Posted by Jonathan J. Miller -Tuesday, January 30, 2007, 12:05 AM
I came across an interesting article this weekend called The Draw of the Flaw [WaPo]. With a tag line of Railroad Tracks, Power Lines, Even Septic Tanks Can Be the Beginning of a Bargain.
A Diamond in the rough story, if you will.
The concept is this.
Many purchasers trying to buy into a housing market will accept obvious flaws because the discount associated with that amenity helps make the property more affordable.
The higher the perceived risk for health reasons, such as transmission lines, or for other defects that limit the number of buyers attracted to the property, the larger the discount.
In other words, if a problem is curable (appraiser speak for fixable) in the long run, the lower the discount. For example, a long commute will likely involve a larger discount than something that is more likely to be cured during ownership (like a massive capital improvement project in front of your property that may take five years to complete). You can’t shorten the commute but eventually that project will get done.
That is a logical approach and for purchasers who can live with inconvenience and it can make sense to some to put up with it by being rewarded with a lower purchase price.
Here’s a two reasons why the lower price invites higher risk and may ultimately backfire on the buyer:
The impact of property defects can change over time - The fact that you can live with the defect doesn’t mean you will find an eager buyer when you go to re-sell the property. Perhaps something that is considered an inconvenience today, may have a more negative impact on value when at re-sale because the value or penalty of amenities changed. Consider this. As a market weakens, inventory rises and the greater competition places defective properties at a disadvantage.
The “beta” of cost savings of the defect can fluctuate over time - I use the word “beta” in the context of a stock. This can be illustrated with location. In a tight, rapidly rising housing market, the spread in value between a location with a further commute and a close-in commute tends to contract, yet it expands during a weakening market condition. In fact, that is why newly developing market areas see higher appreciation during housing booms. But as the market retreats, these area can see bigger drops.
For example, suppose you buy a fund (property) with a beta of 1.5. You can expect that this fund (property) will beat its benchmark (overall real estate market) by 50% on the way up, and do 50% worse on the way down.
So the cost savings of a property defect achieved in a tight housing market may catch some new owners by surprise if their particular market weakens when they go to re-sell. Thats the flaw with the logic of this approach to “save” money.