Real Estate

Real Estate Matters: 'Show me the numbers': the trap of quantitative analysis

 

One unique aspect of Silicon Valley's real estate market is that many buyers and sellers, whether they are engineers or financiers, are used to fact-driven methodology. When it's time to justify the single-most important number of any real estate transaction -- "fair value" of a particular home -- many demand more "numbers" to back it up from comparative market analysis.

However, interpreting these numbers can be quite tricky, as human psychology plays a big role. If not handled properly, the quantitative analysis can become a trap, especially for buyers in today's competitive market.

Firstly, comparative market analysis is backward looking, as it's based on closed transactions, i.e., data points come from transactions closed within a certain time period in the past. It differs from valuation analysis based on future projections that are used often in evaluating income properties and most financial instruments.

If the property market remains stable, transactions closed two months ago may provide a rather accurate indicator for today's value. However, with structurally limited supply and increasing demands, sales prices these days are setting new benchmarks every day. Therefore, if we stick to the data points in the past, we might be one step behind the curve.

By the way, an example of a forward-looking approach in real estate evaluation is to estimate how much a home is worth in 10 years, then discount it back based on an acceptable annual return rate, for instance, 7 to 8 percent to beat inflation. This approach involves many assumptions or uncertainties, thus is not often used in valuing real estate.

Secondly, we need to remind ourselves of the nonhomogeneous nature of real property. In the case of publicly traded stocks, each company does operate different businesses. However, the valuation of those stocks are based on the same cash those businesses generate. This does not apply to real estate where even for the same home, each owner may receive different benefits. Therefore, it most often does not make sense to rely solely on data, or quantitative analysis, while ignoring the qualitative part of the evaluation.

Lastly, and the most important element in today's market, is competition among buyers. For the transactions in which I recently participated, multiple offers were the norm. If a property is priced below its market value based on past data points, it has the effect to bring more competition and end up being sold at a larger premium over the market average. While each property settles its market value under its unique supply-and-demand situation, it has become more and more difficult to determine the fair value in order to define an effective bidding strategy for buyer clients.

In today's highly competitive market, the process of evaluating residential real estate is more of art than science than ever before. Quantitative analysis has to leave the center stage to market momentum until the market becomes more rational. The rapidly changing market today also provides an excellent opportunity for real estate professions to add value.

Xin Jiang is a Realtor with Alain Pinel Realtors in Palo Alto. She can be reached at xjiang@apr.com.

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