I want to share a very simple concept that is easy to understand, but even easier to overlook when you are purchasing an investment property. The concept is Price versus Value.
As Warren Buffet once famously stated, ”Price is what you pay; Value is what you get.” What he meant by the statement is that when value exists irrespective to what price is being asked or requested. As investors, it is so important – no, fundamental – that we understand value, whether we are investing in residential or commercial property.
That sums it up. We are done here…
But wait. If it is this simple to understand, why does it seem so hard to apply? My belief is that there are two primary reasons for confusing price and value.
1) Valuation is sometimes difficult to assess
In residential, “value” is based on comparable sales, but I would argue that this value is unimportant to the investor. In most cases investment value is derived from income and associated investment return criteria:
Capitalization of income: By first understanding the net operating income (NOI) of the property, investors derive value by using a certain capitalization rate (cap rate) to determine the value of the the investment property.
Cash flows: a more complex method especially common in apartment investing, the common valuation method is derived from the discounted cash flows of the asset. The Internal Rate of Return (IRR) uses the time value of money to derive the annual cash flows of the property (net operating income and proceeds from refinance or sale). IRR is a rate of return, so an absolute measure of value is net present value (NPV), which is the time value of the cash flows using the investor’s IRR as the required return.To add to the complexity, when an opportunity exists for an investment to increase in value, the investor may choose to invest based on future valuation (and not today’s values) based on their perception of the increase to net operating income, future market conditions, etc. That increased value can be based on a lower cap rate or higher required return (IRR).
2) We often listen to our emotions and not conviction and do not maintain our standards
When emotions drive us, we easily deceive ourselves into believing that value and price are equal. We may look for reasons to support the decision we want to make and may dismiss others that do not support that decision. Every investor should have investment criteria. Warren Buffett will always be one of the world’s greatest investors and the reason is not because of his raw talent and intellect (both of which are impeccable); it is because of his discipline. He has the discipline to leave emotions out of his investing decisions and allow for the math and deal economics to do the talking. The simple summary here is not to let your emotions override your predefined criteria.
Remember: Price is what you pay; value is what you get.
As investors, we must remember the difference to that we do not overpay and are able to see real opportunities when they arise.
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Rodney Robinson II
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