By Eze Nwagbaraji
On October 1, 2010, the very day that our country was marking its 50 independence anniversary from British colonialists, a real estate management executive friend of mine, who I consider very knowledgeable about his business and I, decided to drive around Abuja, our nation’s capital.
Our interest was to bash in the euphoria that our country as a nation, have reached the half century mark and to enjoy the beauty of our nation’s capital. We discussed the wisdom and courage of our forebears and the numerous founding fathers, who engaged the British in various antics that led to the independence of Nigeria.
At an NNPC petrol station, as we refueled our car, our discussions was interrupted by a brother, who was hawking an assortment of local herbs and liquid solutions, all neatly bottled, some labeled and others not labeled. This brother spoke little English, but he told us that he is a native Bwari, which is an ethnic group in Abuja and Niger State. He made numerous polite attempts to sell some of his herbs to us. Some will cure all sorts of pain, others will improve vision, one was an American Viagra, etc. When asked who made these medicines, he responded “Don’t Worry, Trust Me, it Works.” We did not buy any of his medicines, but this brother through his decency and politeness left us with an impressive understanding of our free market system.
After the encounter with our street trader friend, we quickly focused on property values in Abuja and other parts of Nigeria. I pointed out to my real estate broker friend that real estate valuations in Nigeria is one of the most confused that I have seen or read about in the world. I sought to get him to explain how property sellers and buyers in Nigeria reach valuation figures and as he struggled to explain, I pushed him to understand that there has never been a market for properties in Nigeria and that what we have had to date is a concoction based on greedy mechanisms, devoid of any rational market approach.
What we have is not different from what our friend the hawker is marketing – a cure all solution that is based on his personal guarantees. I advised my friend that what is obtainable in our real estate market is voodoo economics – devoid of any rational market approach.
My real estate broker friend thundered back, what is voodoo economics? I responded “the concept that in the real estate market, the seller demands whatever price he wants believing that there are enough criminals out there that will steal money and buy his property without subjecting the property to its income generating power or the income of the buyer. The brokers also believing that there is a bigger fool (a bigger criminal), who may come later and buy the property at a higher price from the first criminal.” Otherwise, how do we justify the tens of millions of Naira that home prices are fetching across some of Nigerian cities?
Fair Market Value of Investment Property
To investors, the only reason to move funds from other assets is to make profit and for a diversified investor it further includes the need to engage in rational and efficient diversification of an investment portfolio.
Investors do not go into the market to lose money, hence the rational market investor who is engaged in property acquisition is an investor seeking solid returns on his or her money. The primary focus is determining what the prospective property is worth. The current status quo in most Nigerian property market is that value is determined by the deal. This is a grossly inefficient answer. It is an answer that will lead to market failure and portfolio collapse.
“Fair market value” and “Fair market price” are not the same. Fair market value (FMV) is the highest price that a ready, willing, and able buyer is likely to pay and the lowest price that a ready, willing, and able seller is likely to accept for a property. It is a price based upon the assumption that both the buyer and the seller have sufficient information and that the property has been on the market for a reasonable period of time. FMV is an estimate.
Market price on the other hand is the actual amount that a property sells for in a particular market. It is possible that when a property valuation variables such as location, the prevailing average income of the neighborhood or area, the age of the property, the maintenance culture, availability of public amenities such as public water system, public sewer system, efficient security systems, schools, etc., are taken into consideration, the market price may be higher, lower, or equal to the FMV. For a savvy investor, the vision should be to estimate a property’s FMV as accurate as possible, and negotiate a deal at a market price below that estimate.
The most commonly used appraisal techniques in efficient property markets are the market data approach to valuation; the replacement cost approach; and the income analysis approach. There is nothing wrong in using all three approaches and drawing comparisons before investing in any property.
The market data approach method of valuation sometimes described as the sales comparison approach is widely used by real estate agents to value single family and multiple family homes. Real estate agents sometimes call this approach the Comparative Market Analysis (CMA) approach. The CMA approach to FMV simply states that you look at the price at which similar properties in the neighborhood or market sold for, then you draw comparisons with the subject property. Most appraisers will look at what prices such comparable properties sold for over a period of time, usually 12 to 60 months period.
Proponents of the CMA approach state that the appraiser should look at the size, style, age, and condition of the subject property to its comparables. The subject property’s location to its comparables is also important. Variations in these factors results are adjusted to arrive at the FMV.
The CMA approach to FMV has several problems for an investor. In markets where centralized verifiable accurate sales data are not readily available, such information is left to the conjecture of real estate agents and property speculators, a group that lack any meaningful regulation in Nigeria.
There is also the question as to whether there are any two properties that are the same. Though competent appraisers and valuators should carry out adjustments, the problem remains that such subjective methods leave the investor at the mercy of the appraiser.
The collapse of the US real estate market in 2007 that led to the implosion of the equity markets and cascaded into the global financial crisis was triggered by faulty realty valuation techniques. In Nigeria, the term toxic assets that have become a common lexicon among bankers and financial institution operatives, is primarily a problem of failed property evaluation mechanisms that provided bloated values for numerous bank assets. When the borrowers reneged on payment of the loans, the banks suddenly found themselves carrying assets that are less than their original appraised values.
The replacement cost approach to valuation is an attempt to estimate what it would cost to replace the same property. Insurance companies for example, take this into consideration in estimating insurance values for properties. This is what it will cost to rebuild the property from scratch. Every property is a function of the bricks, sticks, and ground on which it sits. This method of appraisal calculates the number of bricks, sticks, nails, etc. including cost of labor necessary to replace the property in real or current time.
Replacement costs arguably remove speculative values on the property.
The income analysis method of appraisal ties the value of an investment property to the income that it is likely to produce. The two basic techniques that can be applied to accomplish this are the gross rent multiplier and the capitalization rate. Both depend upon gathering data from similar properties in the area.
The gross rent multiplier (GRM) is mostly used when appraising single-family investment homes multifamily structures. An appropriate sales price is calculated for the property by using its probable monthly rental income as a comparison factor against the monthly rental income and actual sales prices of comparable properties that were recently sold in the area.
Capitalization rate is used for larger investments, such as apartment complexes, office buildings and shopping centers. It can, however, be applied to mixed-use buildings and multi-family homes. With this method, the estimated market value of the property is calculated from the expected return that’s typically being generated by similar investment properties in the area.
An investor considering the use of real estate as part of a long-term investment strategy should understand how to form return expectations and evaluate these investments in relation to more conventional investment options.
Real estate is increasingly being used as part of a long-term core strategy due to increased market efficiency and increasing concerns about the future long-term variability of stock and bond returns. Real estate is known for its ability to serve as a portfolio diversifier and inflation hedge, so long as the investor follows due diligence it its acquisition. The Nigerian real estate market is made up of a complex and unrealistic market bubbles that are unsustainable.
If an investor plans to make permanent real estate allocation in his investment portfolio, he should be prepared to ask the proper questions and secure the proper answers during the acquisition stages and the most fundamental of these questions should be – what are the return expectations?
The inflation hedging capacity of a real estate investment comes from the owner’s ability to increase rental rates during periods of inflation. Unlike manufacturing concerns and service providers, real estate owners do not have to contend with demand elasticity in order to increase prices, but they do have to compete with rival properties in the marketplace. Theoretically, this also raises rates in inflationary periods. However, real estate tends to maintain the purchasing power of capital, if the landlord can pass on all or a portion of the inflationary pressure to tenants. The ability of real estate to act as an inflationary hedge can only be accomplished as the opportunities for new leasing become available.
Real estate also has the unique ability to reduce risk in the way properties are leased. Portfolios that have followed a cash flow strategy and decided to lock in rates in long-term leases have less risk exposure to market movements, but they also have less inflation-hedging ability. Certain properties that are well occupied and contain long-term leases will have very stable income streams and perform like annuity or low risk bond investments.
Although real estate debt instruments are heavily influenced by the movement of interest rates, their performance also depend on the property markets because their risk will often mirror that of the properties that collateralize them. Oftentimes, property returns are very stable, growing by small incremental amounts until they pop with some market adjustment that leads to their anticipated total return. This change in value can be significant and can explain a large portion of total return, which compels real estate investors to identify when those changes in value will occur in order to make the correct buy, hold or sell decision.
With all of the risk-mitigation potential of real estate, the asset class still bears a considerable amount of market risk. Real estate has shown itself to be very cyclical, somewhat mirroring the ups and downs of the overall economy. In addition to employment and demographic changes, real estate is also influenced by changes in interest rates and the credit markets, which affect the demand and supply of capital and thus real estate values.
Along with changes in market fundamentals, investors wishing to add real estate as part of their core investment portfolios need to look for property concentrations by area or by property type. Because property returns are directly affected by local market basics, real estate portfolios that are too heavily concentrated in one area or property type can lose their risk mitigation attributes and bear additional risk by being too influenced by local or sector market changes.
Some real estate investments mimic the structure, income and risks provided by fixed-income securities while others resemble equities.
The belief is that long-term real estate returns should fall somewhere between those of stocks and bonds. Historic performance has borne this out with all returns of all the real estate quadrants having underperformed those of stocks over the long run. However, having underperformed the stock market does not necessarily make real estate an inferior investment on a risk-adjusted basis.
The unfortunate victims of our reckless real estate valuation markets are those who come to the market to acquire residential homes, where they intend to reside. The voodoo economics in this area of our real estate market is how to justify a residential home in the tens or hundreds of millions of Naira in any city in Nigeria. The valuations defy any economic reasoning because income levels in Nigeria do not correlate with some of the prices that are being quoted in the markets.