption would be reasonable. Personally, I don’t think either scenario is reasonable at this time and I’d be using a rate of decrease, not increase, to apply over a holding period starting right now.
In summary, I think the gathering of comparable data and their initial methodology are both reasonable, but parts of their application are poorly developed from a valuation standpoint. This is probably as a result of neither of these people actually being in the business of real property valuation – they’d get hammered if judged by our standards for not supporting those assumptions. They’re academics working in the macro, not appraisers working in the micro.
If there was any interest in doing so, we could build one of these NPV worksheets and see how the results turn out. We could do that by picking a specific property with a known rent, finding comparable sales data to determine a market value for it, and then running the income/expense, cost of sales and NPV calculations over a limited holding term to see how such an investment would stack up. We could even do a few what-ifs, using different assumptions to demonstrate the effects of those assumptions and to provide alternative ways of considering them.
