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Jul 1, 2019

Risk, Real Estate, and Investment Values: A Transition

Sponsored Content provided by Robert Burrus - Dean , Cameron School of Business - UNC-Wilmington

This Insights article was contributed by Dr. Edward Graham, Professor of Finance at the UNCW Cameron School of Business. Dr. Graham can be reached at [email protected]

The Housing Bubble and the Real Estate Market Recovery
 
The U.S. residential real estate market has been a leading topic in the news over the last decade or more. With increasing mortgage delinquencies in late 2007, and the bursting of the real estate bubble soon thereafter, home values across the US began an historic decline, but have since rebounded. Home values are reaching new highs in many markets, with cities “up north” and in the Rust Belt being exceptions. The Case-Shiller Home Price Index affirms this.

Values peaked across the country in late 2007 or early 2008, and fell 30 percent or more over the next five or so years. In the Cape Fear Region, using an admittedly informal but representative “index” created using home sales data provided by the Wilmington Regional Association of Realtors, prices increased over 75 percent in the seven years ending in the spring of 2007. Prices then fell across the local market, but have since recovered. Few expected the recovery of the real estate market, in either Southeastern North Carolina or across the nation, to be as rapid as it has been. Values, by most measures, are at all-time highs in cities across the US and in the Wilmington area, as well. This has given many folks, homeowners and investors alike, pause.

The Transition of Real Estate in the Investments Universe
 
Real estate, as an investment, has generally occupied a different “space” than traditional investments like stocks or bonds; the real estate investor was often someone already in the field (like a broker or developer) or an institutional investor such as a pension fund or insurance company or real estate investment trust (REIT). Real estate is often outside the comfort zone of most investors. With memories of the Great Recession and the bursting of the real estate “bubble” still in place, folk shied away from real estate as an asset class. That perception, though, has begun to change.
 
The value of a typical real estate investment can be described, loosely, as its estimated income over the first year, divided by some discount or capitalization rate. The home generating a net operating income (or NOI) of $10,000 (the NOI equaling the home’s gross rents reduced by operating costs like property taxes and insurance and repairs) in a 10 percent “world” would be worth $100,000. It is pretty straightforward: if the value, V, equals the cash flow or NOI divided by the cap rate or discount rate, then V=NOI/Rate = $10,000/.10 = $100,000. Whether an office building throwing off $1 million in a 10 percent world and being worth $10 million, or a modest home generating cash flows of $5,000 in that same world and being worth $50,000 [V = $5,000/.10 = $50,000], the relationship remains. Real estate investments are traded in an imperfect market with high transaction costs and they require a special set of skills to manage and to account for. But times, and values, are changing.
 
Recently, over the past couple of years, real estate investments have begun to “dance to a different drummer.” Values are now reaching all-time highs in many markets, and that $50,000 home mentioned just above is now worth $100,000. Its value has doubled not because someone wants to live there and runs up the price in a bidding war (though in some markets that still happens), but because that annual cash flow, of $5,000, that was worth $50,000 in a 10 percent “world” is now worth $100,000. It is worth $100,000 because the discount rate has fallen to 5 percent, and its value is now $5,000/.05 or $100,000.
 
Real estate, once perceived as being encumbered by a set of management problems, being traded in an inefficient market (when compared to capital markets like the NYSE), and being largely illiquid – hard to convert to cash – is now perceived as being less risky than many capital market investments. Real estate can be a suitable store of value over the long term, a store of value that can provide a relatively low-risk return.
 
The next few years will be telling, but recent evidence suggests that investors are far more comfortable today owning real estate as an investment – and not just as a primary residence or second home – than has been the case in quite a while. Real estate prices are not escalating just because more folk are moving to an area, but also because more investors are attracted to the often more stable and predictable returns offered by that single family home, versus the erratic returns coming from the latest idea from Mountain View!

Robert T. Burrus, Jr., Ph.D., is the dean of the Cameron School of Business at the University of North Carolina Wilmington, named in June 2015. Burrus joined the UNCW faculty in 1998. Prior to his current position, Burrus was interim dean, associate dean of undergraduate studies and the chair of the department of economics and finance. Burrus earned a Ph.D. and a master’s degree in economics from the University of Virginia and a bachelor’s degree in mathematical economics from Wake Forest University. The Cameron School of Business has approximately 60 full-time faculty members and 20 administrative and staff members. The AACSB-accredited business school currently enrolls approximately 2,000 undergraduate students in three degree programs and 200 graduate students in four degree programs. The school also houses the prestigious Cameron Executive Network, a group of more than 200 retired and practicing executives that provide one-on-one mentoring for Cameron students. To learn more about the Cameron School of Business, please visit http://csb.uncw.edu/. Questions and comments can be sent to [email protected]. 

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