January 6, 2010
Reporting from: Estepona, Spain
I’m sitting now in lovely Estepona, Spain– a coastal town on the Mediterranean that experienced a massive property boom over the last decade.
The community I’m in is anchored by a five-star Ritz Carlton golf resort, and surrounded on all sides by the mountains or the ocean. Ancient military tacticians marveled at the defensibility of such a position and likely did not envision it being turned into a holiday hot-spot.
As the coastal region here is generally dry, warm, and nestled in the mountains, it’s ideally suited for me. I prefer clean places that are reasonably priced with great weather, access to major transportation, vibrant culture, and yes, a single’s scene. Coastal Spain is all of these… but to buy now I would be overpaying. Here’s why:
When the credit bubble got underway earlier in this century, coastal Spain was overrun with foreign property buyers, and their easy credit inflated home prices. Like other parts of the world, property values in Spain are now upside down in equity– the home is worth less than the mortgage balance.
This is bad news for banks, bad news for owners, but great news for cash buyers… as long as there is legitimate value.
Appraisers generally use three ways to value a property.
The first is the ‘replacement cost’ method, in which the appraiser estimates what it would cost to construct the unit from scratch. Between 2003-2006, the industry was booming… most contractors were booked solid, and demand for materials and labor pushed up construction costs.
Today is a different story altogether; most contractors haven’t seen a payday in months, and material prices have plummeted alongside housing demand. You could now build one of these spacious 2-bedroom villas for around 100,000 euros, not including the land cost.
The second method is the market approach, in which a property is appraised at a similar price point to where comparable properties are selling. If a 2-bedroom villa with an ocean view recently closed at 400,000 euro, then your 2-bedroom villa with ocean view can likely sell for around the same… in theory.
The problem with the market valuation is that it is highly susceptible to the irrational exuberance of the market’s participants. Remember, at the end of the day, markets are simply comprised of emotionally charged individuals… they experience fear, euphoria, anxiety, and impatience, and these emotions skew market valuations.
Throughout history, markets have historically proven that they are terrible indicators of value: loss-making tech stocks traded at infinite valuations, small shacks in California sold for millions of dollars, and debt-free mining companies were valued at less than the cash they had in the bank.
None of these passed the common sense test.
Furthermore, here in Spain, the property market has essentially dried up. Most of the owners have adopted a ‘wait and see’ approach, foolishly believing that if they wait around long enough, price will eventually return to their highs.
This idea is totally absurd. Japanese equity investors are still waiting for the Nikkei to return to its 1989 high of 39,000. Today the Nikkei is still shy of 11,000… so I guess those investors will just have to keep waiting.
Home prices here in Spain won’t start appreciating until the prices are cheap enough to entice buyers. There is no magical timeframe that will suddenly turn around home prices; if sellers refuse to sell, and buyers refuse to buy, then the market can theoretically remain in a stalemate forever… which leads me to…
The third valuation approach is the income method. For an investor, this is the only thing that counts: What is the investment return I can achieve with this property, and is that investment return adequate for the level of risk that I am taking?
As an example, when I was in Southern Italy over the holiday, I went scrounging around my local family’s neighborhood looking at property. I found that the going rate for a modest 2-bedroom home was 220,000 euros.
Then I found out that the same home can be rented for about 450 euro per month.
Some quick, back-of-the-envelope math suggests that, after deducting reasonable amounts for vacancy, maintenance, insurance, and utilities (Berlusconi eliminated property taxes), the net operating income would be around 4,200 euro per year.
If the home is bought with cash, that amounts to a whopping 1.9% yield, roughly the same as a much lower risk Certificate of Deposit. The risk adjusted return on these properties is clearly unreasonable.
I’m seeing the same thing in Spain right now– villas rent for a pittance, but property owners are stubbornly sitting on their asking price, not budging.
Eventually, external pressures will force sellers to capitulate– most won’t be able to continue making their mortgage payments, and others will be so desperate to raise cash they will finally slash prices.
When this happens, prices will drop and yields will rise. I think the time to jump in is when yields comfortably reach double digits and outpace less risky asset classes by a wide margin.
Buying foreign property makes a lot of sense; maybe Spain is for you, maybe it’s not… but you should strongly consider planting an overseas flag, and I recommend using this valuation method to determine your entry point.