Distressed residential real estate investment

Table of contents

I. List of illustrations

II. List of tables

III. List of abbreviations

1 Introduction
1.1 Background
1.2 Problem definition
1.3 Research questions, objectives and delimitations
1.4 Methodology

2 Definitions
2.1 Non-income - producing properties
2.2 Income - producing properties
2.3 Distressed income - producing residential properties
2.4 Opportunistic investment strategy approach

3 Anticipating residential real estate bubbles
3.1 Hypothetic determination of significant factors
3.2 Theoretic validation of significant factors
3.2.1 Public expectations of increasing prices
3.2.2 Asset price and fundamental value
3.2.3 Finite time horizons of protagonists
3.2.4 Dynamically inefficient economy due to over-accumulation of capital
3.2.5 Indicating model of residential real estate bubbles
3.3 Practical validation of significant factors
3.3.1 Considerable economic conditions
3.3.2 Demographics
3.3.3 Fundamental data and asset price
3.3.4 Sentiments
3.4 Summary, results and critique

4 Valuing distressed residential real estate
4.1 Introduction
4.1.1 Problem definition
4.1.2 Research question and objective
4.1.3 Methodology
4.2 Theoretic framework
4.2.1 Valuation in decline
4.2.2 Macroeconomic conditions
4.2.3 Riskless rates and risk premiums
4.2.4 Estimating terminal value
4.3 Case study
4.3.1 Assumptions, parameters and determinations
4.3.1.1 Residential real estate property
4.3.1.2 Economy, finance and risk
4.3.1.3 Market environment
4.3.2 Selected valuation methods and techniques
4.3.2.1 Comparable sales valuation
4.3.2.2 Discounted cash flow valuation
4.3.2.3 Decision tree valuation
4.4 Summary, results and critique

5 Negotiating for purchase price discount
5.1 Theoretic background
5.2 Practical implementation
5.3 Critical reflexion

6 Results, critique and further research requirements
6.1 Results
6.1.1 Anticipating residential real estate bubbles
6.1.2 Valuing distressed residential real estate
6.1.3 Negotiating for purchase price discount
6.2 Critique
6.3 Further research requirements

IV. List of literature

Attachments A

I. List of illustrations

Illustration 1: Distressed income-producing real estate properties; Source: Own illustration

Illustration 2: The real estate cycle for residential housing; Source: Modified from Brueggeman/Fisher, 2011, p. 341

Illustration 3: Rental market equilibrium for residential housing; Source: Modified from Brueggeman/Fisher, 2011, p. 341

Illustration 4: S&P/Case-Shiller Home Price Indices (1988 - 2010); Source: Standard & Poor’s, 2011

Illustration 5: Residential real estate bubbles, indicating model; Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

Illustration 6: S&P/Case-Shiller Home Price Indices (1988 - 2011); Source: Standard & Poor’s, 2011

Illustration 7: Housing units completed (1968 - 2010); Source: Own illustration, data from U.S. Census Bureau

Illustration 8: Housing building permits (1968 - 2010); Source: Own illustration, data from U.S. Census Bureau

Illustration 9: Mortgage delinquency/foreclosure rates (1998 - 2009); Source: Own illustration, data from U.S. Census Bureau

Illustration 10: Residential real estate bubbles, enhancement of the indicating model; Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

Illustration 11: UBS Swiss Real Estate Bubble Index Source: UBS AG

Illustration 12: Relative market growth matrix. Source: UBS AG

Illustration 13: Regional risk map; Source: UBS AG

lllustration 14: The Western Europe property clock. Source: Colliers International

Illustration 15: Residential real estate bubbles; Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

Illustration 16: Real estate appraisal process; Source: Modified from Brueggeman/Fisher, 2011, p. 297

Illustration 17: Theoretic framework for dealing with decline and/or distress; Source: Modified from Damodaran, 2010, p. 376

Illustration 18: Distressed residential real estate valuation, Potential bargainers, valuation principles and appropriate methods; Source: Based on Damodaran

Illustration 19: Market development: Visualisation of rent, purchase price and yield development; Source: Own Illustration

Illustration 20: Valuing the equity stake; Source: Modified from Damodaran, 2010, p. 747 - 748

Illustration 21: Decision tree example; Source: Modified from Damodaran, 2010, p. 69

Illustration 22: Negotiation preparation; Source: Modified from Harvard Business Review and Lewicki/Saunders/Barry

Illustration 23: Relative valuation, regression technique; Source: Own illustration

Illustration 24: Negotiation preparation; Source: Modified from Harvard Business Review and Lewicki/Saunders/Barry

II. List of tables

Table 1: Results of the calculated property values

III. List of abbreviations

illustration not visible in this excerpt

Preface

During the latest years, real estate markets and residential real estate markets in particu- lar experienced strong fluctuations and corrections. These incidents were caused due to varying reasons. One intention when thinking of writing about these characteristics was that I was interested to find out, why these presumably stable markets experienced such rational and irrational developments. The other intention was to conduct research with a focus on the investment opportunity that eventually emerges during or after these de- velopments.

In my opinion, whenever you present an economic topic in written form to an interested and informed reader, an author - besides his commitment to scientific replicability and transparency - has the obligation to provide a passable form of readability.

You as a reader will therefore go through three different phases of a fictional investment process in distressed residential real estate properties: Bubble anticipation, asset valua- tion and price negotiation. Each phase will be observed from a theoretical and a practi- cal position. At the end of each part, summaries provide a review of the substantial and applicable knowledge.

I have tried to make the thesis modular, giving the reader the option to independently choose their specific field of interest, whether it is anticipation, valuation or negotiation. I hope that everyone reading this thesis will gain new insights on the topic. I am looking forward to obtaining comments, critique and further suggestions per email (m.gallop@gmx.at).

Innsbruck, in February 2012

Abstract

This thesis attempts to precisely define the term ‘ distressed residential real estate ’, ena- ble real estate investors to develop practicable methods, how to anticipate bubbles in residential real estate markets, how to valuate distressed properties and how to suc- cessfully negotiate about purchase prices with potential sellers of distressed residential real estate assets.

The thesis will therefore analyze different residential real estate markets that previously experienced strong market fluctuations and corrections regarding conditions that influence the origination or existence of a bubble and accordingly deduce a schematic model helping investors to indicate the potentiality of an existing or developing (price) bubble in residential real estate markets ex ante.

The thesis will furthermore cover the topic of valuation and elaborate modern valuation methods and techniques, which are used in financial valuation nowadays, and apply them - if exercisable - for the use of valuation on real estate assets, more specific, for an investor’s use needing applicable methods to appraise value of distressed residential real estate assets.

The thesis will finally try to combine applicable findings of these two topics (bubble anticipation and asset valuation) and use these findings to comprehensively prepare investors for negotiations about purchase prices with potential sellers of distressed assets. Therefore the thesis will cover the topic of business negotiation, examine existing and promising methods and techniques and derivate applicable implementation for an investors purpose which is to acquire distressed residential real estate properties at discount inter alia resulting from negotiation proficiency.

1 Introduction

1.1 Background

Real estate investment strategies are chosen with the intent of realizing superior invest- ment performance. Many of these strategies overlap and include combinations of one or more strategies (cf. Brueggeman/Fisher, 2011, p. 342). Opportunistic investing is one of those strategies. Investors acquire properties from sellers who are suffering financial difficulty or properties needing renovation, upgrading or repositioning (cf. Bruegge- man/Fisher, 2011, p. 345). One important factor influencing the success of an opportu- nistic investment strategy is an investor’s ability to purchase properties at a discount (Brueggeman/Fisher, 2011, p. 345).

An investor’s willingness to purchase a certain asset should be justified by well- established standards of value (cf. Graham, 2006, p. 206). Graham severely distinguish- es between investment and speculation: ‘The most realistic distinction between the in- vestor and the speculator is found in their attitude toward market movements. The spe- culator’s primary interest lies in anticipating and profiting from market fluctuations’ (Graham, 2006, p. 206). In contrast an investor’s primary interest lies in acquiring and holding suitable investments at suitable prices (cf. Graham, 2006, p. 206). Graham con- tinues his distinction between investment and speculation by stating that ‘market quota- tions are there for .. convenience, either to be taken advantage of or to be ignored’ (Gra- ham/Zweig, 2006, p. 206). During the last decade (2000 - 2010) real estate investors and speculators experienced strong market fluctuations and rapidly changing market quotations. Therefore it is especially difficult for speculators to anticipate and profit from market fluctuations, as it is for investors to acquire and hold suitable investments. Lenders, investors and owners, who are active in the real estate industry, are now faced with extraordinary challenges and opportunities. It can be difficult to evaluate invest- ment opportunities nowadays.

The survey “Emerging Trends in Real Estate Europe 2011” - which has been conducted jointly by the Urban Land Institute and PricewaterhouseCoopers - reveals that there is a high amount of debt in the European real estate industry, which needs to be refinanced (cf. ULI/PWC, 2011, p. 11).

These real estate loans will require refinancing due to the fact that during the latest fi- nancial and economic crisis these loans were extended rather than restructured and will have need for capital in the foreseeable and near future. These real estate loans are pre- dominantly secured by mortgages connected with non-performing assets or so-called “distressed real estate assets”. Diverse financial institutions are trying to shift these dis- tressed real estate properties into the market and remove them from their books. These institutions have sold or are in the process of selling their real estate investment busi- nesses as they discard these management divisions, which they consider now as non- core businesses. Those institutions are being hurt by subpar performance of their assets or portfolios. There is a gradual increase of distressed opportunities coming into the market and the pace of that activity is accelerating. Investors having an exploitative or opportunistic investment strategy could therefore expect interesting investment oppor- tunities (cf. ULI/PWC, 2011, p. 11). These opportunities will be offered not only by financial institutions, but by other property owners who are in (financial) difficulty as well.

1.2 Problem definition

‘There are many reasons why properties become distressed and why owners may be willing to sell them for a discount’ (cf. Brueggeman/Fisher, 2011, p. 209). The sector of residential real estate is vulnerable by virtue of experiencing strong market fluctuations and rapidly changing market quotations, predominantly stirred by (price) bubbles. Ama- teurish estimations of prices are one of the main factors influencing the origination of these misinterpretations of value and price. Real estate assets in general possess the cha- racteristic of reduced fungibility, when compared to other assets, e.g. financial assets such as bonds, etc. It requires a considerable amount of time to trade residential real estate properties, especially if they are distressed for whatever reason (cf. Bruegge- man/Fisher, 2011, p. 210). To reduce the amount of time necessary to trade distressed residential real estate properties, investors will have to anticipate bubbles. ‘Furthermore, in cases where the current owner may have overpaid for a property, because of aggres- sive lending practices or poor estimates of price appreciation, buyers of distressed prop- erties may have to carry properties until “repricing” occurs in a market environment that is changing’ (Brueggeman/Fisher, 2011, p. 210).

There are hence contradicting expectations between sellers and buyers on how to (re)price these distressed real estate properties (cf. ULI/PWC, 2011, p. 11). The finan- cial institutions or owners are reluctant to sell the assets or loans for less than their face value. They are not willing to incur losses from loan write-offs, reduce or wipe out their earnings and erode their capital. It will be a question of price. 40% of the respondents of the Ernst & Young Study “US distressed real estate loans investor survey” claim that pricing differences between the bidder and the asker is one of the main reasons for deals not taking place. If the prices of bid and ask will narrow, the investment activity within this sector of the real estate industry will probably experience recovery (cf. Ernst & Young, 2010, p. 8). As stated in part 1.1. Background, for investors, market quotations are either there to be taken advantage of, or to be ignored. Investors are able to take ad- vantage of this investment opportunity, if they are able to purchase these distressed real estate properties at a suitable price. To achieve this suitable price, they will have to suc- cessfully negotiate about discounts.

1.3 Research questions, objectives and delimitations

Timing is probably one of the most important aspects of an opportunistic investment strategy. Therefore the thesis will examine, under which market conditions possible investment opportunities in distressed residential real estate assets occur and agglome- rate. This paper will solely focus on these types of real estate properties and it will therefore refer to the determination between residential and other real estate properties and precisely define the term of distressed residential real estate properties. The findings that are elaborated through this analysis are then used to develop a general approach for investors to cognize market conditions that favor these investment opportunities in resi- dential real estate markets ex ante. This approach will help investors to identify, eva- luate and seize the opportunity of investments in distressed real estate assets, given the assumption that these opportunities agglomerate after the burst of a bubble. This as- sumption will be reappraised within part 3 Residential real estate bubbles.

The thesis will furthermore examine, how real estate investors then are able to acquire these distressed residential real estate properties at suitable prices, mainly resulting from discounts as stated in part 1.1 Background.

The ability to purchase these assets at a suitable price is a central component of the op- portunistic strategy approach. Valuation and negotiation are essential elements that in- fluence the fortitude of this ability. According to that, the thesis will give attention to these elements, though seen from the restricted perspective of a buyer, whose aim is the lowest possible purchase price. As a result of this constriction, the thesis will examine exercisable methods of valuation that contain practices having the feature to compute depressed value.

Business negotiation is a necessary and challenging aspect of business life. There are basically two primary kinds of negotiation: Distributive negotiations are negotiations, in which the parties compete over the distribution of a fixed sum of value. Integrative negotiations are negotiations, in which the parties cooperate to achieve maximum benefit (cf. Harvard Business School Publishing Corporation, 2003, p. 2). With regard to the constriction mentioned above, the thesis will examine how investors are able to use these methods of valuation in negotiations to compete successfully over the distribution of a fixed sum of value or to achieve maximum benefit.

According to these three areas of research, the thesis attempts to find answers for the following research questions:

1) How are investors able to recognize developing (price) bubbles in residential real estate markets ex ante?

2) Which valuation methods or techniques should investors use to value distressed residential real estate properties?

3) How are investors able to improve their purchase negotiation proficiency?

By combining the results of the different fields of research (anticipation, valuation and negotiation), this paper attempts to equip investors with the theoretic and practical ability to acquire distressed residential real estate properties at a suitable price mainly resulting from negotiated discounts.

Therefore the thesis will pursue the following objectives:

-Precisely define the term of “distressed residential real estate”,

-enable investors to anticipate (price) bubbles in residential real estate markets,

-equip investors with specialized valuation methods for distressed properties and

-prepare investors comprehensively for price negotiations to achieve discount on purchase prices.

To achieve these objectives the thesis determines the following delimitations:

It is not intended to evaluate whether investments in distressed real estate properties deliver superior rates of return or return at all. This thesis will not cover other relevant issues of a comprehensive real estate due-diligence, that should by all means be con- ducted when de facto buying properties, like tax related, commercial related or legal related issues. It will only focus on the commercial aspect of a pre-acquisition diligence. Moreover, the diploma thesis will not deal with the acquisition of targets consisting of multiple elements, like portfolios for example. It will only observe commercial aspects when acquiring a single asset.

The thesis will furthermore not deal with subsequent and integrated elements of the opportunistic strategy approach, which is to upgrade, modify or perhaps reposition the acquired property. The paper will only focus on the ability to purchase the property at a discount and not on consecutive managerial action related to the phase after the acquisition of the property. It is not intended to explore the intercepts between the opportunistic investment strategy and other existing investment strategies in the real estate sector, although there are certainly touching points, e.g. with the market timing strategy or the turnaround investing strategy. The thesis though will establish the main theoretic framework of an opportunistic investment strategy approach.

The thesis will besides not cover the comprehensive topic of real estate financing and especially not cover the legal issues related to loans or mortgages, possible financial restructuring of debt and default in general.

1.4 Methodology

At the beginning, the thesis will elaborate the necessary definitions and differentiations of subsequent relevant terms such as income-producing and non - income-producing real estate properties, distressed residential real estate assets and the opportunistic investment strategy approach. This elaboration will be based on present economic real estate literature, especially when trying to precisely define the term of “distress” in context with “distressed real estate”, a term which is used inflationary nowadays but presumably not as necessarily scientifically defined, as it should be.

Each of the following parts basically consists of a theoretical and practical section.

The thesis will embrace market conditions that favor the development and existence of distressed residential real estate assets. This area of research is initially examined by analyzing the origination, development and burst of a bubble which affected residential real estate properties in the United States during the last two decades. The analysis of the U.S. housing bubble will mainly be based on literature research on scientific eco- nomic articles that have been published before the bubble actually burst, avoiding to refer to literature that was written when everything was more or less obvious. These articles have been written by economists such as Baker, Case and Shiller, etc., econo- mists that are said to have capacious analytical ability within the real estate industry. The findings that are elaborated through the analysis of the U.S. housing bubble will then be used to examine market conditions in a different country, more specific, to ex- amine, whether the residential sector in Switzerland is currently experiencing a develop- ing or even existing (price) bubble in its residential real estate market. The analysis of the bubble in residential real estate in the U.S. and possible bubble in Switzerland will be conducted on a simplified level, with the intention to achieve findings which can therefore be converted for application on residential real estate markets in other coun- tries with different characteristics as well. The thesis will therefore inevitably have to examine the comparability of these bubbles that occurred in different countries and un- der different economic conditions and emblaze these specified domestic characteristics that influence this comparability.

The thesis will then focus on the elaboration of practically relevant valuation methods and techniques that can be used, when conducting a commercial appraisal of the value of a distressed residential real estate asset. The approach is undertaken from an inves- tor’s point of view, with regard on valuation methods and techniques that deliver esti- mations of depressed value. The thesis will initially give a brief description of the con- ventional valuation methods and practices that are used in the area of estimating real estate value but thereinafter focus on estimations of value that are specialized for the purpose of the opportunistic investment strategy approach. This task will be fulfilled by referring to up-to-date literature, not stringent to refer to real estate literature exclusive- ly. These estimations, more specific, the methods and especially the perspective tech- niques, can then be used by investors for initial price offers and subsequent (price) ne- gotiations with potential sellers of distressed real estate assets.

At the end of the thesis, the author will work out existing and practically relevant con- cepts of successful (price) negations, continuously seen from an investor’s point of view who is acquiring distressed residential real estate assets. The thesis will focus on the main types of negotiation concepts, methods and techniques that are used in business negotiations. The thesis will then combine the findings and results of all preceding parts of the paper (anticipation of bubbles and valuation of assets) and transcript them into a negotiation manual, providing the investor with an instrument containing different op- tions, depending on the concept, method or technique the antagonist is using. This task will be fulfilled by referring to results of scientific literature on negotiation, diplomacy, theory of games, etc., not necessarily stringent to refer to economic literature exclusive- ly.

At the end of the thesis, the author will have to critically reflect on the scientific methodology that has been used when creating this paper and its different parts.

2 Definitions

In this part of the diploma thesis we will classify the main property types of the real estate industry and describe the opportunistic strategy approach.

There is a huge variety of possible real estate property types. Investors who are entering the market for real estate tend to focus on the acquisition of a limited number of proper- ty types or even a single property type. The first distinction that can be drawn on real estate property types is between income-producing properties and non-income - pro- ducing properties. In most parts of this paper we will focus on income-producing prop- erties and the economic forces that affect their value. In the third part of this paper we however examine a bubble which occurred in non-income - producing properties, more precisely in the segment of single-family housing (the U.S. housing bubble). This ex- amination will be conducted due to the fact that the burst of this bubble had lasting im- plications for the real estate industry and the global economy as well. Although those properties were mainly owner-occupied, economic developments concerning these properties strongly influence investment decisions in income - producing properties as they affect price levels (transaction and asking prices), rent levels, vacancy and occu- pancy rates. As stated in the introduction, we will try to transfer the results of this ex- amination and apply them to income-producing properties.

2.1 Non-income - producing properties

If owners occupy their real estate properties they can be categorized as non-income producing properties. Ownership is an important goal for many individuals and can be seen as an investment for wealth accumulation or as a consumption good (cf. Brueggeman/Fisher, 2011, p.183). Wealth accumulation can be created through the appreciation of the value of the property or by relating the cost of renting in comparison to the cost of owning. Investors should know the historical trends in their residential investment market indicating the percentage distribution between ownership and rent. In many countries homeownership is considered being a good investment and strongly preferred compared to renting (cf. Brueggeman/Fisher, 2011, p. 190).

However, there are many issues that should be considered in spite of financial returns on equity in residential ownership when it comes to decide if renting or owning should be favored (cf. Brueggeman/Fisher, 2011, p. 190):

-General risks of ownership
-Flexibility
-Downpayments Creditworthiness
-House price volatility (bubbles)
-Maintenance, security and management

Within this paper, we will solely focus on income-producing properties as these are obviously the main and relevant property types for investors.

2.2 Income - producing properties

There are basically two possibilities to generate income from real estate properties: Ei- ther the owner uses the property or the owner leases the property (cf. Cor- gel/Ling/Smith, 2001, p. 64). There are furthermore basically two major categories which can be used to categorize income - producing property: Residential properties and non-residential properties. Residential properties consist of single-family houses and multi-family properties and provide residences for individuals or families. The cat- egory of non-residential properties comprises six major sub-categories: Office, retail, industrial, hotel or motel, recreational and institutional (cf. Brueggeman/Fisher, 2011, p. 254 - 255). Combinations of the categories listed above would be called mixed-use properties. This scheme of categorization is mainly based on the actual way of usage of these properties. Income-producing properties mainly produce income from tenant rent. Other synonymous terms that describe these properties are called “commercial real es- tate” or “investment real estate”. This definition excludes properties that are owner- occupied (for example owner-occupied single-family housing) but includes all other types of rental housing (cf. Corgel/Ling/Smit, 2001, p. 61).

Income - producing residential real estate comprises the following categories or assets:

-Apartments, condominiums
-Duplexes
-Dwellings (single-family or multi-family) Vacation apartments and second homes

‘Income property investors usually purchase such properties primarily to receive (1) periodic income and (2) appreciation. While home buyers also may seek the income-tax advantages and protection from inflation of home ownership, these objectives are usually secondary to shelter and amenities …’ (Corgel/Ling/Smith, 2001, p. 65). Periodic income is specified in the lease contract and is called contract rent. ‘This rent may or may not be equal to the rent that could be obtained by renting the property on the open market - the market rent’ (Corgel/Ling/Smith, 2001, p. 64).

Within this paper we will focus on distressed income-producing residential properties as they are the relevant property types for our investment strategy.

2.3 Distressed income - producing residential properties

The definition of the term “distressed” will be elaborated by referencing to literature which is relevant for our purpose. Our purpose is to buy real estate properties at discount, at prices that are far below the actual market prices. The elaboration of this definition will therefore not end in linguistic, morphologic, syntactic or etymological exaggeration. Instead, this definition intends to help understand the reasons why incomeproducing properties become distressed or are already distressed.

‘The term “distressed” is used to describe various events or circumstances that usually result in the sale of properties that otherwise might not occur’ (Brueggeman/Fisher, 2011, p. 209). These properties may then present opportunities for investors to be acquired at below current market prices. The possible divergence between the market price of the property and the possible purchase price of the property may derive from varying reasons (cf. Brueggeman/Fisher, 2011, p. 209). Investors will have to ascertain why this distressed property situation exists.

The reasons for a necessary and compulsory sale of the property possess a comprehensive character. Investors will have to distinguish between reasons that have been caused by economic or market conditions, reasons that result from the property or its near environment or reasons that affect the owner, creditor, debtor or the financing of the acquisition of the property in general parts.

The following illustration attempts to classify possible reasons why properties become distressed, categorizes these reasons and distinguishes them by relating them to an in- vestor’s sphere of influence. We assume that the initial acquisition of the property took place under conventional loan financing and that we as an investor are able to exert in- fluence as a new investor.

Investors who are attempting to buy distressed real estate properties expect to remedy problems that are within their influenceable sphere. Hereby they increase the property value, return a property’s price to its actual market price and therefore consequently increase their return on investment. The larger an investor’s influence within the illu- strated and possible categories (property, tenant, environment or financing) is, the larger is his ability to remedy or even remove problems which have an effect on value crea- tion. Investor’s abilities to correct these problems may strongly vary and are dependent on multiple factors such as far-reaching social or professional networks, strong political connections, premium information and distinguished knowledge, etc. The success of an opportunistic strategy approach strongly depends on these abilities. As stated earlier, there are multiple investment strategies in real estate and these strategies frequently overlap and sometimes investors combine different strategy approaches to successfully invest in real estate.

illustration not visible in this excerpt

Illustration 1: Distressed income-producing real estate properties; Source: Own illustration

It is now necessary to reconfine the comprehension of this thesis: The scope of this the- sis lies on distressed property valuation, (price) negotiation and acquisition - summa- rized distressed real estate investment. We will not examine how investors successfully accomplish the opportunistic investment approach. In this case it would be necessary to highlight the process after the acquisition of the property and subsequent and required managerial actions. As in our case it is more important to locate possible target markets, identify possible target properties, valuate them and negotiate about discounts. The fo- cus of this work lies on the pre-acquisition phase. If we are about to invest in distressed assets, first we will have to develop an approach to cognize conditions that favor the existence of distressed assets.

If we reverse Illustration 1, initially investors will have to analyze economic conditions and market drivers that favor these conditions. In either fields investors are not or at least quasi-not able to exert their influence within these fields. Investors are only able to observe relevant incidents. Investors have to anticipate conditions that are favorable for the existence of distressed real estate assets. Therefore it is necessary to gain more in- formation and knowledge in the field of economic conditions and market drivers.

As stated in the introduction, the underlying assumption is, that distressed assets agglo- merate after the burst of a (price) bubble. Within part three we will therefore analyze one of the largest bubbles in real estate markets. We use the United States housing bub- ble as practical example to evaluate, which economic conditions and market drivers influence the development of a (price) bubble in real estate and whether there are possi- ble investment opportunities in distressed residential real estate assets after the burst of the bubble. We will transfer the results of this part of the thesis and conduct a practical implementation of our findings on another residential real estate market that is expe- riencing developments leading to the assumption that a (price) bubble is emerging.

2.4 Opportunistic investment strategy approach

As stated earlier, there are many possible asset classes for investments in real estate. We now consider why investors should acquire distressed residential assets.

First we will describe the cyclical nature of the real estate market and afterwards we describe the opportunistic investment strategy.

The cyclical nature of the real estate market depends on the balance between supply and demand for each property type at one point in time. Illustration 2 is showing the cyclical pattern of the real estate cycle for residential housing.

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Illustration 2: The real estate cycle for residential housing; Source: Modified from Brueggeman/Fisher, 2011, p. 341

If the occupancy rate is above the equilibrium rate this indicates a market condition of high occupancy and rising rents and consequently leads to further developments within the sector of residential housing to increase the housing stock. 'If developers deliver additional space to the market, a certain amount of this space will be absorbed’ (cf. Brueggeman/Fisher, 2011, p. 340 - 341). ‘The term absorption refers to the amount of space that was leased by tenants for the year, that is, “absorbed” by the market' (Brueg- geman/Fisher, 2011, p. 346). The amount of space that is not absorbed will lead to an increase in vacancy rates.

Real estate markets are being said having a time lag between the delivery of additional units and the absorption by the market, mainly resulting from long planning phases and construction periods. Brueggeman and Fisher specify the construction periods for sub- urban apartments with 6 - 18 months and for urban apartments with 18 - 24 months.

Illustration 3 is now showing the rental market equilibrium for residential real estate assets:

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Illustration 3: Rental market equilibrium for residential housing; Source: Modified from Brueggeman/Fisher, 2011, p. 341

The residential market rent depends on the supply of housing units and demand for resi- dential space by tenants. If demand for space is decreasing, the market rent for residen- tial space will decrease as well. If the existing stock of space is larger than the demand for space, vacancy rates will rise. There will be a certain amount of vacancy at any giv- en point of time as tenants move out, units have to be refurbished, etc. Investors that perceive rents are falling below the market equilibrium may redevelop existing space and convert the use rather than leasing it under unfavorable market conditions (cf. Brueggeman/Fisher, 2011, p. 257). Brueggeman and Fisher furthermore consider the following influences for demand and supply for residential properties (Brueggeman and Fisher, 2011, p. 259):

Demand:

Number of households, age of persons in households, size of household incomes, interest rates, home ownership, affordability, apartment rents, housing prices.

Supply:

Vacancy rates, interest rates and financing availability, age and combination of existing supply stock, construction costs, land costs.

The illustrations of the real estate cycle and the rental market equilibrium for residential assets are an investor’s framework to make single-property real estate investment decisions based on current market conditions. Corgel, Ling and Smith define the following components for real estate investment decisions: ‘Forecasting cash proceeds from the eventual sale of the property; converting uncertain future cash flow streams into present value; and applying decision-making criteria to compare the expected benefits and costs’ (Corgel/Ling/Smith, 2001, p. 61).

Following the main idea of this thesis, investors will have to establish an investment strategy as a plan to guide their asset acquisition. This strategy may be separated into three components: Philosophy, objectives and policies (cf. Corgel/Ling/Smith, 2001, p. 62). The investment philosophy mainly distinguishes between active or passive invest- ments. With this work we focus on active investment, which implies direct equity par- ticipation in which investors take active roles in finding, buying, managing, and selling the real estate (cf. Corgel/Ling/Smith, 2001, p. 62). The philosophy also reflects their preferences for risk or return. Investments in distressed assets by nature carry more risk than other real estate investments. We already listed the main categories why assets be- come distressed and defined an investor’s ability to remedy the causes within these cat- egories. Once investors defined their philosophy they will have to set their investment objectives, which can be used as general guidelines for choosing specific properties comprising earning income, benefiting from appreciation and diversifying from across property types and locations (cf. Corgel/Ling/Smith, 2011, p. 63). Investment policies then create a profile of investments that satisfy investor objectives and are consistent with the investor’s philosophy, including financial and non-financial criteria. The strat- egy can be used as a preliminary screening device to evaluate potential property in- vestments.

The following formulation of an opportunistic investment strategy will thereinafter be used as a plan helping us to answer our research questions and reach our objectives:

Investment philosophy

Investors will acquire distressed residential income-producing real estate properties from sellers who are in financial difficulty or properties needing renovation, upgrading, or repositioning. The relationship between the investor and the real estate investments will be an active one. Investors will participate with direct equity and take active roles in finding, buying, managing, and selling or leasing the real estate. Investors cognize that investments in distressed assets contain higher risk than investments in other real estate property types and therefore demand higher returns compared to other investment opportunities in real estate.

Investment objectives

The objective of this strategy is to acquire residential income-producing properties at transaction prices that are (far) below the market values and to obtain an attractive and above-the-average rate of current income from the property investments that offer pros- pects of long-term growth. To fulfill these objectives, distressed residential real estate investors acquire properties whose market price has been corrected to historic bottom levels after the burst of a (price) bubble in residential real estate markets. Investors ex- pect to remedy other problems that caused the property to become distressed, such as seen in Illustration 1 where we classified possible reasons and related them to an inves- tor’s sphere of influence.

Investment policies

The following non-financial criteria are an integral part of our opportunistic investment strategy:

- Urban or sub-urban location with positive demographic conditions and development (as seen in point 3.2.2.2 Demographics)

- Favorable economic conditions (GDP, inflation, etc.)

- Favorable market conditions (occupancy rate, market rent, etc.)

- Sound building stock or economic adaptable building stock

- Non-hindering current legislation and assessable future, relevant legislation

The following financial criteria are an integral part of our opportunistic investment strategy:

- Property’s purchase price at historic bottom

- Continuing demand for residential real estate

- Supply shortage due to reduced development

In general, the overall situation in the investment market should move from decline to recovery (as seen in Illustration 2: The real estate cycle), the downside risk is limited, the upside potential is promising.

In part three we will now examine under which economic and market conditions possible investment opportunities in distressed assets occur or even agglomerate an how we are able to use our defined opportunistic strategy approach.

3 Anticipating residential real estate bubbles

One intention of writing this part of the paper is to quickly provide the reader with an overview on the macro-economic environment that existed when this paper has been written. The focus lies on occurrences that are and were relevant for the real estate sec- tor. The other intention is to work out a solution for investors to indicate the potentiality of a bubble in residential real estate markets and deduce general conclusions for other residential real estate markets. If the focus of this work lies on distressed real estate properties, we have to keep the importance of timing in mind. If we refer back to the last part, properties are distressed due to varying reasons. We assume that prices for real estate properties are at their historic bottom after the burst of a bubble. This situation offers the ideal momentum for investments in distressed assets, as long as the reasons affecting the distressed situation will be removed by the investor or due to changing economic and market conditions. Investors who are able to cognize bubbles far in ad- vance are able to thoroughly prepare these investments by having value estimations that are based on economic principles rather than temporal misinterpretation.

3.1 Hypothetic determination of significant factors

If we aim to elaborate how to anticipate bubbles we will inevitably have to define the term bubble. What is a bubble? Case and Shiller define the term by stating that it ‘… refers to a situation in which excessive public expectations of future price increases cause prices to be temporarily elevated’ (Case/Shiller, 2004, p. 299). These price levels however cannot be sustained forever. Another definition of a bubble would answer the incipient question as follows: ‘The major quarrel in the literature relates to the question of whether large changes in prices are due to shifts in the fundamentals or departures of the asset price from the fundamental value. A bubble is said to occur if an asset price exceeds its fundamental value. The difficulty lies in determining the fundamental value of an asset. The fundamental value of an asset is generally not exogenously given; it is endogenously determined in equilibrium. This fundamental value determines whether a bubble occurred at all and which component of the price is due to a bubble’ (Brunner- meier, 2004, p. 47).

To quote Binswanger’s definition of a bubble: ‘Research on bubbles has shown that in intertemporal general equilibrium models with agents having rational expectations, bubbles may only persist if agents have a finite time horizon, such as in an overlapping generations economy, and if the economy is .. dynamically inefficient due to overaccumulation of real capital’ (Binswanger, 1999, p. 116).

By summarizing those definitions, we come to the conclusion that (price) bubbles de-velop, exist or persist, if the following conditions apply:

-Public expectations of further increasing asset prices
-Departure of the asset prices from their fundamental values
-Finite time horizons of protagonists
-Dynamically inefficient economy due to over-accumulation of real capital

These premises are extremely generalized which is why they should enable us to apply our perceptions on different markets in different countries.

We will now analyze the U.S. housing bubble which occurred in the asset class of single-family housing during the last two decades and still plagues the world’s largest economy. We approach this with regard on these four premises that were extracted from the different definitions of a bubble.

3.2 Theoretic validation of significant factors

The housing bubble in the United States occurred between 1990 and 2012. This eco- nomic and speculative (price) bubble initially affected few, single and especially metro- politan areas, expanded over the whole United States and its burst later even had an im- pact on the global economy. The complex formation of different causes that influenced the origination of the bubble and the impact of its burst on the global economy may not be entirely analyzed within a simple part of a diploma thesis. We will rather focus on basic and relatively common findings and use them to develop an easy approach to in- dicate the possibility of a developing or already existing bubble in residential real es- tate markets. Therefore we will have to simplify our findings, which are based on a bubble that occurred in the residential real estate market or - more precisely - in the segment of mainly owner-occupied single-family housing, which is a part of the nonincome - producing properties. We already distinguished between income-producing and non-income - producing assets in part 2. Definitions.

Our deduced findings will then hopefully help us to determine the ideal moment for buying distressed income-producing real estate assets. Now we go through the four premises which indicate a bubble.

3.2.1 Public expectations of increasing prices

The following illustration shows the “S&P/Case-Shiller Home Price Indices” giving three different variants of curves indicating price changes for single-family homes in the United States: We see the 10-City Composite, 20-City Composite and U.S. National curve. The different S&P/Case-Shiller Home Price Indices track the prices of single- family housing in several metropolitan areas within the United States. A specialty of these indices is the “repeat sales method”. This method uses data on properties that have sold twice or more to measure the average change in home prices during certain time intervals (cf. Standard & Poor’s, 2009, p. 3). One will recognize that during the years from 1990 until 2005 prices for single-family housing rose steadily. In 2004 - 2005 prices reached their peak level with an annual percentage change of almost 16% (U.S. National) up to app. 20% (10-City Composite). If we want to evaluate those price in- creases we have to relate them to the rate of inflation: ‘Through the post-war period 1950 to 1995, house prices grew at approximately the same rate as the prices of other goods and services … Since 1996, however, house prices have risen by more than 45 percent after adjusting for inflation’ (Baker, 2005, p. 1). We also see a strong decline since 2006 and a temporarily rebound in 2010. The rebound in 2010 was not strong enough to lead to further price increases. We still experience decreasing prices until this part of the paper was written (July/August 2011). ‘The rebound in prices seen in 2009 and 2010 was largely due to the first-time home buyer’s tax credit. Excluding the results of that policy, there has been no recovery or even stabilization in home prices during or after the recent recession. Further, while last year saw signs of an economic recovery, the most recent date do not point to renewed gains’ (Standard & Poor’s, 2011, p. 2).

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Illustration 4: S&P/Case-Shiller Home Price Indices (1988 - 2010); Source: Standard & Poor’s (2011)

In 2002, Baker tried to find out, whether the run-up in home prices in the United States between 1995 und 2002 was based on changes in fundamentals or simply a bubble. He came to the conclusion that ‘… that there is no obvious explanation for a sudden in- crease in the relative demand for housing which could explain the price rise. … The only plausible explanation for the sudden surge in home prices is the existence of a housing bubble.’ He also came to the conclusion that ‘… a major factor driving housing sales is the expectation that housing prices will be higher in the future. While this process can sustain rising prices for a period of time, it must eventually come to an end’ (Baker, 2002, p. 17f).

Case and Shiller argue that economists normally do not ask what people think (cf. Case/Shiller, 2004, p. 301). In 2004 the economists tried to find out more about people’s thinking concerning the housing bubble by conducting a survey which com- pared metropolitan areas which reputedly went through a bubble, with an area that did not. They drew a random sample of 500 home sales and compared it with a similar sur- vey they organized in 1988. Their analysis indicated that ‘elements of a speculative bubble in single-family home prices - the strong investment motive, the high expecta- tions of future price increases, and the strong influence of word-of-mouth discussion - exist in some cities’ (Case/Shiller, 2004, p. 342). Some indicators of a bubble sentiment were surprisingly high in 2003, most notably the ten-year expectations for future price change’ (cf. Case/Shiller, 2004, p. 341).

Why are those expectations of future price increases so important? They are important if they are ‘… sustaining the market, whether these expectations are salient enough to generate anxieties among potential homebuyers, and whether there is sufficient confi- dence in such expectations to motivate action’ (Case/Shiller, 2004, p. 300). Case and Shiller also give examples for this kind of economic action: People buy homes because they expect prices to continue to grow in the future. People will not need to save as they would normally do because prices of homes will increase and this will allow them to withdraw equity out of their homes due to increased values and flexible financing mod- els. People also perceive less risk if prices have gone up over a long period of time (cf. Case/Shiller, 2004, p. 299). Case and Shiller also argue that there was a tendency to view housing as an investment: Annual price increases of more than 10% promise a lucrative investment. ‘Expectations of future appreciation of the home are a motive for buying …’ (Case/Shiller, 2004, p. 321). The authors then intelligently used their survey to find out more on people’s perception of seeing housing as an investment. There is yet a dispute in literature whether to regard single-family housing as an investment or not. Housing can be seen as an alternative to renting. If renting is more cost-effective than owning, housing would for example not be a good investment (Brueggeman/Fisher, 2011, p. 185).

Both cited papers (Baker, 2002, “The run-up in home prices” and Case/Shiller, 2004, “Is there a bubble in the housing market”) hence determined that there were public expectations of further price increases in the housing market. Those expectations were relevant and important for the future continuance and development of the housing bubble as they motivated (ir)rational actions. The authors warned with dunning words that they have indicated the existence of a bubble in the U. S. housing market. It is not clear why those warnings have not been heard or taken seriously although they were proclaimed years before the bubble finally burst.

One will now recognize the necessity and benefits of a survey that explores people’s thinking and identifies people’s motivation for economic action.

It is inevitable to use this method and draw reliable conclusions if we want to ascertain and quantify public expectations on further price increases. In our point of view we will not solely look at the general public. Instead we will examine methods where we can assess investor’s sentiment as well. This will allow investors to detect the existence of a bubble or forecast a developing bubble and deductively help to time the ideal point of buying distressed assets. In point 3.2.3 Lessons learned, Sentiments we will therefore look at methods that are able to predict bubbles by examining people or investor senti- ments and help to identify and quantify the risk or - in our case - chance of unsustaina- ble price movements and price corrections.

3.2.2 Asset price and fundamental value

In 2002 in his briefing paper “The run-up in home prices: Is it real or is it another bubble?” Baker examined the following fundamental economic factors that could have influenced the rise in home purchase prices between 1995 and 2002:

-Housing cost and the rate of inflation
-Housing share of consumption spending Income
-Interest rates
-Housing as source of wealth Valuation of housing
-Rental price
-Variations in regions (especially metropolitan areas) Retirement income
-Population (For more detailed information see chapter 3.2.2.2)

To summarize, the paper concludes that one-third of the run-up in home sales prices between 1995 and 2002 was in line with the rate of inflation. The run-up of the remain- ing two-thirds could not be explained with the fundamental factors listed above (cf. Baker, 2002, p. 17). Baker plausibly opposed the development of housing prices with the development of fundamentals which lead him to the corollary that the existence of a bubble is given.

Case and Shiller also tried to analyze the connection between home prices and fundamental data. They focused on the time period between 1985 and 2002. In their point of view the following fundamentals should be considered when trying to evaluate whether a bubble exists or not (cf. Case/Shiller, 2004, p. 304 - 306):

-Income
-Population
-Employment and unemployment rate Housing starts
-Mortgage cost

Case and Shiller found out that in most states in the U.S. prices of housing and income moved in line (cf. Case/Shiller, 2004, p. 306). At the end of their analysis Case and Shiller conclude that ‘… income alone explains patterns of home price changes since 1985 in all but eight states. In these states the addition of other fundamental variables adds explanatory power, but the pattern of smoothly rising and falling price-to-income ratios and the consistent pattern of underforecasting of home prices during 2000-02 meant that we cannot reject the hypothesis that a bubble exists in these states’ (Case/Shiller, 2004, p. 312). Unlike Baker, Case and Shiller though did not examine the connection between income and prices with a detailed view on the share of housing in consumption. Baker considered the value that people place on housing, as opposed to other goods (cf. Baker, 2002, p. 6). The author found out, that there was no clear link between the pace of income growth and the share of housing in consumption (cf. Baker, 2002, p. 6 - 7). The writer also states that ‘… we should not expect large changes … in the relative price of housing from the income growth in the nineties. … the share of family expenditures devoted to housing actually falls slightly as income rises’ (Baker, 2002, p. 7).

The devil is in the details. Case and Shiller conducted an impressive study but they overlooked an important detail. That is the reason why they came to the conclusion that at least in some states income alone explained patterns of rising prices. Although both papers clearly state that there is evidence for a bubble one may have the impression that it is relatively easy to be misleading by the amount of fundamentals that should be considered when trying to do scientific work on bubbles.

What is the conclusion for investors trying to evaluate whether changes in prices are due to changes in fundamentals or not? Certainly it is necessary to evaluate influencing fundamental economic indicators that compare developments of fundamentals and pric- es. Investors will though inevitably have to combine research on fundamentals with research on sentiments.

3.2.3 Finite time horizons of protagonists

In 1988 (the final version was written in January 1989) Mankiw and Weil examined the impact of major demographic changes on the housing market in the United States be- tween 1970 and 1990. They predicted that the real housing prices will fall substantially in the two decades between 1990 until 2000 (cf. Mankiw/Weil, 1988, p. 236). ‘Between 1970 and 1980 housing prices rose dramatically: … the real price of housing rose be- tween 19 and 32 percent. … this increase in housing prices was largely attributable to the aging of the Baby Boom’ (Mankiw/Weil, 1988, p. 236). In the same paper Kenneth Rosen predicted that ‘the demand for housing will grow slowly in the future’ (Rosen, 1984, cited in Mankiw/Weil, 1988, p. 236). ‘… the quantity of housing demanded is a function of age, income and a variety of other household characteristics’ (Mankiw/Weil, 1988, p. 239). ‘… changes in the age composition of the population affect the demand for housing over time’ (Mankiw/Weil, 1988, p. 241).

Mankiw and Weil assumed that the age structure of housing demand is constant over time. Mankiw and Weil then estimated that real housing prices will fall substantially due to the aging of the population and that ‘… housing prices will reach levels lower than those experienced at any time in the past forty years’ (Mankiw/Weil, 1988, p. 236). The German author Tobias Just states in addition that Mankiw and Weil did not expect a decrease in population, they solely examined the changing age structure of the popula- tion at all. In many European countries we experience declining population figures be- sides. This is why demographic changes in Europe within the next years could have even more serious economic implications than the developments in the U. S. during the 80’s (cf. Just, 2009, p. 7).

Mankiw and Weil also found an unsurprisingly strong and significant relation between housing demand and the real price of housing. They evaluated that ‘… a one percent increase in the demand for housing leads to a 5.3 percent increase in the real price of housing’ (Mankiw/Weil, 1988, p. 246). The authors continued their analysis by stating that ‘… the changes in housing demand caused by changes in birth rates are forecasta- ble far in advance. … the fall in housing prices … will likely be one of the major eco- nomic events of the next two decades’ (Mankiw/Weil, 1988, p. 248). They concluded their paper with a dunning appeal: ‘… we will see a large and sudden drop in housing prices and residential investment, which may be a potential source of macro-economic instability’ (Mankiw/Weil, 1988, p. 255).

As we have already seen in point 3.1.1 and 3.1.2, there were other warnings based on scientific examinations on different influencing elements stating that the market for res- idential real estate assets in the United States developed a bubble or already experienced a bubble. It is yet unclear why all those warnings have been ignored. If warnings are neglected there has to be some reason why negative future economic changes are faded out. Case and Shiller did research on this topic and came to the conclusion that sellers of homes e.g. resist cutting prices. The bid-ask spreads widens sharply as demand drops. They also stated that this kind of rigidity would have a negative effect on the U.S. econ- omy (cf. Case/Shiller, 2004, p. 335). We will return to the interesting topic of “price rigidity” when we analyze how to negotiate successfully about purchase prices. If an investor is trying to successfully negotiate about low purchase prices of distressed assets he will have to find a way how to break this rigidity. In point 3.1.4 we will also return to the ignorance of these warnings and take a look at the political side of this peculiarity.

Binswanger argues that ‘… there is no general argument against bubbles in an economy if each agent’s horizon is short and if new agents enter the economy over time’ (cf. Binswanger, 1999, p. 130). The author simplifies by explaining that the older generation in a society is able to pass a bubble to the newborn, young generation. As long as this is the case bubbles can persist and do not burst. ‘The dramatic rise in the number of births in the 1950s and the subsequent decline in the 1970s - the Baby Boom and the Baby Bust - are widely recognized as among the most important changes in the United States in the past 50 years’ (Mankiw/Weil, 1988, p. 235).

Those major demographic changes resulted in a drastic change of the age composition of society and therefore did not let the handover of the bubble take place. First-time home purchasers tend to be 28 - 32 years of age (cf. Brueggeman/Fisher, 2011, p. 184). The Baby Bust resulted in a dramatic slump of first-time home purchasers. As long as a bubble is not able to expand, it will inevitably burst.

What is meaningful for investors if we look at protagonist’s time horizons being a con- stitutive element of a bubble? This paper will not focus on the implications of demo- graphic changes on real estate although future changes within this field will have signif- icant impact on assets, especially residential assets. Just describes that the foreseeable demographic changes in industrialized nations will eventually even lead to a so-called “asset-meltdown” (cf. Just, 2009, p. 5). We will also not focus on certain human psy- chological phenomena like herding. Those fields of knowledge are too distinguished and too important to be treated within a single part of a diploma thesis. We will rather focus on another main element of a bubble: Stupidity. Binswanger defines the concept of “speculative bubbles” .. is usually thought of .. describing certain high price growth episodes on .. markets that are rather short term. A Bubble is finally supposed to burst leading to a sudden return of prices to their fundamental values …’ (Binswanger, 1999,

p. 110). The scientist is then mentioning that a bubble is not necessarily prone to burst unless there are enough fools who still buy assets and expect them to resell at even a higher price. If we use the concept to quantify the risk or chance of a bubble for residen- tial real estate assets we will have to scientifically evaluate people and investor senti- ment indicating current market quotations. In point 3.2.3 we will examine methods that help investors to appraise the current level of sentiments in commercial real estate mar- kets. This will help us to evaluate the consistency of finite time horizons of protagonists and to find the perfect timing for investments in distressed real estate assets.

In the next chapter we will have a closer look on Binswanger’s interesting arguments for bubbles having a positive effect on the economy. This will help to understand why people may have neglected warnings of negative future economic developments.

3.2.4 Dynamically inefficient economy due to over-accumulation of capital

Bubbles tend to have a negative aftertaste. We should not deny potential negative effects on the overall economy but we should also look at the positive impacts of bubbles. Binswanger argues that bubbles do have the potential to increase dynamic efficiency and that there is a substantial positive effect under certain economic conditions. ‘If bubbles reduce capital accumulation they can be beneficial as they increase the potential level of consumption for everybody’ (cf. Binswanger, 1999, p. 116). When are economies inefficient? ‘Economies are said to be dynamically inefficient if people save too much and over-accumulate capital’ (Binswanger, 1999, p. 118).

The American stock market had its latest major bubble in 1998 - 2000. Some believe that the appearance of the housing bubble right after the stock market bubble is not a coincidence. After the decline of the stock market people may got fed up with the stock market and its high volatility and became more positive about real estate investments, which were meant to be relatively risk-free due to constant price increases. Case and Shiller note that there is no clear evidence that the stock market bubble and the housing bubble are somehow connected (cf. Case/Shiller, 2004, p. 328) but the authors admit, that they found out that ‘… the stock market’s performance “encouraged” them (people) to buy a home, whereas only a small percentage found it discouraging. (Case/Shiller, 2004, p. 328). Although Case and Shiller could not find any clear argu- ments supporting the theory that the two bubbles are connected, people still believe in this popular notion (cf. (Case/Shiller, 2004, p. 328). It is still plausible to assume that after the stock market crash people saved more, over-accumulated capital and were in search of other investment opportunities containing less risk but promising future pros- pects. As Binswanger argues, saving has negative effects on the economy.

Bubbles have the potential to reduce these negative effects that saving has on the economy. Politics has the ability to avoid dynamically inefficient economies which develop due to over-accumulation of capital by implementing and executing strategies. In the next chapter we will take a closer look on the “National Homeownership Strategy”, which was an unprecedented partnership between public and private institutions in the U.S. This strategy was primarily realized to make housing more affordable for lower income-families and to trigger multiplication effects on the economy.

The development of steady growing prices for housing since 1990 generated many calls for government intervention to help provide more affordable housing in the United States. At the request of President Clinton (President of the United States between 1993

- 2001) the U.S. Department of Housing and Urban Development accepted the calls for government intervention to help provide more affordable housing. The Federal Gov- ernment implemented the National Homeownership Strategy to increase the rate of ho- meownership between 1995 and 2001. The initial objective of the strategy was to create ownership opportunities particularly for lower-income households and other under- served populations and increase the overall homeownership rate to 67.5% by the end of the year 2000. This objective should have been achieved with accomplishment of the following measures (U.S. Department of Housing and Urban Development, 1995, p. 8):

-Cutting housing production costs
-Making financing more available, affordable and flexible
-Targeting assistance to underserved communities
-Opening the home buying market to underserved populations
-Raising awareness of homeownership opportunities
-Expanding homeownership education and counseling

The Strategy also focuses on the macroeconomic benefits of increased home-ownership. Investment in housing is important for the U.S. economy as it accounts for nearly one- third of the change in GDP. Housing production is said to have strong “multiplier- effects” due to powerful economic activity and is able to jump-start other sectors of the economy (cf. U.S. Department of Housing and Urban Development, 1995, p. 7).

By implementing and executing this strategy and its measures politics created a promis- ing atmosphere of possible lucrative investments in residential housing. This atmos- phere spurred (ir)rational actions of people. People perceived housing as the ideal in- vestment opportunity. Affordable housing was seen as the savior of future prosperous economic developments. In 2005 Baker stated that ‘the housing bubble has created more than $5 trillion in bubble wealth, the equivalent of $70,000 per average family of four’ (Baker, 2005, p. 1). People were able to use this politically induced wealth and spend it on consumption. This process helped to move the economy out of recession, due to the fact that the U.S. economy is dependent on strong domestic consumer spending (cf. U.S. Department of Housing and Urban Development, 1995, p. 7).

The strategy also admits that research on some key points remains inconclusive but that the benefits will surely predominate the drawbacks. There were warnings that home- ownership of lower-income families holds serious financial risk. The default risk is higher among lower income borrowers (cf. U.S. Department of Housing and Urban De- velopment, 1995, p. 3). To successfully achieve the aim of increased home-ownership the Government intended to make financing more available, affordable and flexible, especially for lower income families. Those families did not qualify for mortgages un- der normal circumstances. The Government wanted to break this serious barrier and qualify them for a mortgage. The strategy was committed to cut transaction costs, re- duce down payment requirements and interest costs and to increase the availability of alternative financing products, such as ARMs (adjustable rate mortgages) (cf. U.S. De- partment of Housing and Urban Development, 1995, p. 9).

In the next paragraph we will examine the connection between the Federal Government and the so-called Government-sponsored enterprises, which were created to successfully implement this part of the strategy.

As already stated, the national homeownership strategy commits the government and the mortgage industry to a number of initiatives especially designed to cut transaction costs, reduce down payment requirements and interest costs and increase the availabili- ty of alternative financing products (U.S. Department of Housing and Urban Develop- ment, 1995, p. 9). To realize these initiatives the congress chartered The Federal Home Loan Mortgage Corporation (commonly known as “Freddie Mac”) and The Federal National Mortgage Association (commonly known as “Fannie Mae”). In his paper “The role of the Fannie Mae/Freddie Mac duopoly in the American housing market” author David Reiss gives a brief introduction to the role of the duopoly in the American hous- ing market:

‘Fannie and Freddie primarily engage in two activities: First, they help mortgage originators package their mortgages into residential mortgage-backed securities (RMBS). This helps maintain a stable and liquid market for RMBS.

Second, the two companies raise capital by issuing debt securities and use those funds to purchase mortgages and related securities’ (Reiss, 2009, p. 337). ‘Borrowers get mortgages from lenders in the primary market. Primary market lenders then sell these mortgages to secondary mortgage market firms and use the proceeds to originate more mortgages in the primary market. The secondary mortgage market firms then sell se- curities backed by the mortgages that they purchased to investors and use proceeds of the sale to purchase more mortgages from primary market lenders’ (Reiss, 2009, p. 338

- 339). Both Fannie Mae and Freddie Mac are able to profit greatly from issuing debt and purchasing mortgages and RMBS because of their cheaper borrowing costs which are a privilege attendant to the special relationship with the federal government (cf. Reiss, 2009, p. 336 and 338 - 339).

We now could continue our analysis of the U.S. housing bubble and try to connect the issuing of debt securities based on residential mortgages with the following subprime- mortgage crisis and the financial crisis with its global consequences. If we refer to our main and guiding idea of this paper it was intended to elaborate methods and practices that are suitable for investors who want to profit of distressed real estate assets. There- fore we will now stop the analysis of the past historic developments and focus on con- clusions which will help investors more than any deepening and wide-ranging macroe- conomic analysis of the past would do. Our aim is to examine the conditions that influ- enced the origination of the bubble in real estate, more specific in the single-family housing market in the U.S. It is not intended to elaborate the aftermath of the burst of the bubble, the exploitation of issuing asset backed mortgages containing serious finan- cial and default risk, its secondary purchase and its consequences for the global econo- my.

Investors have to be aware that certain political objectives and the measures for obtain- ment of these objectives strongly influence people’s investment sentiment. If we refer back to point 3.1.3 and the inevitable consequences of changing demographics being one of the main fundamental causes influencing housing demand, one may perceive the National Homeownership Strategy as a politically influenced shadow darkening the view of people’s perception of real asset values. The strategy influenced the bubble’s creation and extended its duration.

We will now use the knowledge we have gained by analyzing the United States housing bubble to obtain a model to assess the environment that creates or supports bubbles in residential real estate markets. This model will help investors to identify potential exist- ing or developing bubbles. In the next part 3.2 Lessons learned we will then use these findings we have made in the parts 3.1.1 - 3.1.5 and undertake a practical approach to appraise market conditions in the residential real estate sector in a different country.

3.2.5 Indicating model of residential real estate bubbles

The following illustration visualizes the relevant and constituting factors that influenced the (price) bubble in residential real estate markets in the United States and shows possible methods how to evaluate these conditions or elements:

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Illustration 5: Residential real estate bubbles, indicating model; Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

Investors who are willing to acquire properties in the residential real estate market have to be aware that the market is dominated by individuals and amateurs having relatively small or no experience in real estate at all.

The following factors are mainly affected by the decisions and actions amateurs are willing to undertake:

-Dynamically inefficient economy due to over-accumulation of capital
-Public expectations of increasing asset prices
-Finite time horizons of protagonists

These elements are relatively difficult to evaluate but investors will have to combine research within this field with research in the fields of asset price and fundamental val- ue. It is relatively easy to obtain data on asset prices and to evaluate whether current market prices reflect fundamental basics or if deviants exist or start to develop.

Although investors should focus on relevant fundamental data and its consequences for asset prices, they should however not neglect the constituting elements that motivate people who actually perceive residential real estate being seen as a lucrative investment. As already stated in point 3.2.1. Public expectations of increasing asset prices, Case and Shiller did research on this topic. They conducted a survey in 1988 and 2003 and com- pared metropolitan areas, which reputedly experienced a bubble in residential real es- tate, with an area that has not experienced a bubble in real estate. The survey in 1988 and 2003 contains questions to evaluate people’s perception of seeing residential real estate as an investment. The economists evaluated whether people did buy real estate as an investment and what kind of risk they perceive when buying real estate in their area or city. Shiller and Case state that in 2003 in metropolitan areas like Los Angeles, San Francisco or Boston people did buy residential real estate for future price increases ra- ther than simply for the pleasure of occupying the home. The investment motive is thought to lend instability to bubbles and increases the tendency of a burst if this motive weakens (cf. Case/Shiller, 2004, p. 321). The attractiveness of this kind of investment strongly depends on peoples risk perception. If people perceive less risk with an in- vestment in real estate, they may be motivated for irrational and inefficient economic actions.

If we refer back to the introduction of this thesis we will still have to elaborate why (price) bubbles and especially the burst of these bubbles is relevant for investments in distressed real estate assets. The assumption was that price levels are at their historic bottom after the burst of the bubble. The following illustration shows the latest issue of the S&P/Case-Shiller Home Price Indices in the U.S.:

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Illustration 6: S&P/Case-Shiller Home Price Indices (1988 - 2011); Source: Standard & Poor’s (2011)

This chart shows the index levels for the 10-City and 20-City Composite Indices. We realize that home prices are back to their levels where they were in 1998. In May 2011 16 of the 20 cities examined reported positive monthly changes on home price devel- opment. Although there have been several months of improvement since 2009 S&P’s analysts point out that there will be still a long way to see a real recovery hence prices did stabilize at the current level (cf. Standard & Poor’s, 2011, p. 2). If we examine the supply side of U.S. residential real estate we may refer to a statement of one of the commonly know real estate investors in the U.S., Sam Zell, who is also known for its distressed property acquisitions: ‘The .. real estate market has and will come through all of this in pretty good shape. .. nothing has been built since 2007, supply has been li- mited, and the low interest rates mean there is no cost of money, so banks have been able to feed distressed properties into the market’ (Treasury&Risk, 2011, p. 2).

The U.S. Census Bureau announces residential construction statistics. The following chart shows the housing units completed in the U.S. during the phase between 1968 and 2010, indicating that since 2006 there was a substantial decrease in the completion of housing units.

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Illustration 7: Housing units completed (1968 - 2010); Source: Own illustration, data from U.S. Census Bureau

Illustration 8 is quite similar to Illustration 7 hence in 2010 the number of housing building permits slightly increases, indicating a possible reversal of the trend of diminished demand for residential real estate, which could also have a positive impact on the development of home prices.

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Illustration 8: Housing building permits (1968 - 2010); Source: Own illustration, data from U.S. Census Bureau

Distressed real estate investors look for a market environment that is changing towards an increase in prices and that underwent a phase of “repricing” and is now entering a phase of stabilization (cf. Brueggeman/Fisher, 2011, p. 210). If we refer back to Brun- nermeier’s definition of a bubble, the difficulty for investors lies in determining the fundamental value of an asset and which component of the price of an asset is due to a bubble or was due to a bubble (cf. Brunnermeier, 2004, p. 47). Investors who are will- ing to acquire real estate properties in the residential market in the U.S. will have to ask themselves two questions: What is the fundamental value of residential real estate? Are there still components of bubbles in the (transaction) prices of residential real estate or did the market correction in 2006 - 2011 eroded out these components of bubbles? In- vestors will have to ascertain that current price levels are justified by established estima- tions concerning demand and supply for residential real estate. As stated earlier, this part of the thesis was written with the intention to examine which conditions influence the origination and existence of a bubble in residential real estate markets. It was not the intention in writing this part to examine whether the future outlook for promising in- vestment opportunities in residential real estate in the U.S. is given.

Hence we still have to reassess whether properties are now available at discount and if investment opportunities agglomerate after the burst of a bubble. We already realized that the phenomena of price rigidity exists. Case and Shiller examined, that in a case of a bust of a bubble, prices do not fall to clear the market quickly. Sellers resist cutting prices. The lowering of prices is a last resort for potential sellers (cf. Case/Shiller, 2004,

p. 335). If we take a closer look on Illustration 9 which is showing the mortgage delin- quency/foreclosure rates in the residential real estate sector in the U.S., we see that be- tween 2006 and 2008 there was a substantial increase in the rates of delinquency (up to 3%), loans entering the foreclosure process (up to app. 1.5%) and loans who were al- ready in a foreclosure process (up to app. 1.25%). In the United States, banks and lender maintain so-called REO’s (real estate owned lists), containing information on properties that lenders have acquired by deed in lieu of foreclosure or through foreclosure and auc- tion. These lenders are usually not in the business of investing and especially managing real estate, they usually sell the properties as soon as possible (cf. Brueggeman,/Fisher, 2011, p. 210). Illustration 9 is furthermore indicating that investment opportunities ag- glomerate after the burst of a (price) bubble in residential real estate.

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Illustration 9: Mortgage delinquency/foreclosure rates (1998 - 2009); Source: Own illustration, data from U.S. Census Bureau

In the next part of this thesis we will now try to apply our findings originating from the analysis of the U.S. residential real estate bubble and undertake a practical approach to indicate another bubble in residential real estate in a different country.

3.3 Practical validation of significant factors

In 2009 Shiller stated that ‘… the current world economic crisis was substantially caused by the collapse of speculative bubbles in real estate … markets - bubbles that were made possible by widespread misunderstandings of the factors influencing prices. These misunderstandings have not been corrected which means that the same kinds of speculative dislocations could recur’ (Shiller, 2009, p. 2).

What a positive outlook for distressed real estate investors who understand the underly- ing factors that influence price changes. As already stated, there were numerous warn- ings that there was a developing bubble in the U.S. housing market during the last two decades. Although those warnings were shouted out by honorable economists, most of the people ignored those warnings and were surprised by the immense implications on the global economy, which were caused due to the burst of the bubble and its aftermath. If we look at this incident from an investor’s point of view, we do realize that there are probably favorable investment opportunities after the burst of a bubble, assuming that properties are now available at discount. There are admittedly hindering phenomena related to the pricing attitude of sellers of distressed assets that may complicate the pos- sibility for investors to achieve discounts, like high asking price rigidity and denial of the existence of a (price) bubble. We will refer to these phenomena when we discuss the topic of negotiation.

In this part of the thesis we now use and refine our indicating model that helps investors to appraise considerable factors in a specific country, which could be a possible target market for distressed real estate investments. Then we will present an existing and ap- plicable method, enabling investors to evaluate relevant fundamental data and relate them to the current asset prices in real estate markets and indicate the risk or chance of an already existing or developing bubble. At the end of this part we will assess the cur- rent level of sentiments (investor or consumer) concerning investments in a domestic real estate market. All three elements will be elaborated by referring to findings that have already been made in parts 3.2.1 - 3.2.5 by analyzing the U.S. housing bubble. To precisely indicate the potentiality of a developing or an existing (price) bubble it is ne- cessary to combine different approaches and use different methods.

In this part of the introduction we will therefore expand our initial model and focus on three different fields of observation:

Considerable economic conditions Fundamental data and asset prices Consumer or investor sentiment

When referring to Illustration 5 (indicating model) we now add an additional point (considerable economic conditions) to consider divergent economic conditions in another residential real estate market.

Within the next three parts of our practical validation we assume that we as an investor evaluate whether Switzerland is currently experiencing or will experience a (price) bubble in its residential real estate sector or certain segments of it and whether investment opportunities in distressed income-producing assets are already available or will be available in the near future.

Switzerland as a country of interest for further research was chosen due to the fact that the country already experienced a price bubble in real estate markets a decade ago and several institutions like banks, etc. installed warning systems detecting divergences be- tween fundamentals and asking or transaction prices or price exuberances. The respon- sible persons in operating or supervising functions in diverse financial institutions are now aware and sensitized of this issue. Another reason for choosing Switzerland as a country of interest is the fact that Switzerland is not a member of the European Union and therefore has an independent monetary policy, which is conducted by the Swiss National Bank. Although the possibility to conduct this policy certainly has some ad- vantages, we will also examine that this kind of solitary position within the European Union also maintains some negative consequences for economic developments.

This practical approach is utilized due to the fact that this will help us to validate whether the extrapolated model showing how to anticipate residential real estate bubbles (Illustration 5) can be used on residential real estate markets in other countries as well. It will therefore be necessary to conclude this part by drawing general conclusions which have been worked out by adopting this approach.

At the end of this part the conclusions that where observed in the Swiss residential real estate market will be contrasted with the elaborated four constituting elements of a real estate bubble that affect individuals and market participants (capital accumulation, expectations of increasing asset prices, finite time horizons). The thesis will also contrast current asking and transaction prices and oppose them to fundamental data.

Illustration 10 visualizes our approach that we conduct in this part of the thesis:

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Illustration 10: Residential real estate bubbles, enhancement of the indicating model;

Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

Within each field of observation we will ascertain whether practical implements already exist in Switzerland and whether these tools are appropriable.

3.3.1 Considerable economic conditions

First we will take a snap-shot of the considerable economic conditions in the Swiss real estate market. In this part we will assess the existing economic environment in Switzer- land by referring to Illustration 10, which can be used as an investment scheme to ap- praise considerable economic conditions that are relevant for investments in residential real estate properties.

Illustration 10 is primarily fragmented into the following points:

-Considerable economic conditions
-Fundamental data and asset price
-Consumer or investor sentiments

The illustration shows the following main economic conditions for residential real estate investment and its subsequent categories that investors should be aware of:

-Global, macroeconomic development
-Market drivers
-Demographics

Within this part of the thesis we will focus on national economic developments that are relevant for the residential real estate sector. Although the illustration is showing that the global, macroeconomic development is relevant for investors, it would go beyond the scope of this work to deeply analyze developments within this field of observation. Instead we will focus on domestic developments in Switzerland that are relevant for the residential market and therefore use the findings of market reports that are tailored for real estate professionals. The thesis should however not neglect intercepts with global, macroeconomic developments, in particular developments that are relevant for the resi- dential real estate market, e.g. migration due to unfavorable employment opportunities caused by increasing pressure on Swiss exporters. We already stated the intentions why Switzerland as a country of interest was chosen. Another simplistic reason would be that the country is relatively small and for this reason straightforward.

At the time when this thesis was written, the global macroeconomic environment and especially the stock and currency markets experienced high volatility and strong price corrections. Switzerland was then perceived as being a safe haven for investments of different categories. This perception has lead to a massive increase of the value of the Swiss Franc in relation to other currencies. In relation to the Euro the currency gained app. 40% since June 2008. The Swiss franc set new highs against all major currencies. The strength of the Swiss economy is strongly dependent upon the health of the global economy and, in particular, the Euro zone (cf. Cushman & Wakefield, 2011, p.1). Ex- ports have been one primary driver of economic growth. The latest financial turmoil following the debate to increase the U.S. debt ceiling did have its implications on the Swiss economy. The strong franc is already causing difficulties to exporters and hinders their ability to achieve further price increases and decreases their margins.

If we take a closer look on the growth rates of exports we realize that in the fourth quar- ter of 2010 we had a plus of 5,9% and in the first quarter of 2011 Switzerland expe- rienced an increase of 24,7% in the amount of exports compared with the previous year. Exports now contribute to a 20% share of GDP (cf. Schweizerische Nationalbank, 2011, p. 15 - 16). The Swiss national bank furthermore accentuates that the margins of expor- ters are under pressure although robust international demand from abroad backs the de- velopment of Swiss exporters. The bank also states that the general economic domestic conditions still enable a positive outlook for the future (cf. Schweizerische National- bank, 2011, p.19).

The consulting firm Cushman & Wakefield is offering a wide range of free research publications that are available online. Their series “Market Beat” provides investors a quick and widespread possibility to characterize an economy. Following the latest issue of this series describing national markets, the current status of the Swiss economy can be described as favorable, the economy has one of the lowest inflation and unemploy- ment rates in Europe and a steady GDP - growth of nearly 2,6% as in 2010.

The economic snapshot mainly focuses on the following economic indicators (cf. Cushman & Wakefield, 2011, p. 1):

-GDP
-Inflation
-Interest rate
-Employment and unemployment rate
-Consumer spending, industrial production, investments
-Currency exchange rates

These indicators are commonly used in research publications and provide a quick overview on a national economy. The report states that the Swiss economy is profiting of strong growth in exports. The rate of inflation is low and is currently not considered to be a problem in the near future.

If we take a closer look on prices and inflation expectations, more specific, residential property prices and apartment rents, the Schweizerische Nationalbank refers to the fol- lowing findings: There is a vigorous upward trend in prices of single-family homes and owner-occupied apartments, whereas asking prices and transaction prices rose steadily. The national bank yet states that these price developments are consistent with the most important fundamental factors. In the long term these price increases will not last forev- er. There is a great probability of a sudden and drastic correction (cf. Schweizerische Nationalbank, 2011, p. 23). We already realized that price developments for assets and rent developments have to be consistent otherwise the chance of a possible bubble is increasing.

The Schweizerische Nationalbank cites that the rise in apartment rents has been moderate. Discrepancies between the development of prices and rents enhance the possibility of an increasing asset bubble although structurally sound markets like Switzerland do not suddenly collapse (cf. Schweizerische Nationalbank, 2011, p. 23).

The research publication “Swiss Issues Real Estate” from Credit Suisse is a relatively comprising report that includes a general description of the Swiss real estate market and furthermore provides insights in the different sectors of the market (residential property, office property, retail property). We will mainly focus on the find- ings of this research publication on the residential property sector. The report initially states that the economic growth which some countries are experiencing nowadays main- ly is due to government’s massive injections of capital and stimulation programs (cf. Credit Suisse, 2010, p. 5). Switzerland experienced a dramatic collapse of its real estate market when a price bubble burst in 1990. At that time Switzerland entered an econom- ic phase called the “Swiss Disease”. It took the country nearly half a decade to recover from this economic downturn (cf. Credit Suisse, 2010, p. 5). During this crisis, mone- tary authorities injected massive amounts of liquidity into the markets to save them from a collapse. These injections were a significant factor influencing the boom in real estate (cf. Credit Suisse, 2010, p. 6). Real estate was then believed to be a save invest- ment in an inflationary climate (cf. Credit Suisse, 2010, p. 6). The price increases lead to the fact that banks were willing to grant more generous mortgages on real estate ig- noring the risk of price decreases. The following mechanisms that occurred during this phase were also observable until recently in the U.S. residential market: Overrating of trends, underestimation of the risk, high leverage, dubious creditworthiness of borrow- ers, rising inflation and rising interest rates (cf. Credit Suisse, 2010, p. 6).

If we closely examine the latest measures the National Bank has undertaken to stabilize the market price of the Franc, we realize that they strongly increased the liquidity in the banking system and that they decreased the interest rate (cf. NZZ, 2011, p. 11). Inves- tors now may discover an economic situation that contains the potential for irrational price exuberances in residential real estate markets. Low interest levels increase price distortions in real estate markets: Investments in real estate are perceived as an inflation hedge and low financing cost lead to an increase in mortgage granting. Binswanger ar- gues that the Swiss banking system is in funds of massive amounts of capital, much more than during normal times. There are however missing lucrative investment oppor- tunities for financial institutions (NZZ, 2011, p. 14). The current interest rate for daily allowance (3 month) in Switzerland amounts to almost 0% (0.0133%) (cf. Volksbank AG, 2011, p. 2).

Philipp Hildebrand, former President of the Swiss National Bank, sees regional and segmental price distortions, especially in the market for residential real estate, more specific, condominiums (NZZ, 2011, p. 11).

The Swiss housing market currently has yet not been destabilized by the global reces- sion and lessons have been learned from painful experiences gained during the “Swiss disease” and the developments concerning the U.S. housing bubble. This was the case as the market successfully resisted any excesses both in terms of mortgage policy and exaggerated price trends although there will be future challenges waiting in the near future (cf. Credit Suisse, 2010, p. 6). After having overviewed the current national eco- nomic conditions in Switzerland and its connection to the residential real estate market we will now examine the current market condition in the residential property sector. This will be done mainly by referring to the market report of Credit Suisse. The report indicates that there are awaiting challenges for the real estate market in Switzerland: Rising unemployment, stagnating real incomes and a continuing downturn in immigra- tion are threats for future positive development (cf. Credit Suisse, 2010, p. 8). If we ana- lyze the methodology of the report, it contains segments describing influencing ele- ments for demand and supply in residential real estate in Switzerland. The report de- fines the following market outcome for residential real estate in Switzerland (Credit Suisse, 2011, p. 8 -22):

-Atypical end of building boom
-Vacancy levels to rise in 2010
-Some regional markets still tight
-Scissors movement of transaction prices for houses and condominiums
-House prices and rents for new builds under pressure in 2010; Only modest decrease for condominiums
-Peripheral regions facing price falls in 2009
-High prices restrict potential demand for single-family dwellings
-Demographic trap
-Outmoded housing stock
-Trend to sustainability incompatible with the concept of the single-family dwelling
-Risk of houses standing empty, especially in peripheral regions

By reading through these lines describing the market outcome in residential real estate, a reader may not get the impression that the market outlook for residential real estate in Switzerland is still promising. Within the next part we consider the topic of demographics being one of the main factors influencing economic conditions.

3.3.2 Demographics

If we cover the topic of demographics we will not approach that by doing excessive mathematical and statistical work. Our approach is to recognize general trends that in- fluence residential real estate markets in the near future. This approach will be realized by summarizing the main scientific findings of Just and his work “Demographics and real estate” (or “Demographie und Immobilien” in its German version) which has been conducted on demographic developments in Germany. We will then examine signaling demographic changes in Switzerland which are relevant for real estate, more specific in this case, residential real estate investment and possible (price) bubbles.

Demographics and their developments are an important determinant influencing the demand for residential real estate. The main elements of demographics are population stock, population growth and the age structure of the population. The share of consump- tion which is dedicated for residential living actually declines with rising income. Baker already did research on that topic, as stated in part 3.2.2. Commodities having that kind of attribute are called inferior goods (cf. Just, 2009, p. 45). We also used the term “over- lapping generations economy” when referring to an economic situation where bubbles can persist. The model of overlapping generations comprises three generations: Earners, retirees and adolescents. This model also comprehends the following four aspects of demographic changes (cf. Just, 2009, p. 47):

-Retirement provisions enforce reallocation
-Higher income increases for highly qualified manpower
-Neglected wealth effects
-Considerable regional differences

Just further highlights that households and not individuals are the main consumer of residential real estate (cf. Just, 2009, p. 48). The average size of households has con- stantly decreased during the last 30 years, (cf. Just, 2009, p. 47) and almost 40% are now single-person households although there is a tendency showing that the pace of increase in single-person households is already decreasing. It is also ascertainable that the so-called “Baby-boomers” are somehow wandering through the phases of different age groups in society. There are several periods that relate to the term “Baby-boom”. In Europe we mainly talk about the generation that was born between 1946 and 1964.

It is relatively difficult to prognosticate the numbers of households as there are various economic and societal tendencies that have to be taken care of. It is yet foreseeable by various methods that the number of households will increase in the future (Just, 2009, 56). Immigration strongly influences this development. The increasing number of households will cause substantial structural adjustments within the following fields (cf. Just, 2009, p. 62 - 63):

-Regional differences
-Distribution of households in different age groups
-Distribution of households in different types (e.g. single-person households)

As Just describes, these adjustments will lead to more retirement households, target groups for residential real estate are getting older and there will be more small households (cf. Just, 2009, p. 63).

If we examine the demand for residential space, we have to assert the following effects (cf. Just, 2009, p. 66 - 67):

-Lifecycle-effect
-Remanence-effect
-Cohort-effect

The lifecycle-effect describes a situation, whereas people adjust their demand for space over their lifetime. This development strongly depends on income- and family-situation (cf. Just, 2009, p. 66). The remanence-effect describes a situation, whereas people above the age of 50 do not adjust their demand for space. The cohort-effect finally describes differences in demand between diverging age-groups. There are several reasons for this development, such as income and wealth (cf. Just, 2009, p. 66 - 67).

The aging of the population will eventually lead to an increase in ownership in residential real estate (cf. Just, 2009, p. 71). An increase in households and a tendency towards larger residential space will eventually lead to an increase in demand. Just anticipates that these tendencies will probably last until 2025, depending on the underlying immigration scenarios (cf. Just, 2009, p. 75).

Residential real estate is a very heterogeneous good. It is therefore more applicable to differentiate consumers than the actual good (Just, 2009, p. 81). This can be done by applying the model of Sinus-Milies - types. We will not explain this model, we will instead concentrate on its implications on real estate: It is important for investors to know that different types of consumers demand for different residential space. It is also important to anticipate further developments and plausible adjustments within certain milieus, e. g. apartment-sharing communities of retirees.

Reactions of real estate markets are asymmetric. Residential real estate market’s reac- tions on growing economies are delayed, an increase in demand in residential space automatically leads to a delayed increase in supply. In diminishing markets supply is though persistent. Falling rents and prices do not lead to a reduction in supply as owners are not willing to demolish their residential property as a kind of last resort to adapt supply. By doing so, the benefits of use would be socialized, whereas the cost of demo- lition would be privatized.

Concluding this introduction to demographics and (residential) real estate, Just examined the following trends:

The number and composition of households is more important for the demand for resi- dential real estate than the actual population stock or growth. In foreseeable time (10-20 years) the number of households will continue to grow and there is a cognizable ten- dency towards smaller households. There are notably regional differences. There is sig- nificant uncertainty concerning different scenarios, mainly regarding the three listed effects (lifecycle-effect, cohort-effect and remanence-effect) and possible scenarios on immigration. There is a clear trend that an increasing population stock has a positive effect on demand for residential real estate, yet it is stated that swift adaption in living space is able to diminish that correlation. Investments in residential real estate in fast- growing regions promise above the average returns (cf. Just, 2009, p. 110 - 111).

Just describes that these observed trends in demographics are probably commonly known among investors and that there is substantial chance for over-reaction in certain segments of real estate, e.g. the creation of excess supply in living-space for elderly or students (cf. Just, 2009, p. 47 - 48).

We will now use these scientific findings and apply them for our case, which is to examine whether there is the potential for successful distressed real estate investment in in Switzerland. This will be done by referring to relevant parts of the market report of Credit Suisse and comparing them with the elaborated findings.

The market report primarily identifies the following demographic elements that are sub- stantially influencing demand for residential real estate (cf. Credit Suisse, 2010, p. 8 - 23):

-Immigration (Family reunification and skilled labor)
-Regional disparities
-Demographic trap

The report is showing that the demand for residential properties in Switzerland is main- ly driven by immigration. Although general macroeconomic developments, as stated earlier, may not promise a continuation of this development, immigration helped the population in Switzerland to grow by an above-average 1.1% in 2009 (cf. Credit Suisse, 2010, p. 8). Immigration hence adapts to economic cycles with a delay and correlates closely with employment levels (cf. Credit Suisse, 2010, p. 8). It is unclear how the pressure on exporters and possible political measures will influence this development. The report yet states that skilled labor with superior qualifications will still have a chance of finding a job in Switzerland (cf. Credit Suisse, 2010, p. 9). The report also provides a regional analysis indicating the following trend: Immigration in central and urban locations (like Zurich) is at a very high level. People who arrive in Switzerland for the first time tend to live near to their job. The migration process does not stop here, people that used to live in cities are getting older and start having families and find cen- tral locations less appealing than locations surrounding cities in the periphery. The re- port clearly states that this trend is visible (cf. Credit Suisse, 2010, p. 10).

In part 3.3.4 UBS Swiss Real Estate bubble index we conduct research on fast-growing regions within Switzerland. There are certain regions which experience strong population growth and already possess high population stock. This examination was elaborated by referring to the “UBS Swiss Real Estate Bubble Index ” , more precisely to the “ Rela tive Market Growth Matrix ” and its visualization in form of a map.

There is an observable trend indicating that urban regions within Switzerland (e.g. in Luzern, Zurich, Bern etc.) undergo a phase of increase in population growth and stock.

The report indicates another trend which has already been prognosticated by Just: There are large differences in regions within Switzerland, resulting from different reasons as density in population and the limited supply of real estate due to scarcity of land and strict building plans (cf. Credit Suisse, 2010, p. 13). The report furthermore affirms Just’s estimate that the main focus of residential properties is shifting away from single- family dwellings and toward condominiums, reflecting the increase in smaller house- holds. The single-family house segment faces structural problems and prices could ease by 2-3% (Credit Suisse, 2010, p. 19). What reasons cause these structural problems? One reason may be that the purchase prices of a single-family dwelling are at very high levels and exceed the financial possibility of many families whereas condominiums attract especially younger people with relatively small prices due to lower proportions of land cost (cf. Credit Suisse, 2010, p. 20).

The population in Switzerland is aging like many other populations in western countries do. Mankiw and Weil elaborated that the baby-boom generation wanders through the different age groups and demands for different real estate properties. Just describes this phenomenon as the “life-cycle-effect”. The report furthermore states that the trend to sustainability is incompatible with the concept of the single-family dwelling and that there is a high risk of houses standing empty, especially in peripheral regions (cf. Credit Suisse, 2010, p. 22). The report yet alludes that peripheral regions near to catchment areas offer potential for the conversion of properties for different uses (e.g. demolition and replacement with condominium blocks) (cf. credit Suisse, 2010, p. 22).

By analyzing demographic developments based on the listed constituent elements, investors may detect that there is sufficient chance for mismanagement or failures in management concerning the administration of a residential real estate portfolio. If asset managers take the wrong decisions regarding the design of offered living-space then there is potential for the existence of distressed real estate. Institutions who own mislead portfolios or single properties of residential real estate may experience (financial) pressure and are forced to sell their distressed assets.

If an investor is willing to profit of distressed real estate investments he somehow has to locate possible target markets that will suffer from temporarily price declines. The long- term (demographic) prospects for the target region and the demand for certain types of properties still have to be sound. Investors will then also have to identify distressed properties or distressed companies. However comprising this scientific examination of possible target markets or assets will be, word-of-mouth regarding potential properties or enterprises at the end will probably deliver the desired results whereas scientific re- search on bubbles is only able to provide the theoretic and initiative background.

3.3.3 Fundamental data and asset price

As stated earlier Switzerland already experienced a bubble in residential real estate markets in 1990, when the market incurred a dramatic collapse. ‘The scale of Switzerland’s real estate crisis of the 1990s can indeed be likened to the current one in the US, in terms of both its size and the fact that a “house of cards” was built up and subsequently collapsed’ (Credit Suisse, 2010, p. 5). In Switzerland, about CHF 42 billion in domestic loans have been written off between 1991 and 1996. Diverse financial institutions then realized the need for early warning systems helping to indicate the threat for exuberances in the real estate market. One of these institutions, the Swiss bank UBS AG, developed an index which will be presented now.

We will now examine an already existing method which has been developed to indicate the chance of a bubble in the Swiss residential real estate market. This method is using statistical data on relevant fundamentals and opposes it in relation to the current asset prices. As we have already seen, this method has already been used to analyze the de- velopment of the U.S. housing bubble. The thesis yet highlighted two approaches which have been conducted by Baker and Case/Shiller, who defined relevant and important fundamentals possessing the ability to influence price changes in the residential real estate market (see point 3.2.2 Asset price and fundamental value). The authors then ex- amined the connection between fundamentals and price changes and related possible diverging developments to each other. If price changes and more specific price increas- es are not based on or in relation to uninterrupted changes in the fundamentals, then those changes or increases will not be of endurance.

The “ UBS Swiss Real Estate Bubble Index ” is designed to indicate the chance of a bub- ble in the Swiss residential real estate market. The methodology of the index is designed to calculate the average of trend-adjusted and standardized indicators weighted using a principal component analysis showing the standard deviation from the average. There are five levels that indicate the threat or chance of a bubble: Slump, balance, boom, risk and bubble. With this index investors are able to identify unsustainable price move- ments or estimate the chance and incidence of a possible (price) correction. The index comprises six sub-indices (cf. UBS AG, 2011, p. 1) that track the relationship between and the proportion of

-purchase and rental prices,
-house prices and household income, house prices and inflation,
-mortgage debt and income,
-construction and gross domestic product,
-credit applications for residential income property

As we have already seen in point 3.1.2 this method of indexing is error-prone if factors are being determined that are not relevant, if important factors are missing (e.g. demo- graphic factors) and if those factors determined are not investigated with the necessary attention to detail (e.g. connection between share of housing in consumption and aver- age income growth). This method is also unfeasible if it does not aggregate the exami- nations on a general and manageable level. Baker for instance solely examined single factors and fundamentals and did not aggregate them on a total level. Although he clear- ly stated that in his belief the U.S. residential real estate market experienced a bubble, his method showing single, unconnected and isolated exaggerations was not applicable to quickly reach a broader audience. The index of UBS’s Wealth Management Research instead aggregates the developments of six sub-indices and therefore enables a relative- ly conclusive overview of the current residential real estate market in Switzerland. We have yet determined that there are no factors observed by the index which are related to demographic developments. As stated earlier, demographic changes are of high impor- tance for price developments, especially in residential real estate markets. It is therefore necessary to separately deal with this factor.

The following illustration shows the total UBS Swiss Real Estate Index (UBS AG, 2011, p. 1):

illustration not visible in this excerpt

Illustration 11: UBS Swiss Real Estate Bubble Index Source: UBS AG

The overall index is currently indicating a “boom” in the market of residential real estate assets. One recognizes a steady increasing development whereas the index between 1998 and 2002 was in a “slump” position and entered the phase of “balance” between 2002 and 2009. Since 2010 however the index is indicating a booming market situation. If the historic development continues we will see a market containing risk. The index is not showing that the market is currently experiencing a bubble.

As an example for a single sub-index, the index contains for instance the sub-index for credit applications for residential income property of UBS clients. This index shows credit applications for real estate which is not intended for owner occupancy. It there- fore reflects the interest in owning real estate as a financial investment or possible spe- culative purchase. If this index indicates such a trend we may already experience a de- veloping real estate bubble in residential real estate markets in Switzerland as credit applications for income property experienced a strong upward change between 2010 and 2011 (UBS AG, 2011, p. 3).

This index also helps understanding that residential real estate can be seen as an investment or as a commodity. If people expect prices to continually improve they perceive less risk with the investment in residential real estate assets. If investments are perceived containing less, minimal or even no risk at all, then (ir)rational actions are one possible consequence (as already seen in point 3.2.1). This sub-index may also be used to indicate current expectations of future price increases, which are a relevant constituting element of bubbles in real estate.

As stated, there exist six sub-indices which are summed up by the UBS’s total index and it would be interesting to analyze each one of them. Our main interest and purpose of this thesis yet does not allow an extensive research on all sub-indices of the UBS index. For our purpose it is adequate enough if we use the results of the total index. Investors therefore may not discover a market having a bubble although there are certain signs that the market is moving in that direction.

The U.S. housing bubble was relatively difficult to recognize due to diverging developments in different metropolitan areas. Some economists therefore did refer to a situation where only small and local bubbles existed and did not admit until the very end of the burst of the bubble that it was a nationwide development. Former Federal Reserve Chairman Alan Greenspan e.g. acknowledges that he failed early to see that this could pose a danger to the economy (cf. MSNBC, 2007, p. 1). Real estate markets show very heterogeneous developments within certain regions.

The UBS index is aware of this special characteristic of real estate markets and there- fore differentiates risk regions in Switzerland by illustrating a regional risk map. There- fore an adjusted relative market growth matrix is used to specify developments in dif- ferent regions. Illustration 12 is showing the “Relative market growth matrix” which is based on population change and population stock and price changes and price levels. With this matrix the UBS identifies regions holding the greatest risk potential with na- tional importance. In a first step every region in Switzerland is assigned to one of these four categories (Evolving Markets, Star Markets, Marginal Markets and Developed Markets). This assignment is based on population change and population stock. One may now argue that the second part of the UBS’s early warning system is considering demographic changes and that the apprehensions which have been formulated at the

beginning of this part have been reflected in the system. By comparing these methods with the insights from part 3.3.2 one may then realize that the consideration of popula- tion change and population stock is not enough if we deal with the extensive topic of demographics and its implications on real estate. Markets that are however experiencing a high population growth and already have a high population stock are assigned to the segment of “Star Markets”. In a next step the matrix furthermore differentiates certain market phases within these markets: Cheap, flourishing, expensive or booming market phases. This differentiation is now based on price changes and existing price levels. If the market is experiencing a strong price increase and is having high price levels we would attach the phase to a “Booming” phase.

Relative market growth matrix

Population change and stock, price change and level

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Illustration 12: Relative market growth matrix. Source: UBS AG

Illustration 13 now exemplarily shows the regional risk map for Switzerland, which differentiates between monitoring regions and risk regions based on the assessment of the relative market growth matrix.

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Illustration 13: Regional risk map; Source: UBS AG

This visualization helps to identify local bubbles and indicate the chance of nationwide developments (cf. UBS AG, 2011, p. 5). As we can see there are certain regions in Switzerland that experience booming residential real estate markets. We also see that there are regions that are not affected by strong price increases and therefore the current economic situation does not possess the potential to account for a nationwide development of increasing asset prices. If seen from an investor’s point of view this regional visualization is yet an ideal tool to locate possible target markets in residential real estate within Switzerland that may experience or will experience a (price) bubble. Once an investor has been able to locate a target market or even better a certain region within a country, he is able to locate possible single target objects.

Economic indicators and risk maps may be used to identify the risk of (price) bubbles or possible corrections accurately enough. An exact forecasting of price bubbles is yet not possible. Investors are able to use these indices and risk maps to identify markets that possibly will experience price corrections. They can prepare their investment calculations on certain objects in advance and enter price negotiations with concrete conceivability and realistic price estimation based on fundamental factors assuming that the phenomenon of price rigidity is not constricting this intention.

The UBS index is relatively easy to understand and provides investors with practicable information on a local real estate market. Investors can easily convert the methodology of this index and adopt it for other real estate investment markets as well. The main idea of the index is to quantify and estimate the potentiality of a developing bubble. The idea is carried into execution with two different approaches: The index compares fundamental factors with relation to price movements and identifies and visualizes special local areas of interest. Although one may argue that Switzerland as a country is relatively easy to overview, this methodology may also be used for larger countries and different real estate markets, e.g. office or retail real estate markets.

The nationwide residential market in Switzerland has not yet moved in a category which could be described as carrying risk, although one may anticipate or foresee this devel- opment in the (near) future. Investors who are trying to profit of buying distressed resi- dential income-producing properties should constantly survey this market. The total index is therefore a very practicable and quickly usable tool and is complemented by the visual map showing different regional markets and their characteristics in terms of de- mographics and prices.

To conclude our analysis, there is yet still some research left which has to be done on demographic developments in Switzerland. As already mentioned, these developments are not covered within the first part of the index. The system of trend-adjusted and standardized indicators does not comprise demographic changes. Although we have some minimal demographic aspects covered in the second part of the system (population stock and population change represented in the regional risk map) an intelligent investor may still want to regard this topic with necessary diligence, referring to demographic changes in the United States which were an important factor influencing the development of the bubble in residential real estate markets.

3.3.4 Sentiments

In this part of the thesis we examine how to evaluate people or investor sentiments. First we will assess investor’s perception of future real estate investment outlooks on a global and regional basis which is mainly done by referring to surveys. We will examine the methodology behind the surveys and relate the results to findings we have already drawn from other observations on price expectations and finite time horizons of prota- gonists (see point 3.2.1 . and 3.2.2 ). Expectations of continuing future price increases, people’s perceptions of price developments and finite time horizons are essential ele- ments of developing price bubbles in residential real estate, especially when they moti- vate people and cause (ir)rational actions. This approach will help us to elaborate simi- larities and differences between public or people’s expectations and professional’s ex- pectations on future developments of residential real estate markets.

The research “Global Investor Sentiment Survey” has been conducted in the third quar- ter of 2010 and is the latest review of investor sentiment published by Colliers Interna- tional Global Investment Services. This survey has the purpose to better understand global investor attitudes in the current marketplace at a global and regional level, in- cluding investor’s outlook for the coming 12 months. There were more than 200 res- pondents representing a broad selection of institutional and private investors with a total investment portfolio of approximately $710 billion (cf. Colliers International, 2010, p. 26). The focus of the study lies on the delivery of a global picture of investor’s senti- ment although there are results for different local areas available. There are several areas of research investors have been questioned about (cf. Colliers International, 2010, p. 26):

-Strategy: Changes within real estate portfolios
-Risk: Attitude to portfolio risk
-Buying property: Cross-border investment or domestic
-market investment Market sentiment: Rents for office, retail, residential and industrial markets
-Finance: Cap-rates and access to debt
-Outlook: Optimism

Like many other investor sentiment surveys Colliers International is using a clock to symbolize the stage of the so-called property cycle and visualize the results of the survey.

This clock is divided in four parts which indicate the stage of the real estate cycle: Downswing, trough, upswing and peak. We already examined the different cycles for real estate markets in point 2.4.

Most respondents feel that the market in the next 12 months will be little changed from now on. Investors expect that the market will be at the early stage of an upswing. Cha- racteristics of an upswing market would be rising demand, falling availability and va- cancy and increasing rents. (cf. Colliers International, 2010, p. 7) Given that description we assume that the ideal momentum for investments in distressed real estate assets is the immediate market phase after “trough”. Investors are able to use this method to time the ideal point for purchasing distressed real estate assets. It is necessary to note that with this tool investors anticipate and appraise the future sentiment within their local market. There are several regions that have been surveyed with this method: Asia, Pa- cific, Western Europe, Eastern Europe, Middle East and Africa, United States, Latin America and Canada.

If we take a closer look on our example market Switzerland we are able to orient on the property clock for Western Europe. The following three illustrations show the indication of investor sentiments in Western Europe in 2010 Q1, the current cycle and where investors expect the cycle to be in 12 months.

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lllustration 14: The Western Europe property clock. Source: Colliers International

If we compare the estimations where the cycles would be in 12 months, we can see that on a global level investors are a bit more confident about the coming future development than investors in the region of Western Europe are.

Investors expect the market in Western Europe to hit 7 o’clock, which would indicate that there is a cognizable trend towards an upswing in the market.

Property clocks are a very easy to use tool allowing investors to quickly evaluate investor sentiment in different real estate markets. Several larger real estate consulting enterprises offer freely accessible property clocks on their websites. Here is a list of companies offering different types of property clocks covering relevant property types in different locations and different market segments:

-Cushman & Wakefield
-Jones Lang LaSalle
-Knight Frank
-Collier’s International
-Marcus & Millichap
-Etc.

If we closely examine the market segment for residential real estate, we refer to the report of Marcus & Millichap, the 2011 real estate investment outlook report. The report assesses investors perception of property types and examines their estimation of future developments in the U.S. The report conducts research on investor attitudes and expectations by an online survey accessible for public and private investors and developers of commercial real estate. The majority of the respondents are private investors (35%), developers (20%) and private partnerships (18%). The survey yielded over 500 valid responses (cf. Marcus & Millichap, 2011, p. 1).

The report indicates that the commercial real estate market has reached the bottom and the sector of residential real estate leads the way in the recovery, showing the fastest improvements in fundamentals (cf. Marcus & Millichap, 2011, p. 3).

72% of survey’s respondents believe that now is the time to buy residential real estate tracking along with confidence in improving fundamentals. If we refer back to Illustra- tion 3, we experience that transaction prices for residential real estate in the U.S. are now at their pre-bubble level. Investors now believe that this is the time for investments in residential real estate.

The assumption that after the burst of a bubble the momentum for investment opportunities is favorable can be affirmed for the second time.

The real estate consultancy company King Sturge collects data on survey responses from more than 1,000 market experts in real estate focusing on the development of the appraisement of professionals of the investment climate in Switzerland within certain segments. The survey concludes that the segment of residential real estate is experienc- ing a strong growth period since it reached its bottom in 2008/2009. The overall climate for real estate cyclical is constantly improving since 2008/2009 and reaches a new high in its latest census from March 2011 (cf. Schweizerischer Verband der Immobilienwirt- schaft, 2011, p. 1).

Market experts are above the average optimistic about residential real estate, although the two other segments show constant improvement in optimism and future outlook as well. Substantive sections of the survey furthermore indicate that the current level of confidence is at pre-crisis levels and the appraisal of the earning climate rises at 6.4% on a monthly basis (cf. Schweizerischer Verband der Immobilienwirtschaft, 2011, p. 1). If we reconsider the estimations of professionals concerning residential real estate in- vestments we do realize that they are confident and optimistic about future develop- ments in this market segment. Although current market estimations do not indicate that the market is already at its peak in Switzerland, we may see this market situation in the foreseeable time, as long as confidence in current economic conditions is not weaken- ing. It is now necessary to estimate the current sentiments of the general public as we know that the market of residential real estate is predominated by amateurs having little or no experience with investments in real estate at all. Therefore we will refer to the findings of Case and Shiller and their survey in 2003 indicating the existence of a real estate bubble in the U.S. Case and Shiller compared regions in the United States that reputedly went through a phase of bubble sentiments with an area that has not. Case and Shiller tried to shed light on a number of aspects of residential real estate buying beha- vior, such as investment motivations, expectations of further price rises, the amount of excitement and discussion about real estate, sense of urgency of buying a home, sim- plistic theories about residential real estate, the occurrence of sales above asking prices and the perception of risk (cf. Case/Shiller, 2003, p. 321). As already described, the economists received app. 700 completed questionnaires gauging human behavior during a purported real estate bubble (cf. Case/Shiller, 2003, p. 319). The questionnaire contains questions about the following main topics:

-Price expectations, sense of excitement and talk
-Housing as an investment
-Buyer’s agreement with simple theories of housing prices
-Popular themes mentioned in interpreting recent house price changes
-Real estate market vs. stock market investment
-Excess demand and upward rigidity in asking prices

Investment motives are clearly important among buyers of residential real estate. By doing research on current market estimations in Switzerland one may get the impression that among professionals the country is currently experiencing a developing real estate bubble. Although there are various installed and approved warning or detecting systems in diverse financial or governmental institutions there is yet no survey available that contains research on people’s sentiments on residential real estate and their investment or buying motives. We will therefore have to refer to the index of the UBS AG indicat- ing the credit applications for residential property which is not intended for owner oc- cupancy. This helps to understand whether the acquisition of residential real estate is being perceived by the general public as being a good investment. The share of credit applications for real estate investments slightly decreased to a 20% share of total resi- dential real estate credit applications whereas the change year-over-year slightly in- creased to app. 25%. As stated earlier we see a strong increase in applications since 2009/2010 although the trend seems to come to an end in August 2011. This sub-index of the UBS index is the only index that fell slightly in August 2011. All other sub- indexes (as seen in point 3.3.3) slightly increased since the latest publication of the in- dex. If we refer to Case and Shiller and their survey we know that the motif of seeing housing as an investment is only one of several motives that influence people’s action concerning the acquisition of residential real estate. It is yet important to adhere that there is no research available that has been conducted on people’s sentiments concern- ing residential real estate in Switzerland. As we know people’s perception of existing or future (price) developments is essential for the indication of a real estate bubble in the residential sector it is therefore not possible to present further results or findings and draw reliable conclusions on people’s sentiments.

3.4 Summary, results and critique

This part of the paper defined the significant factors influencing the origination and the development of (price) bubbles in residential real estate markets. These factors have been elaborated based on descriptions of bubbles in its most facile wise. This was con- ducted with the intention to develop a method to indicate (price) bubbles in different residential real estate markets in various countries showing divergent characteristics.

Our leading research question was to acquire knowledge, how investors are able to recognize developing (price) bubbles in residential real estate markets ex ante. Therefore we precisely defined the term of “distressed residential real estate” and determined market drivers and economic conditions being one of the main reasons for properties becoming distressed. These factors are furthermore not within the influenceable sphere of an investor and should therefore be considered especially. Therefore we examined whether the factors describing bubbles could be noticed during one of the largest bubbles in residential real estate markets, the U.S. housing bubble.

By adopting the findings that have been made during the analysis of the bubble in residential real estate in the U.S., the thesis then tried to practically enable investors to anticipate (price) bubbles in residential real estate ex ante.

Therefore we asked the question whether Switzerland is currently experiencing or will experience a bubble in its residential real estate market. We considered and overviewed current economic conditions in Switzerland and referred to methods or instruments that have already been established due to national or international experiences and used them to apply our indicating model (Illustration 5). The indicating model yet had to be expanded regarding economic conditions as we were analyzing a different residential real estate market in a different country. Demographic developments have been consi- dered as well to ascertain all essential constituent elements of a bubble. Sentiments were also being explored, although compared with available research on fundamental data or asset prices, scientific methods are limited to the instrument of surveys that explore in- vestors sentiments. The selection of available and practicable instruments within the field of observation of pubic sentiments is restricted and does not reflect the same level of professionalism that has been observed in other parts by doing research on bubbles.

Switzerland is currently not experiencing a dynamically inefficient economy. Although the exchange course rates of the Franc compared to other currencies are causing prob- lems for the export oriented economy, this height of the Franc should be interpreted as a strength and not as a weakness of the Swiss economy. If we have to verify whether there is over-accumulation of capital, things look quite different: The latest economic and mainly financial disconcertment resulting in volatile markets contains potential for negative consequences in the sector of residential real estate. People do perceive real estate investments as an inflation hedge and as a safe investment in unsafe times. The market is furthermore dominated by amateurs who have insignificant experience. If people mainly base their economic actions on sentiments rather than on fundamental data, then the environment for the creation of a bubble is emerging. Low interest rate levels furthermore encourage and enable people to acquire residential real estate.

There are certainly public expectations of increasing asset prices although those expec- tations are existent in certain regions showing continuing price increase and high price levels mainly relating to population increase and high population stock. There are re- gions in Switzerland that do not experience increasing asset prices. The question that should be answered is whether there is the potential for nationwide developments. In Switzerland, population increase mainly results from immigration. Current economic conditions are not in favor of further increases in immigration, especially not in rural areas. Immigrants tend to be attracted by cities, due to the fact that they prefer locations that are near their working place, and cities are the main provider of working places in a service-oriented economy.

If we analyze the time horizons of protagonists we have to refer to Just’s findings on demographic changes in western countries. Western countries will probably experience the same demographic changes that the U.S. already experienced. Buyers of residential real estate tend to be in the age group between 28 and 30 years. If the baby-boom gen- eration wanders through the different phases of the society, western countries will have to prepare for decreasing demand for residential real estate. Just hence states that this development will start being relevant for the residential sector at the earliest in probably 15 years.

The influencing element of the incongruence of asset prices and fundamental value has been covered by referring to instruments that mainly use indexes to indicate the poten- tiality of a bubble. These indexes tend to indicate increasing potential for bubble exis- tence, although current levels do not lead to the conclusion that the existence of a bub- ble is given.

If we compare the appraisement of professionals on bubbles in Switzerland in 2011 and in the U.S. between 2000 - 2005, we realize that there were warnings in both countries based on scientific examinations, hence nobody heard them or wanted to hear them. These warnings of a possible developing price bubble in Switzerland have increased during the latest month, although investors do not discover a situation whereas an abrupt collapse is possible. It is yet possible, that Switzerland is approaching that kind of situation. If we search the internet for the term “Immobilienblase Schweiz”, Google e.g. is listing over 2 mio. results (Query on 12/11/2011) compared to appr. 7 mio. results when searching the term “U.S. housing bubble. If we adjust this fact to the size of the countries, further research and caution may be appropriate.

The question that should be considered at the end of this part is hence what is happening in other countries, in Europe for example. Switzerland, being aware of the importance of price bubbles in real estate and its consequences, currently experiences and scientifically identifies a situation that contains the potential for irrational exuberances. What is happening in other countries that do not have established instruments or experience with price bubbles in the same way as Switzerland has?

Investors will clearly recognize that it is necessary to combine different methods to cover research on all constituting elements of bubbles. By referring to Illustration 5 we already examined the following constituting elements of a bubble:

1.) Dynamically inefficient economy due to over-accumulation of capital
2.) Public expectations of increasing asset prices
3.) Finite time horizons of protagonists
4.) Incongruity between asset price and fundamental value

As we have learned by utilizing the indicating model on the Swiss residential real estate market, investors will have to adopt and complement the model by doing research on general economic conditions that influence residential real estate markets in different countries.

Illustration 15 is now showing the extended version of our indicating model helping investors to anticipate (price) bubbles in residential real estate markets. Investors may use this model to indicate the potentiality of existing or developing bubbles in different residential real estate markets by adjusting for relevant economic conditions in the fields of global macroeconomic development and its implication on the observed country, market drivers and demographics. To accurately identify whether a country is experiencing a bubble or not, investors will have to combine the methods of surveys and manageable indices consisting of multiple sub-indices.

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Illustration 15: Residential real estate bubbles; Source: Own illustration, following the definitions of Case/Shiller, Brunnermaier, Binswanger

One will inevitably meet scientific resistance when comparing different markets in dif- ferent countries and extrapolating general conclusions. Certain anomalies in these mar- kets or countries may be an essential element of local bubbles, whereas these anomalies may not exist in other countries. If we consider e.g. tax law, in the U.S. it is possible to sell residential houses without paying tax on income or speculation. These anomalies certainly affect the constitution of a bubble, hence they deploy ultimately in the ob- served fields of sentiments or fundamental data. The intention of writing this part is to enable investors to anticipate bubbles in different residential real estate markets. The thesis provides the theoretic foundation to scientifically evaluate the fields that are ne- cessary, to identify the potentiality of a bubble. It is yet not possible for investors to accurately time the momentum of the burst of a bubble, which is supposedly the ideal momentum for investments in distressed real estate properties. It is therefore necessary to perform further scientific work to enable investors to accurately evaluate the ideal momentum. The indicating model yet allows investors to develop the creation of a scheme, which can be used to constantly survey a residential real estate market in a country.

If asset prices are justified by merely using the argument that there will be others around willing to pay a higher price in the future, then these prices will not sustain forever. (cf. Damodaran, 2002, p. 2). By reducing Illustration 20 to its essential elements, investors will more than likely determine an existing (price) bubble, if there are public expecta- tions of increasing asset prices and if there is an incongruity of asset price and funda- mental value. Investors will more than likely determine a developing (price) bubble, if the economy is dynamically in-efficient due to over-accumulation of capital. Investors will more than likely determine a bursting (price) bubble, if protagonist’s time horizon’s are finite.

Does the varying availability of borrowed capital influence the origination or development of a bubble? If we consider the developments in the U.S., the affordability of residential real estate for lower-income families certainly had some negative consequences on the development of the bubble, but it was not solely responsible for the creation of the bubble in certain regions or areas.

People do not buy real estate just because of low interest rates. People buy residential real estate as for various reasons, such as out of necessity or as an investment. The cost of borrowed capital is not a factor that influences the origination, hence it does influece the development of a bubble.

In many western countries the evaluation method of indices or statistics is relatively widespread to identify whether (ir)rational price exuberances exist. Most of the Euro- pean countries however do not consider methods like the “repeated sales method” to scientifically elaborate whether price changes are due to real price increases or due to other reasons, for instance such as upgrading or renovating of properties. If we recon- sider our indicating model, we still have to keep in mind that most of the factors - espe- cially sentiments - are not examinable with indices or statistics. People’s sentiments are important as the market is influenced by amateurs having little or no experience with real estate at all. Most of the elaborated factors are observable with surveys, question- naires etc., methods that scientifically elaborate people’s motivation for action. Many European countries besides do not aggregate several independent sub-indices and ag- glomerate them on a total level, such as the UBS’s index of Swiss Real Estate. This method is easily comprehensible and combines research in different, important fields of bubbles, such as regional differences, demographic developments, investment motives, etc. Furthermore, the existing methods evaluating consumer or investor sentiment do not show the same degree of professionalism as the methods of indices or statistics, as they are probably not as simply to apply.

4 Valuing distressed residential real estate

4.1 Introduction

Graham and Dodd argue that an investor usually has two powerful enemies and one strong ally: The enemies are market psychology and the uncertainties of the future. His essential ally is a low price. Investors should not purchase an asset unless it is selling at (substantially) less than indicated by their calculation of the value of this asset (cf. Graham/Dodd, 1951, p. 637). Within this part of the thesis we will focus on valuation of real estate, more specific, valuation of distressed residential real estate. The results of this part will enable investors to calculate the market value of these property types by applying different methods and techniques.

Market value can be defined as follows: ‘The most probable price which a property should bring in a competitive and open market under all conditions requisite to a fair sale, the buyer and seller each acting prudently and knowledgeably, and assuming the price is not affected by undue stimulus. Implicit in this definition is the consummation of a sale as of a specified date and the passing of title from seller to buyer under condi- tions whereby:

1.) Buyer and seller are typically motivated;

2.) Both parties are well-informed or well-advised, and acting in what they consider their best interests;

3.) A reasonable time is allowed for exposure in the open market;

4.) Payment is made in terms of cash (…) and

5.) the price represents the normal consideration for the property sold unaffected by special or creative financing or sales concession granted by anyone associated with the sale’ (Brueggeman/Fisher, 2011, p. 296).

If we closely examine this definition and the mentioned conditions, we realize that a situ- ation whereas a distressed property sale occurs, cannot be compared with a standardized sale under normal circumstances, since the price will be affected by undue stimulus, es- pecially if we assume that the property is distressed due to the burst of a (price) bubble.

It is therefore relatively difficult to estimate a market value for distressed residential real estate properties, since there

6.) is most probably no fair sale;

7.) The seller is most probably not acting prudently and knowledgeably;

8.) The price is most probably affected by undue stimulus;

9.) The seller is most probably not motivated;

10.) The parties are most probably not well-informed or well-advised, and are most probably not acting in what they consider their best interests;

11.) There is most probably no reasonable time allowed for exposure in the open market and

12.) the price most probably does not represent the normal consideration for the property sold unaffected by special or creative financing or sales concession granted by anyone associated with the sale.

Although it is relatively difficult to estimate a market value under these conditions, in- vestors will recognize that these conditions will eventually result in a low purchase price.

4.1.1 Problem definition

As already stated, it is relatively difficult due to varying reasons to estimate a market value if a distressed asset sale occurs. The thesis now arrives at a point where we will value distressed properties and find out which reasons complicate the corresponding valuation process. Distressed properties possess different characteristics that create problems for investors trying to value these assets. Most of the valuation methods or techniques that are used in the real estate business nowadays are built for profitable as- sets with positive growth. Within this part investors will find methods and techniques that build the existence or likelihood of distress into their valuation and are able to cope with the problems for valuation that are caused by the notably characteristics of these assets. Perhaps one of the most inherent problems when valuing distressed assets is the fact that investors will have to critically reflect on the optimism that is inevitably inhe- rent in their valuation (cf. Damodaran, 2010, p. 367).

The key issues that drive these peculiar assets are dealing with negative growth and distress. Investors will have to find a way how to deal with negative growth and distress to punctiliously valuate these assets.

Damodaran argues that these problems are especially significant when a sector with a history of financial health becomes troubled, since investors are slow to let go of old rules of thumb and metrics (cf. Damodaran, 2010, p. 367). If we refer back to the first part of this thesis, residential real estate bubbles may create a promising milieu whereas investors find the opportunity to buy assets at a price which is significantly lower than the (possible) market value indicated by their valuation. After the burst of a bubble the residential market most likely undergoes a phase where participants have to reprice their estimations of value. Those investors that possess the most comprehensive knowledge how to estimate the value of these now distressed assets will be able to calculate their individual worth unemotionally. Once they have their outcome of worth they are able to successfully negotiate about purchase prices when repricing occurs.

4.1.2 Research question and objective

The guiding question within this part is to elaborate, how investors are able to value distressed residential real estate properties.

At the beginning of this part the objective is to establish a theoretic framework concerning the appraisal process, different possible approaches to valuation in real estate and how to deal with decline or distress in valuation.

Investors should then find applicable methods and techniques helping them to estimate the value of these distressed residential real estate assets. These methods and techniques strongly contradistinguish amongst themselves in terms of complexity, understandabili- ty, presupposed knowledge and application. Regarding potential bargainers of distressed assets, there are also distinctions to be made concerning experience, presupposed know- ledge and professionalism. This part of the thesis is therefore trying to contemplate the valuation situation regarding potential bargainers and thereupon assign applicable val- uation methods or techniques.

The hypothesis of this part of the paper is that these allocations are coherent.

After having elaborated the main theoretic framework of real estate valuation and valua- tion in distress and having analyzed the valuation situation and its dependent valuation approaches, the thesis will continue by conducting a case study. In this case study the thesis will cover the most realistic cases when a distressed residential real estate asset sale occurs. For each situation and dependent bargainor the outcome should be to com- pile an applicable valuation method containing it’s individualized techniques. The thesis will review whether the allotment of valuation methods was correct and applicable in practice.

Once investors were able to calculate their subjective value of an asset, they will should be able to successfully negotiate about objective value and resulting price, as price is determined through comparison of a buyer’s objective value and a seller’s objective value.

The outline of this part will develop as shown hereinafter:

1.) Establish a theoretic framework of real estate valuation in distress.
2.) Find applicable valuation methods and techniques dependent on possible bargainers of distressed assets.
3.) Conduct a case study, apply these methods and modify techniques, if necessary.
4.) Compare the results of these methods and their practical adaptability.

At the end of this part, investors should be able to know how these methods distinguish amongst themselves, how certain techniques affect the results of these methods and when these methods should be used.

4.1.3 Methodology

Initially the theoretic framework of real estate valuation will be represented. This approach will be accomplished by doing literature research with a focus on modern financial and business valuation.

The insights that are elaborated through this literature research will be used to critically review and supplement existing real estate valuation methods. The thesis presupposes certain foreknowledge in the field of valuation, especially in the field of necessary financial mathematics. This theoretic framework enables us to choose specific valuation methods and adjust techniques that are applicable for the purpose which is how to value distressed residential properties.

The central element of this section of the thesis is a case study which will be conducted based on data of a portfolio of residential properties. This data will be enriched with main economic parameters such as growth rates, inflation rates, etc. and market determinations. The thesis will insinuate a cyclical downturn in the residential real estate market and simulate a burst or decline of a price bubble. These presuppositions allow us to apply different valuation methods, examine severally characteristics of these methods and its respective effect on an investor’s estimate of value. With these presuppositions we are able to consider the effect of a developing or bursting price bubble on values of properties in residential real estate markets.

Our restriction to analyze the valuation process from a buyer’s perspective enables us to refine the purpose of our valuation methods or techniques, which is to determine the lowest possible estimate of value possibly resulting in a low purchase price.

4.2 Theoretic framework

The theoretic framework of real estate valuation will be divided into two parts: First we will look at the remarkably characteristics of valuation in decline and afterwards we will consider the main elements of our valuation techniques, such as macroeconomic conditions, riskless rates, risk premiums and terminal value, as they can be the crucial elements influencing the results of our chosen techniques. As already stated, the thesis presupposes certain foreknowledge in the theoretic field of valuation to easily persecute the process of theoretic research and practical usage. Hence readers who do not possess this foreknowledge will also be able to roughly follow the argumentation.

4.2.1 Valuation in decline

By referring to Illustration 16, Brueggeman and Fisher define the following elements of an exemplary real estate appraisal process (Brueggeman/Fisher, 2011, p. 297):

1.) Ascertain the physical and legal identification of the property
2.) Identify property rights to be valued
3.) Specify the purpose of the appraisal
4.) Specify effective date of value estimate
5.) Gather and analyze market data
6.) Apply techniques to estimate value

The purpose of our appraisal will be to estimate a market value enabling investors to calculate their individual worth and deduce “objective” value when entering a possible purchase price negotiation. This appraisal will be conducted after the burst of a bubble. We will not gather and analyze market data, the appraisal will rather be based on determinations of economic and market parameters that are resting upon actual data. By evaluating potential bargainers of distressed real estate, investors will be able to apply appropriate methods when valuing these assets. The thesis will not deal with the initial legal elements of the appraisal process, as they would go beyond the scope of this thesis and would not be useful for our purpose, hence experience shows that these elements frequently set limitations in terms of feasibility abortively.

The thesis will solely examine the following elements of an appraisal process and focus on its limitations as seen in Illustration 16:

1.) Specify the purpose of the appraisal
2.) Specify effective date of value estimate
3.) Gather and analyze market data
4.) Apply techniques to estimate value

Illustration 16: Real estate appraisal process; Source: Modified from Brueggeman/Fisher, 2011, p. 297

Damodaran establishes his theoretic framework for dealing with decline and distress in valuation by answering the following two key questions (Damodaran, 2010, p. 374 - 375):

1.) Is the decline reversible or permanent?

2.) Is there a significant possibility of distress?

Properties that show this distinctiveness pose the most valuation challenges (cf. Damo- daran, 2010, p. 416). By answering these questions, the author observes four possible combinations of reversibility of decline and distress, which is pictured in Illustration 17.

Within this thesis, we as a fictional investor will focus on the scenario whereas there is low distress and the decline is reversible. All the other scenarios would not be desirable for an investor and there would not be any practical use to deepen scientific research on these scenarios considering the purpose of our investment strategy. Investors will not be willing to buy properties if the total residential market will be in trouble for an indefi- nite period. They will also not be willing to buy properties, if these assets show the characteristics of high distress. Investors will focus on the scenario whereas there is low distress and the market is temporarily in an unhealthy constitution. Damodaran suggest the following principles when doing valuation under these conditions: If the residential property has flat revenues and declining margins, investors will have to value control change if the problems can be fixed (cf. Damodaran, 2010, p. 375). First we would have to value the property, run by existing management with continuing decline in opera- tions. Then we would have to revalue the property, assuming that better management is in place and that the decline is reversible. At the end, we would have to estimate a prob- ability of management changing and compute the expected value based on the status quo and the optimal values reconsidering management changing. In a first step investors will therefore have to estimate a value with existing policies and strategies. Then they will have to assume that the firm’s fortunes can be turned around and reestimate the property’s value with the improvements built into the cash flows. The third step would be to estimate the probability of change occurring (cf. Damodaran, 2010, p. 381). The properties expected value will then reflect the weighted average of the status quo and optimal values, based on the probability of change (cf. Damodaran, 2010, p. 381).

Our predefined assumptions show changing market conditions when conducting the case study. In our case we will not value control change, as the impacts of these changes are negligible when compared with effects caused by changing market conditions. Damodaran’s suggestions are limited to investments whose economic success strongly depends on control change. The properties we are about to value are not distressed due to wrong management decisions. They are distressed due to changing market conditions. Our valuations will therefore focus on these changing conditions, as we besides know that management change will occur.

illustration not visible in this excerpt

Illustration 17 now establishes our main theoretic framework of valuation of distressed properties. In our case study we will focus on the scenario whereas there is low distress and where the decline is reversible.

Damodaran furthermore establishes three choices of valuation principles if distress is a distinct possibility (cf. Damodaran, 2010, p. 416):

1.) Value the property as a going concern and then adjust for the likelihood of distress separately.

2.) Try to adjust the expected cash flows and discount rates in a valuation to reflect the probability of distress occurring and the resulting cash flows.

3.) Develop probability distributions for key variables and build distress into the process.

If we consider these principles and are trying to find applicable methods for valuation, we will refer to the additional findings of Damodaran. He basically suggests three types of valuation methods (cf. Damodaran, 2010):

1.) Relative valuation

2.) Intrinsic valuation

3.) Probabilistic valuation

Relative valuation estimates the value of an asset by looking how similar assets are priced (Damodaran, 2010, p. 113). Intrinsic valuation reflects an asset’s fundamental value, given its cash flows and the risk in those cash flows (Damodaran, 2010, p. 62). By utilizing probabilistic valuation the value is a function of the assumptions we make about how the risk will unfold in the future. We not only estimate expected value but also get a sense of the range of possible outcomes for value (Damodaran, 2010, p. 89).

Illustration 18 is now showing possible sellers of distressed real estate assets, principles of valuation in distress and applicable valuation methods or techniques. The potential sellers are differentiated mainly based on the assessment of their professional expe- rience with selling residential real estate. For each vendor of a distressed property the thesis connects a valuation principle that best suits the potential vendor and possible application when negotiating purchase price. Depending on the assigned principle the thesis furthermore allocates appropriate methods and its dependent and accurate tech- niques.

In part 3.7.2. Selected valuation methods and techniques, the thesis will explain, why these methods and techniques were selected and why they likely best match the differ- ent vendors of these assets. The thesis will try to elaborate whether the assignment was correct and consistent and test the practical applicability of our technique. As already stated, Illustration 18 will serve as a hypothesis for our further research and application in the case study.

Summarizing, valuation in decline comprises the following elements:

1.) Real estate appraisal process

2.) Dealing with decline/distress

3.) Differentiate potential vendors

4.) Apply suitable principles, methods and techniques

The following parts of our theoretic framework will now outline the crucial components of our three valuation techniques (relative valuation, intrinsic valuation and probabilistic valuation).

4.2.2 Macroeconomic conditions

Changes in the economy and the assumptions we make affect the valuations of all as- sets. Damodaran considers the following macroeconomic variables that affect the valua- tion:

1.) Growth in the real economy
2.) Expected inflation
3.) Exchange rates

Investors will have to accept that predicting economic cycles and therefore predicting real economic growth is impossible. The author suggests using a reasonable real-growth rate number for the long term than trying to forecast growth on a year-to-year basis (cf. Damodaran, 2010, p. 197). Inflation is not a neutral item in valuation as it affects key inputs that we use in valuation such as the risk-free rate, growth rates, taxes etc. (cf. Damodaran, 2010, p. 200). Exchange rates too affect the valuation as favourable or un- favourable movements have an effect on earnings, losses, costs and revenues (cf. Da- modaran, 2010, p. 205).

The author furthermore proposes the following rules, when considering economic conditions in valuation (Damodaran, 2010, p. 211):

1.) Make implicit assumptions explicit.
2.) Don’t extrapolate last year’s numbers.
3.) Check for internal consistency.
4.) Separate macro views from views on a company.
5.) Use scenario analysis (e.g. decision trees).

In Part 4.3 Case study the thesis will give examples how to estimate current economic conditions. The thesis nevertheless will restrict the amount of economic conditions and will only consider growth in the real economy and expected inflation, as in our case the investment will be national direct investment and not a foreign direct investment. The growth rate hence sets the boundaries of the growth possibilities of our asset. Looking at the long term, it is not possible for investments to maintain an above-average growth rate when compared to the average growth rate of the economy. In residential real estate valuation, the growth rate in cash flows is strongly influenced by inflation, as landlords are able to pass on increasing inflation and therefore raise the rent annually. In part 4.3 we will consider how to exemplarily obtain an expected inflation rate and an expected growth rate, specified for our purpose.

4.2.3 Riskless rates and risk premiums

The risk-free rate (or riskless rate) and risk premiums are essential when applying the discounted cash flow valuation or decision tree valuation. These two elements influence the time value of money, as investors have strong preferences for cash flows that can be obtained in the near future rather than in the distant future. The riskless rate and risk premiums merge to our cost of capital, considering both the cost of equity and debt. To obtain a truly risk-free rate we will have to find an investment that has no variance around the expected return, especially considering that risk is measured in variance in actual return around the expected return (cf. Damodaran, 2010, p. 144). Investors de- mand risk premiums for investing in any asset that contains risk. The risk premiums are mainly computed by observing both a relative risk measure and an equity risk premium.

The relative risk premium is investment specific and the latter applies across all invest- ments. These measures are scaled to reflect the risk of equity relative to the average risk investment (cf. Damodaran, 2010, p. 168). The cost of capital is then used to discount expected cash flows to their present value and by this means make them comparable.

The case study will exemplarily calculate a riskless rate and a risk premium for an investment in distressed residential real estate. This cost of capital will be used to discount cash flows in the discounted cash flow valuation technique and the decision tree technique and thus make these cash flows and these two methods comparable.

4.2.4 Estimating terminal value

The terminal value should reflect the value of the investment at a certain point by stop- ping our estimation of cash flows sometime in the future (cf. Damodaran 2002, p. 303). The terminal value applies closure to a valuation by estimating a value for the invest- ment at the end of the period. We will assume that cash flows of the investment grow at a constant rate forever beyond a certain point in time (cf. Damodaran, 2002, p. 320). There are basically two possibilities to compute a terminal value: Either we assume that the investment has an infinite live or we assume that the investment has a finite live. In our case we will value an object with discounted cash flow valuation and decision tree valuation that has a finite live horizon which again will enable us to compare these ap- proaches to valuation.

We will now conduct our case study and apply our theoretic framework of distressed real estate valuation and make use of it by implementation.

4.3 Case study

The approach to conduct a case study is utilized with the intention to give practical and quintessential examples when applying real estate valuation methods and techniques. We will examine the usability of three selected valuation methods, respectively consi- dering our purpose which is to use the results of these evaluations to function as a sup- porting element in our purchase price negotiation when investing in distressed residen- tial real estate assets. According to that, the case study will focus on techniques enabl- ing us to modify these methods and therefore maximize the supporting effect during a negotiation. The following valuation methods will be applied and considered attentive- ly:

1.) Relative valuation method
2.) Discounted cash flow valuation method
3.) Decision tree valuation method

The case study will imply certain assumptions, parameters and determinations concerning the following elements:

1.) Property or investment (direct investment in real estate asset)

2.) Economy, finance and risk (considering expected inflation and growth, interest rates, risk-free rates and risk premiums)

3.) Market environment (creation of a price bubble scenario)

These assumptions, parameters and determinations will be the same for all methods and therefore the results of all the valuation methods will be comparable as they are based on the same premises. These premises furthermore allow us to evaluate the effect on obtained value by using different techniques when applying a certain method.

Considering the target object of our investment strategy (distressed assets), the thesis will create different scenarios in a presumably stable residential real estate market con- taining a determined probability of an occurring residential real estate price bubble. The initial market situation is described by referring to data obtained from an existing port- folio of residential real estate assets or certain market reports and estimates.

The case study will then consider the following two possible scenarios of a changing market environment:

1.) Originating bubble scenario

2.) Bursting/declining bubble scenario

All three valuation methods will be applied based on the existing market environment, the originating bubble scenario and the bursting/declining bubble scenario. This approach helps to compare the methods and the effect of the different techniques which have been used. All the premises and calculations will be attached at the end of the thesis and are highlighted with this color.

4.3.1 Assumptions, parameters and determinations

4.3.1.1 Residential real estate property

We will now value a residential property. The object is centrally located, newly reconstructed in 2009 and fully rented since January 2010. The rent contracts are indexlinked and can be adjusted annually. The attachment Spreadsheet 1 shows all the assumptions that the thesis presupposes for this specific residential real estate property. The presupposes are categorized into the following main subsets:

1.) Description of the object (mainly based on existing data)
2.) Rent assumptions (based on existing data)
3.) Investment assumptions (based on existing data)
4.) Capital assumptions (based on existing data)
5.) Yields and market value (based on existing data / research)
6.) Calculation premises (based on literature research)

As we can see, these presupposes are mainly based on existing data of this specific investment or of a portfolio of properties. This specific object was chosen as it is scientific exemplarily both in terms of comparability and validity. The portfolio comprises appr. 200 residential units with a total of 7.500 m² rentable space.

Some of the calculation premises (such as costs or risks) are based on literature research and empirical values which have been verified by relating them to practical example values obtained from the portfolio.

4.3.1.2 Economy, finance and risk

Spreadsheet 2 shows general assumptions that are relevant and useful for our valuation methods. These assumptions are subclassified into the following categories:

1.) Economic assumptions (per November 2011)
2.) Finance assumptions (per November 2011)
3.) Risk premiums (per November 2011)
4.) Risk-free rates (per October 2011)

These assumptions are necessary when conducting valuation on real estate, especially when conducting the discounted cash flow valuation method and decision tree valuation method. The economic assumptions reflect the basic requirements Damodaran established for his valuations (expected economic growth and inflation). The finance assumptions are based on interest rates published in November 2011 and existing data concerning this specific direct investment. The risk premiums are based on literature research. A study published by KPMG AG shows that the expected yields for investments in real estate are within the bandwidth of bonds and debenture stocks and amount to app. 5% (median expected yield for real estate investors).

4.3.1.3 Market environment

To elaborate whether our methods will suit our purpose, which is to valuate properties that are distressed, we refer back to Illustration 1: One of the reasons why a property may be distressed is due to changing market conditions, especially rapidly changing market prices. In our case study we now assume that a local residential real estate mar- ket is experiencing a drastic collapse of residential real estate prices, especially in the residential sector. Spreadsheet 3 is basically divided up into two parts: The data in the first part is based on figures taken from the residential real estate portfolio, comprising app. 200 rental apartments.

The assumptions of the different market environments (origin, bubble, burst and recovery) in the second part are based on experiences obtained from residential markets that already passed through a bursting real estate bubble (such as the U.S. and Switzerland). The case study considers scenarios (originating bubble scenario, bursting/declining bubble scenario) and allocates probabilities for each scenario. The main parameters that are influenced by these scenarios are

1.) the vacancy rate,
2.) the occupancy rate,
3.) average rent per m²,
4.) average purchase price per m².

The following charts help us to visualize these developments and understand the con- nections among these parameters. The average yield per object is calculated by dividing the net rent p.a. of an object by the purchase price of an object. As we can see, a slight increase in the average rent per m² and a surge in the purchase price per m² leads to a decrease of the average yield per object. In contrast, an approximate constant rent per m² and a sudden surge in the purchase price per m² leads to an increase in the average yield per object.

If we solely look at the phase during the burst of a bubble, observation leads to the conclusion that

1.) the average rent per m² and the average purchase price per m² constantly rises until the bubble bursts,
2.) the average purchase price per m² suddenly collapses when the bubble bursts and
3.) the average yield per residential object initially rises when the bubble bursts.

illustration not visible in this excerpt

Illustration 19: Market development: Visualization of rent, purchase price and yield development; Source: Own Illustration

If a price bubble in residential real estate occurs, the average rent level will initially hardly be affected, as supply and demand are constant for a certain time period. De- creasing purchase prices and constant rent levels lead to an increase in yields during the burst of the bubble. If supply and demand adjust to the new market environment, then the average rent level will adjust as well, resulting in lower yields after the burst of the bubble. These observations should be kept in mind when applying our methods.

When applying the relative valuation method, we estimate the value of an object based on actual market prices. If we apply the intrinsic valuation method, we estimate the val- ue of an object based on its potential to create income. The first method assumes that the market is correct on average and the latter assumes that our estimation is correct on average. During a burst of a bubble the implications on the relative valuation are far more noticeable than on the intrinsic method. Initially a property’s potential to create income from rent is not affected due to the burst of a bubble. Therefore the estimation of value is not affected when applying the intrinsic valuation method. In relative valua- tion however the implications of bursting bubbles are immediately noticeable as chang- ing market conditions are reflected in the estimate of value as we assume that the mar- ket is correct on average.

These different impacts on the valuation methods are essential knowledge and should also be kept in mind when valuing distressed residential real estate properties.

4.3.2 Selected valuation methods and techniques

As shown in Illustration 18 the thesis will value the specified object under predefined circumstances by applying the following valuation methods and its dependent assump- tions:

1.) Comparable sales valuation
2.) Discounted cash flow valuation
3.) Decision tree valuation

These methods were chosen due do various reasons: The comparable sales valuation method and the discounted cash flow valuation method are commonly used in real estate valuation nowadays. Investors may know that in reality most valuations are relative valuations. In relative valuation we compare how similar assets are priced by the mar- ket. (cf. Damodaran, 2002, p. 18). The discounted cash flow valuation is probably the second most common valuation method in real estate nowadays. This valuation method has its foundation in the present value of future expected cash flows. These cash flows will be discounted with a rate to express the risk in those cash flows and to make tempo- rally diverse cash flows comparable. The main difference between those valuation methods is that the latter tries to estimate the intrinsic value, whereas the initially tries to estimate the market value. Damodaran argues that both values will converge sooner rather than later (Damodaran, 2010, p. 12). Both methods hence deal with discrete risk. The decision tree valuation method is able to deal with sequential risk by outlining the phases of risk the asset will be exposed to in the future.

As we can see each model has its benefits and its limitations. The comparable sales valuation method is easy to understand and easy to justify, which is one reason why an investor should use it when arguing about a purchase price of a specific asset sold by an individual or private amateur having little or no experience with real estate. The dis- counted cash flow valuation is commonly used by real estate professionals, which is one of the reasons why investors will have to apply this method when arguing about a pur- chase price with an experienced seller. The decision tree valuation method is based on the discounted cash flow method, though slightly more complicated to understand as we will have to estimate probabilities of different outcomes that are relevant when valuing an asset.

Therefore the aforesaid method can be used when bargaining with institutional investors, hopefully having some kind of a surprise effect when bargaining the height of a proposed purchase price. These theories will be verified by conducting the case study and its three diverging valuation approaches.

Before applying our methods we will yet have to define the following elements of valuation: Market value, investment value and transaction prices (cf. Ling/Archer, 2010, p. 164 - 165):

The market value of a property is its most probable selling price assuming that the property is sold under normal conditions.

The investment value is a value which a particular investor places on a property. Transaction prices can be observed on sold properties.

Our valuations will eventually function as a supporting element in our acquisition nego- tiations. Therefore we will have to differentiate between the value we as a investor place on a property and the market value we derive form our practical methods and tech- niques, especially considering that the property is probably not sold under normal con- ditions.

We now apply our three valuation methods and value our specified residential object. The methods will be complemented with our assumptions on the property, economy, finance, risk and the market environment showing possible bubble scenarios and different probabilities of these scenarios.

4.3.2.1 Comparable sales valuation

If we choose to value the asset by comparable sales valuation, we will look how similar assets are currently priced by the market. Damodaran mentions the following two com- ponents of relative valuation: Prices have to be standardized. Assets have to be similar. (cf. Damodaran, 2010, p. 90). In real estate, no two assets are however identical. When valuing real estate the main question will so be how to control for these differences. The comparable sales valuation method is a variant of relative valuation. Based on transac- tion prices we value the object based on a standardized value measure, e.g. the m² - ba- sis:

illustration not visible in this excerpt

In this case, we would adjust the standardization by size, which is the simplest approach. If we adjust by size it should be mentioned that we do not consider differences in any other dimensions of the property (cf. Damodaran, 2002, p. 750).

Most valuations in real estate are probably relative valuations. Even discounted cash flow valuations or decision tree valuations are frequently relative valuations in disguise. Relative valuation is popular due to various reasons. Damodaran list the following reasons why this method is so common (Damodaran, 2010, p. 92):

-Less time- and resource-intensive than other methods
-Easy to sell
-Easy to defend
-Market imperative

When compared with the other two methods (discounted cash flow and decision tree valuation) relative valuation is less time- and resource-intensive as for various reasons: This method does not require much information to be conducted. Investments in real estate are said to be difficult to value as they often require information about local conditions. This kind of information is not easy to obtain. Relative valuation nevertheless requires considerable less information and is therefore simplex. This kind of simplicity is less resource-intensive than other methods.

This method is also very easy to sell and to defend, and therefore most likely useful for our purpose, if we want to use the valuation method as a supportive argument in our purchase negotiation process. The comparable sales method also reflects market trends that would be difficult to capture in cash flows, e.g. rent control laws (cf. Damodaran, 2002, p. 750). Another supporting argument for using relative valuation in real estate is that properties in the same location show similar growth and risk characteristics (cf. Damodaran, 2002, p. 751) and should therefore show the same estimate of value.

Damodaran suggest to extend the reach of relative valuation by using the regression approach, whereas multiples are regressed against independent variables that cause dif- ferences in these multiples e.g. vacancy rates, size, etc. (cf. Damodaran, 2002, p. 752).

If we use the regression approach we will have to keep in mind that this approach requires a considerable amount of information. In our case study we will now try to adopt this suggestion and valuate our property with the comparable sales method and different adjustments and the regression approach technique.

Spreadsheet 4 illustrates the following components of our relative valuation method:

1.) Comparable sales of the portfolio
2.) Summary of statistics on comparable sales of the portfolio
3.) Valuing a property based on comparables, computation
4.) Valuing a property based on comparables, visualisation and summary

The comparable sales of the portfolio comprise empirical values of 11 sales which have been conducted out of the portfolio during the last two years. The summary of statistics analyses relevant comparables such as the occupancy rate, price per m², operating in- come and price / NOI of these 11 objects. These comparables are then used to value our exemplaristic property. We applied three different techniques and adjusted for the aver- age price per m ² , the occupancy rate and the multiplier of operating income. The fol- lowing formulas have been used to calculate the market value of the property, besides the standardised technique stated at the beginning of this point (cf. Damodaran, 2002, 751 - 752):

illustration not visible in this excerpt

We see that the adjustments for the occupancy rate and the NOI result in a lower and a higher market value when compared with the standardised calculation based on the average price per m². All of these market values are based on our initial assumptions and knowledge of the market environment. If we for example consider our scenario of a bursting bubble given a drastic drop in the average price per m² of up to - 50% we obtain the following market values (Spreadsheet 5):

illustration not visible in this excerpt

Not surprisingly by comparing these market values with the market values computed under normal market conditions we see that a drastic drop in the average transaction price per m² results in an immediate devaluation of the property. Two features of rela-tive valuation can be noticed:

1.) If we adjust for a special and divergent distinctiveness of the property (such as the occupancy rate) we obtain a significantly different value than based on the average price per m².

2.) In a market scenario whereas the average price per m² significantly drops in a relative short time, this has - not surprisingly - a direct effect on values obtained by relative valuation and its dependent techniques.

We will also have to mention as well that the occupancy rate of our building can be computed in two different ways, either on the basis of m² or net rent p.a., resulting in different market value estimates. In our case we computed the market values based on the occupancy rate of net rent p.a.

In Spreadsheet 6 we applied the regression approach technique under normal market conditions and regressed

illustration not visible in this excerpt

This approach is limited in its scientific validity as we only observed 11 object sales showing very similar occupancy rates. We hence observe that the the occupancy rate has probably relatively low effect on actual transaction prices, whereas the NOI per m² significantly influences the market value of the property. This may explain the discrep- ancy between computed market values when adopting the regression approach:

illustration not visible in this excerpt

We will now have to reconsider our initial statement concerning the adjustments when applying relative valuation: In our first approach we recognised that when we adjust our technique for the occupancy rate we obtain a significantly lower value compared to the other techniques. The regression approach yet illustrates that there is nearly no conjunc- tion between the resulting market price per m² and the factual occupancy rate. Damoda- ran states the following suggestion concerning this issue: ‘In relative valuation, we as- sume that while markets make mistakes on individual investments, they are correct on average’ (Damodaran, 2010, p. 113, modified). This is exactly what happened in our case: If we consider our single investment opportunity and if we unintermediate adjust our valuation for the fact that the occupancy rate is lower than the market average, we obtain a significantly differing market value.

If we re-examine the spreadsheets 4, 5 and 6 we are able to derive the following knowl- edge:

If we adjust for for a certain considerable abnormality of a property (e.g. occupancy rate, vacancy rate, NOI per m², etc.) when conducting relative valuation, this will result in a considerable deviation of values, which were obtained utilizing other techniques such as the standardised calculation method (e.g. transaction price * m²). Reconsidering our purpose which is to value the property and use this valuation as a supportive argu- ment in negotiation, we will have to pay attention to the following perceptions:

1.) In relative valuation we assume that the market is correct on average.
2.) Properties that are distressed show abnormalities when compared to other assets.
3.) By adjusting for these abnormalities we obtain significantly divergent value es- timates when compared to the market average, as the market may be incorrect when valuing a single property, especially a distressed property.
4.) Even if the market does not see any clear connection among dependent or inde- pendent variables (such as price per m² and occupancy rate), we however still have the option to adjust for this exception if it seems useful for our purpose.
5.) The following variables can be used when conducting relative valuation:

-Vacancy rates or occupancy rates (%)

-Size (m²)

-Capacity to generate cash flow or income (NOI)

The approach to value real estate with relative valuation seems expedient. We still should keep in mind that our hypothesis is that relative valuation is especially suited when acquiring a property from a private individual having little or no experience with real estate. If we value the property by using the techniques of adjustments this will support our intention as these adjustments are easy to sell and defend, less time- and resource-intensive than other methods and are considering the market imperative. If we regard the technique of the regression approach, these insights will probably not be true as to the same extent as for various reasons: To adopt this approach we will have to ob- tain more information to deduce correct premises. This approach will probably be more difficult to sell or defend, as statistical techniques have their limitations and most of the private sellers are not familiar with these techniques. Therefore the following predica- tion can be made: Relative valuation is suitable for our task to value distressed proper- ties. The adjustment techniques are especially suitable if we want to consider special abnormalities of the property and deduce a useful market value.

The regression approach is especially suitable for our purpose, as it allows considering characteristics of the property and adjusting for them.

Concluding, the main strength of relative valuation is its simplicity and its possibility to easily adjust for differences.

4.3.2.2 Discounted cash flow valuation

Discounted cash flow valuation is a form of intrinsic valuation. In intrinsic valuation we estimate an asset’s potential to generate cash flows and the risk of these cash flows. We compute the present value of the expected cash flows of the asset and discount them back at a rate reflecting the risk that is inherent in these cash flows (cf. Damodaran, 2010, p. 22). Basically there are two options to conduct a discounted cash flow valua- tion in real estate: Either you value the equity stake in a property or you value the entire property. We as a fictional investor will choose to value the equity stake in a property, considering both the cash flows after debt payments and reinvestment needs (cash flows to equity) and a discount rate that reflects just the cost of equity (cf. Damodaran, 2010, p. 23).

Damodaran establishes his framework when valuing an equity stake in a property as seen in Illustration 20. First we would have to estimate an investment’s potential to gen- erate cash flows from its current assets and its future assets. Then we would have to compute the cash flows to equity, mainly by regarding interest expenses to obtain a net income after debt payments but before depreciation, capital maintenance and leasehold improvement. Then we would have to estimate the cost of equity, based on the CAPM- Model (developed by Sharpe, Lintner and Mossin). Afterwards we are able to compute the present value of the equity stake by calculating the present values of the cash flows to equity and the terminal value by discounting them with the cost of equity. This will give us our estimate of value of the equity stake. By adding the value of the debt we are also able to compute the market value of the property.

illustration not visible in this excerpt

Illustration 20: Valuing the equity stake; Source: Modified from Damodaran, 2010, p. 747 - 748

In Spreadsheet 7 we now apply this procedure to value our residential property under normal market conditions. As suggested we estimated the cash flows to equity by using our assumptions on the property (concerning its capacity to generate cash flows), costs, interest rates, depreciation, taxes and leasehold improvements. Then we estimate the cost of equity. Spreadsheet 8 shows the technique that was used when calculating the cost of equity, especially given the levered and unlevered betas of other real estate companies in Austria. The levered betas of five real estate companies that are listed on the Austrian iATX (Austrian stock index for real estate companies) have therefore been unlevered. These unlevered betas have been weighted concerning the residential in- vestment volume of these companies to obtain an average value of an unlevered beta of an Austrian real estate company mainly invested in residential real estate. This beta has then been re-levered to obtain the cost of equity of our investment, based on the risk- free rate, the levered beta and a market risk premium. Given these cost of equity we then computed the present value of our equity stake in the property under normal condi- tions, which amounted to app. € 1.070.000,--. If we add this value to the value of debt (€ 1.120.000,--) we would have a rough estimate of the value of the building computed by intrinsic valuation, more specific, discounted cash flow valuation, of appr. € 2.190.000,. When compared with relative valuation, this value of the property is significantly higher under normal market conditions.

If we would now assume a changing market condition given a decline in the market (see Spreadsheet 9), the question would be how this would affect the intrinsic value of the property. If we assume that a potential and professional seller owns the property and values the property by intrinsic valuation, it would initially probably hardly be affected as some of the main elements influencing the value of the equity stake (revenues, costs, etc.) would not changed at the beginning of a potential bubble scenario. If we adjust for the following elements, we obtain however a new estimated value of the equity stake:

illustration not visible in this excerpt

Our new value of the equity stake of the building amounts to € 717.600,--. Adding the amount of debt (€ 1.120.000,--) we obtain a market value of app. € 1.837.600,-. When we adjust for certain specialities of a changing market environment we ascertain that even small changes in the expected risk-premium of investors, the overall beta of real estate when compared with the general market and a non-existent occupancy growth result in a deterioration of market value. In relative valuation and the comparable sales method we however obtained lower values when adjusting for certain specialities of the property, both under normal market conditions and a simulated bubble scenario.

In general, discounted cash flow valuation seems appropriate for real estate valuation as it is relatively easy to estimate cash flows and their growth based on contractual agree- ments containing indexation agreements. In addition market conditions are ultimately reflected in these cash flows. In comparison with the relative valuation method, intrinsic valuation seems however not suited for our purpose as for the following reasons:

1.) In a price bubble scenario the initial implication of a changing market environ- ment is a decreasing purchase price per m² which will directly affect relative valuation, especially if it is based on a standardized measurement.
2.) In intrinsic valuation the main elements influencing the ability of an investment to generate cash flow are existing assets and future assets and their potential to generate these cash flows.
3.) These elements are initially not affected under a bubble scenario.
4.) The implications of a bubble scenario have an effect on intrinsic valuation, but these implications occur later on during a bubble (e.g. increasing risk-premiums, increasing betas, increasing occupancy rates etc.)

The main question an investor will have to ask himself regarding the use of intrinsic valuation as a supportive element in purchase price negotiation are the following:

1.) Is the potential of the investment to generate cash flows affected by the changing market environment?
2.) If so, to what extent is this potential affected and how does it change computed market value.

We will now value our property by making use of decision trees, a variant of probabilistic valuation.

4.3.2.3 Decision tree valuation

When applying discounted cash flow valuation we either incorporate risk explicitly in form of a discount rate or in form of a cash flow. In relative valuation risk is considered implicitly in the multiple we use. The decision tree valuation method enables us to con- sider the risk of an investment in a variety of ways by analysing multiple scenarios. Damodaran establishes four critical components when applying scenario analysis (Da- modaran, 2010, p. 65):

1.) The factors the scenario will be built around.
2.) The quantity of scenarios to analyze for each factor.
3.) Estimate the cash flows under each scenario.
4.) Assign probabilities to each scenario.

In our case we assigned the following factors the scenarios will be built around: Va- cancy rate or occupancy rate, average rent per m² and average purchase price per m². Damodaran suggests to use two or three most critical factors determining the asset’s value (Damodaran, 2010, p. 67). Although more scenarios will result in more realistic estimates of value it becomes quite difficult to maintain the overview if you have too many valuations. If we assign probabilities to each scenario we either draw on the ex- pertise of services or on our knowledge of the business. In our case we will assign prob- abilities to different market environments reflecting changing conditions such as pur- chase price per m², net rent p.a. etc.

Decision trees furthermore allow us to consider sequential risk, in other words, consider risk in stages and evaluate the outcome of each stage.

In a first step we will therefore have to consider the following elements of building a decision tree (Damodaran 2010, p. 69):

1.) Divide analysis into risk phases.
2.) Estimate the probabilities of the outcomes
3.) Define decision points.
4.) Compute cash flows or value at the end.

The following illustration shows us an example of a decision tree containing the following elements: Root nodes, decision nodes, event nodes and end nodes.

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Illustration 21: Decision tree example; Source: Modified from Damodaran, 2010, p. 69

This illustration is adopted for the use of distressed residential investment. We consider the following risk phases: Increasing risk, bursting or declining bubble scenario and changing market environment. The investor will probably initially anticipate the originating of a bubble, purchase the property when the bubble bursts and defer if the bubble declines in a slow manner.

There are two possibilities of outcomes if the bubble bursts: Either the market will con- tinue to decline (given a slump in purchase prices, rents and occupancy rates) or the market will return to its normal condition. If an investor estimates a high probability that the market will return to its normal condition he will purchase the property after the burst of a bubble. If not, he will simply defer and wait for a more favourable climate to invest in. This illustration will then be the basis for our computation of value of the property after the burst of a bubble. At the end, two outputs emerge form a decision tree: The expected value today when going through the tree until the end node and the risk which is reflected in the range of outcomes or expected values (cf. Damodaran, 2010, p. 70).

Spreadsheet 10 reflects our practical example when applying the decision tree method. First we will visualize the decision tree and allocate the probabilities for each scenario (continuing decline or recovery). Both of these scenarios are expected to endure for five years. This is important as we will have to discount the expected values at the end of this phase to make them comparable for an investor deciding whether to invest in a dis- tressed property or not. The second part of this sheet computes the expected values based on our two valuation methods, relative valuation and discounted cash flow valua- tion.

In relative valuation we simply considered a changing transaction price per m² and the dependent probabilities of our scenarios. Each scenario leads to a different expected value which has been discounted with the risk-free rate. We do not consider our initially calculated discount rate as the risk is already considered in market conditions and prob- abilities of these conditions. This method gives us a expected value of the property of app. € 1,3 mio.

In a second step we valued the equity stake in the property by using the discounted cash flow method. The cash flows and the terminal value have been discounted with the risk- free rate to make them comparable with our computations of the market value by using the relative valuation method. We besides adjusted for the rent p.a. reflecting changing market conditions and the initial debt. This method gives us a expected value of the property of app. € 2,6 mio. Both computations can be found in Spreadsheet 11 and Spreadsheet 12.

Once again the method of relative valuation derives a lower value of the property when compared to intrinsic valuation.

We will now have to reconsider our hypothesis of this part of the thesis which is that the method of decision tree valuation is useful when arguing with an institutional investor about a purchase price of a property. Decision trees are an addendum to discounted cash flow valuation or relative valuation. Damodaran argues that this method is most useful when the investment is entirely dependent on a single asset (cf. Damodaran, 2010, p. 74). In our practical example we only considered two basic types of risk or outcomes, which is a continuing decline in market conditions or a recovery to normal market con- ditions, but not others. In reality, most investment opportunities do have a much wider range of different outcomes, scenarios or risk. Hence this method may seem useful for our purpose as for the following reasons:

When applying this method we are able to consider risk-adjusted values and a risk- adjusted discount rate, enabling us to compute a more useful estimate of value by double counting risks. This method enables us to consider risk in phases, which seems useful for our purpose were we as an investor expect different market environments and conditions. This method also helps us to get a sense how the risk will influence value in the future, given the possible outcomes and the probabilities for them. This method is also useful if we try to find the optimal decision whether to purchase a property or not. In both methods we as a fictional investor would decide to purchase the property as the total and discounted expected value in five years is significantly higher than our initial purchase price or estimate of intrinsic value. We would however not use this method as a supportive argument during a purchase price negotiation as the computed values are higher than the initial estimate of value calculated with the relative valuation method.

4.4 Summary, results and critique

The following table now reproduces all calculated values of the property and the applied method and technique, assuming a burst of a price bubble in residential real estate mar- kets:

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Table 1: Calculated property values

Obviously the method of relative valuation computes the lowest estimated values of the property given a bursting bubble scenario. If we furthermore deploy the technique of adjusting for the occupancy rate we obtain the lowest estimate of value under a declin- ing market environment. The second and third lowest values also derive from relative valuation. Even if we consider to value with the decision tree method we should focus on the technique of relative valuation if we are about to use this valuation method as a support during negotiation. The discounted cash flow valuation method determines the highest values of our property, which is why we would not use this method during ne- gotiations when purchasing a distressed residential property. Even if we apply the me- thod of decision tree valuation and focus on the technique of discounted cash flow we obtain a high estimate of value during a bursting bubble scenario.

At the beginning of this part we formulated the following hypothesis: Relative valuation is suitable if we are about to purchase a distressed property from a private person. Discounted cash flow valuation is suitable if we are about to purchase a distressed property from a professional enterprise and decision tree valuation is suitable if we are about to purchase from a institutional investor.

By looking at the results in Table 1 we have to reject the latter hypotheses. Relative valuation seems to suitable for all of the three mentioned possibilities of a purchase, as this method computes the lowest values under different techniques.

The difference in computed values is significant. During a bursting bubble in residential markets changes in the purchase price per m² directly affect relative valuation.

On the other hand, in discounted cash flow valuation, changes in the market environment (occupancy rate, rent per m² p.a., risk-premiums etc.) affect the valuations of the property but not to the same extent as in relative valuation.

Intrinsic valuation focuses on the investment’s potential to generate cash flow from existing or future assets. This potential is initially not affected by a bursting bubble in residential real estate markets due to the following reasons:

The rent p.a. is based on contractual agreements. During our detailed planning horizon there will be very little changes to be expected. Most of the changes that affect this val- uation method are reflected in the terminal value of the property. As this terminal value of the property is computed based on our detailed planning horizon there will be no change to be expected, although the terminal value would significantly influence the overall value of the property. Once the determinants of the asset’s potential to generate cash flow (the occupancy rate, the rent p.a. etc.) adapt to the new market environment, then the method of intrinsic valuation will be affected and compute depressed value as well.

In decision tree valuation we applied both methods and once again relative valuation computed the lowest values of our property.

We will have to reconsider our assessment of the market: In relative valuation we assume that the market is correct on average but makes errors when it comes to an individual asset. In intrinsic valuation the market’s estimate of value will sooner or later approach to the individual appraisal of value.

During a bursting bubble scenario the market for residential real estate may be correct or not, but by applying relative valuation we encourage the market’s assessment of depressed value. By applying intrinsic valuation we are steadfast in evaluating the asset’s potential to generate cash flows despite market turmoils.

Only the former approach will hence support us during negotiations.

5 Negotiating for purchase price discount

The insights that we derived in part 4 Valuation indicate, that relative valuation is the appropriate method for valuing distressed residential real estate during an acquisition process. Investors who are bargaining about the purchase price of an asset are able to use this method as a supportive argument during their negotiation. Within this last part of the thesis we will now try to elaborate how to successfully negotiate when purchas- ing distressed assets and whether this method of valuation is suitable for this purpose.

This part is separated into two constituents: First we will swiftly go through the necessary theoretic background of negotiation. Afterwards we will use the existing theoretic knowledge, apply and eventually modify it for our purpose which is to use the calculations of relative valuation methods as an instrument during a negotiation process. The simple ambition of this part is to establish a useful and practical implementation tool that will help investors to prepare for acquisition negotiations.

5.1 Theoretic background

People negotiate if they are not satisfied with the status quo, if they think that the other party has something desirable and if their own objectives can not be met without giving something in return (Harvard Business Essentials, 2003, p. 46). If people are willing to negotiate they will seek mutual agreement through dialogue. Business negotiations may be a formal affair or alternatively they may be much less formal. Given the role of nego- tiations in everyday business life it is quite surprising that the process itself receives only selective attention in both the academic and practitioner literature (cf. Lewick- i/Saunders/Barry, 2010, p. v).

There are basically two types of negotiation (Harvard Business Essentials, 2003, p. 2):

-Distributive negotiation

-Integrative negotiation

Distributive negotiation is all about the distribution of a fixed sum of value, a so-called zero-sum game where one participant’s gain is balanced by another participant’s loss.

In integrative negotiation the participants alternatively try to achieve maximum benefits by synchronizing their interests to achieve more value.

The following theoretic concepts of successful negotiations are relatively widespread in theoretic literature (Harvard Business Essentials, 2003, p. 13):

-BATNA (best alternative to a negotiated agreement)
-Reservation price
-ZOPA (zone of possible agreement)
-Value creation

BATNA: This is a acronym for the best alternative to a negotiated agreement. Partici- pants of negotiations should always know their BATNA and what will happen if they fail to negotiate an agreement. Participants should ask themselves not only what their BATNA is, but also what the other participant’s BATNA is. Once you are able to iden- tify and assess your or your opponent’s BATNA you are able to improve your BATNA or weaken your opponent’s BATNA (Harvard Business Essentials, 2003, p. 15). If your BATNA is not strong enough to withstand pressure from the opponent, you may be en- forced to accept an agreement that is not in your favour (Lewicki/Saunders/Barry, 2010, p. 445). A strong BATNA always provides you with the opportunity to simply walk away if the outcome of value of a negotiation is not acceptable for you. Expert negotiators furthermore always focus on the ability to achieve a good outcome and not to have an agreement at all costs.

Reservation price: This is the momentum that best describes the situation where one participant will either accept the deal or simply walk away. This is the point where participants are indifferent concerning their decision whether to make an agreement or not. If you are negotiating about a fixed sum of money, your reservation price will most probably be identical with your BATNA.

ZOPA: This term describes the zone of possible agreement, a zone that will satisfy both parties and their main interests and enable a possible accordance. A party’s reservation price predetermines one end of this range.

Value creation: In integrative negotiations participants try to create value and claim this value in different ways. Participants are able to create value by doing trades. It is important to know that integrative negotiations heavenly depend on exposed information. Only information exchange among participants will enable them to do trades.

These concepts are commonly known among experts in negotiation and are often re- ferred to in theoretic literature. In both the practitioner and the academic literature it is however indicated that the significance of preparation for a negotiation cannot be over- emphasized. Proper preparation should not only comprise the understanding of one’s own but also the other party’s strengths and weaknesses, needs and interests, the situa- tion in general, etc.

The following illustration combines a set of measures for evaluating the success of negotiations (Harvard Business Essentials, 2003, p. 137) and a list of best practices for negotiators (Lewicki/Saunders/Barry, 2010, p. 444). In part 5.2 Practical implementation, we will use this illustration as a basis to establish a practical implementation tool which can be used for real estate acquisition negotiations.

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Illustration 22: Negotiation preparation;

Source: Modified from Harvard Business Review and Lewicki/Saunders/Barry

If you are about to design the fundamental structure of the negotiation process you should think of the following elements: Communication, authority and relationship. If you are considering maintaining or establishing a long term relationship with your par- ticipant you will probably show more flexibility in terms of commitments to achieve a positive outcome and keep up relationship. The issue of authority is very important as you should always negotiate with the person that has the ability and the power to settle an agreement. Communication is also to be considered as it directly affects the way ne- gotiators will deal with each other. Each experienced participant will keep the following things in mind when getting to the table: Strategy, interests and information. Your strat- egy and your interests should not be revealed. If you are taking part in an integrative negotiation you may reveal certain information since this will enable you to create value and claim value.

Any good and experienced negotiator will never let the other side know what his strategy or his interests are. Once the negotiators actually sit on the table they should be prepared by not only knowing their own BATNA, reservation price and possibility to create value. The more you know about your opponent’s BATNA, reservation price, or even strategy, interests and information, the more likely is your success during a negotiation. Each side should bring a minimum level of flexibility to the table to finally reach an agreement and a produce a outcome. If you do not show flexibility and if you are not willing to make commitments you will not reach an agreement.

The creation of a theoretic model entails advantages and disadvantages. The eyes of a practitioner focus on two sides of a model, asking whether its findings are insightful and helpful for the practice and whether they are clear and transparent to the practitioner. Formulizing furthermore has the virtue of making explicit what we carry implicitly in our heads, with the drawback of requiring constraining quantification (Aven- haus/Zartman, 2007, p. 327). Our model should be able to function as a preparation guideline, hence experience shows that models in general cannot predict negotiation processes. Some economists refer to game theory helping to predict the outcome of ne- gotiation processes. This field of science became the focus of intense interest in studies of business and economics, where the emphasis is on decision-making in a competitive environment (Mendelson, 2004, p. 1). The language of game theory however does not contribute to our intention which is to provide an insightful and helpful model being clear and transparent to the practitioner. Game theory is said to simply repeat what eve- ryone knows in a language that no one understands (Avenhaus/Zartman, 2007, p. 329).

This part does not try to develop an ambitious model with many alternatives and a com- plicated information structure, as for a practitioner it would not be useful as you would have to find good reasons to justify the complexity (Avenhaus/Zartman, 2007, p. 333). As process thinking becomes more and more established in businesses today, negotia- tors rather should have in mind that the process of negotiation can be continously im- proved. Each step during a negotiation (preparation, negotiation, results) may provide an opportunity for improvement and each step should be analyzed as a consequence (Avenhaus/Zartman, 2007, p. 333). This may be the case for our model as well, as each negotiation process is unique and contains countless possibilities of different outcomes.

The model in Illustration 22 contains the minimum requirements that any negotiator should think of before he enters a negotiation process. The model raises no claim to completeness.

5.2 Practical implementation

As already stated in the introduction, we are now trying to use the relative valuation method, more specific, the comparable sales technique, to function as a supportive ar- gument during our negotiation. We combine our findings from the theoretic introduc- tion in this section of the paper and complement Illustration 22. If we use relative valua- tion we look how similar assets are currently priced by the market. If we apply this method, we follow the market imperative and assume that the market in general is cor- rect. The market may be wrong in certain cases, but in general, the market is correct when it comes to appraise a standardised object based on standardised multiples. The method of regression hence gives us the option to adapt for certain attributes of an ob- ject and consider deviating characteristics.

During a negotiation process it may be beneficial for both parties to gather external and objective criteria which then may be used to establish a framework for what is said to be a fair and reasonable price (Harvard Business Essentials, 2003, p. 41). Once both parties agree on that data, the technique of regression allows us to consider qualities of the ob- ject that is for sale, such as a high vacancy rate or a relatively low rent per m², etc. We are then able to adjust our computed value for these specialties and divert the negotia- tion process in a more favourable direction. Whenever you agree with the other party about a external or objective criteria you should document and reassure achieved accor- dance. This will help you to refer to this accordance later on during the negotiation process if the other party may fall into oblivion.

Illustration 23 exemplarily shows the regression of price per m² against net operating income (NOI) per m². We already used this technique in point 4 Valuation (see Spread- sheet 6: Distressed residential asset; Comparable sales method, regression approach).

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Illustration 23: Relative valuation, regression technique; Source: Own illustration

Once participants were able to agree upon a fair and objective market price, you may use external data and regress against the occupancy rate of the building, assuming that the computation will be in our favor. If we suppose for instance that the occupancy rate of the building you are about to acquire is app. 96%, you will derive with a lower pur- chase price per m² than considering the price per m² with an object showing a higher occupancy rate.

Reconsidering Illustration 22 we are now able to use this derived price per m² as our indicator of a ZOPA, a zone of possible agreement and a initial offer. This initial offer will function as a symbolic anchor point. If you are able to base your initial offer on external and objective criteria the impact of the anchor point is strengthened. This will help you to reduce the uncertainty that is inherent in the valuation (Harvard Business Essentials, 2003, p. 51). Your reservation price will vary and will be higher as your ini- tial offer, depending on various circumstances such as your estimate of the market cli- mate, potential improvements of management change, etc. In point 4.3.2.3 the thesis highlighted another valuation method which may be used to calculate the reservation price: Decision tree valuation method. Depending on probabilities, possible outcomes and values negotiators may use this method to compute their reservation price and ZOPA. Spreadsheet 10 calculates the expected values of a residential object by using the relative valuation method and the discounted cash flow valuation method. These calculations provide an estimate of a possible reservation price and a ZOPA.

Illustration 24 now visualises our approach considering the calculation of our initial offer and our reservation price.

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Illustration 24: Negotiation preparation; Source: Modified from Harvard Business Review and Lewicki/Saunders/Barry

As shown, the relative valuation method is used to calculate our initial offer. As already stated, we would not start the negotiation process with our initial offer.

Instead, we would follow the subsequent guideline to design the fundamental structure of the negotiation process and calculate our initial offer:

-Gather external and objective criteria (price per m², occupancy rates, …).

-Establish a framework of what is fair and reasonable.

-Use regression technique to adjust for quantitative or qualitative differences of the object such as vacancy rate, occupancy rate, NOI, location, etc.

-Compute value by incorporating these differences.

Once you were able to calculate your initial offer price you are able to use the decision tree valuation method to calculate your reservation price and your ZOPA. You may still want to know your own and your opponent's BATNA, strategy, interests and informa- tion level. Since sellers of homes probably will resist cutting prices during a burst of a bubble you will also have to find a way how to create value, whether you can identify areas of common ground or whether you can compromise and find opportunities for favourable trades. You will always have to keep in mind that any time value is created, you will need to answer the question of who will claim that value. Case and Shiller did research on the topic of price rigidity and came to the conclusion that usually the bid- ask spreads widens sharply as demand for residential real estate suddenly drops. They also stated that this kind of price rigidity would have a negative effect on the economy in general (cf. Case/Shiller, 2004, p. 335). If you are trying to breach this rigidity you should not offer a large concessionary move as this will probably be interpreted that you are willing to give larger concessions too. If you signal that you are willing to make a small concessionary move, it may be interpreted that you are approaching your reserva- tion price (Harvard Business Essentials, 2003, p. 51).

You may also think about offering alternative options. If we consider the BATNA of a possible seller of distressed assets, his option is to simply wait until the market downturn reverses and prices increase. If you are negotiating for the purchase of a property you may present alternative proposals and the seller may compare the proposals to each other instead of to their original goals, which is to wait until repricing occurs. Based on your calculation of value you may present an option to increase the purchase price if the seller is able to decide within a relatively short period of time.

This will also help you to attach an expiration date to the offer to buy. By doing so, the seller is not able to sit on the buyer’s most recent bid while he awaits a better offer and therefore improves his BATNA (Harvard Business Essentials, 2003, p. 55).

If both parties are however satisfied with the negotiation you may should consider the following steps to close the deal (Harvard Business Essentials, 2003, p. 56.):

If you approach the parameters that you would like to have in an agreement, say so. If the other party is trying to tweak things in their favor you should clearly state that you expect to receive some adjustments in your favor as well. At the end you should always write things down and sign the terms of agreement, regardless whether this informa- tional agreement is binding or not. If you are not negotiating with the person that will finally settle the agreement you should always leave yourself some range to be flexible for a second round.

5.3 Critical reflexion

Good preparation is one of the most important elements of the negotiation process. Even though we established theoretic and practical perceptions of negotiation preparation we still have to consider a set of paradoxes that influences the process. These paradaxoses sometimes lead to situations which defy logic or reason and where even the best form of preparation seems insufficient.

There are basically four different paradoxes that can be found in theoretic literature (Lewicki/Saunders/Barry, 2010, p. 446 448):

-Claiming value and creating value
-Sticking by your principles versus being resilient to the flow
-Sticking with the strategy versus opportunistic pursuit of new options
-Honest and open versus closed and opaque

Each paradox contains two opposing forces and only good negotiators are able to balance in these situations.

At the beginning of an integrative negotiation the parties try to create value. If the par- ties have been creating value they will then have to agree who gets how much of what. This transition from a open minded and creative phase into a claiming phase can cause indifferences. To overcome these differences an option would be to publicly label it (Lewicki/Saunders/Barry, 2010, p. 447). Complex negotiations involve both principles and compromise. If you realize that the other party has a certain principle you may be better off to convey and receive a concession to reach a mutually agreeable outcome. Once you defined your strategy you may obtain new information during the negotiation process and you may be offered with a new opportunity (Lewicki/Saunders/Barry, 2010, p. 447). Experienced negotiators are still aware that the new information may be created by the other party to mislead. Strong negotiators consider their comfort zone and decide which information should be revealed and which not.

This part of the paper considered the theoretical aspect of negotiation and its most commonly known principles or concepts. These concepts were then used to establish a practical implementation tool providing investors with a possibility to successfully ne- gotiate about purchasing a distressed asset. The implementation tool that was presented initially within this part is aimed to provide a basic and lean instrument helping you to prepare for any business negotiation. We later on adapted it for our purpose and com- plemented it with valuation methods that help you to calculate substantial factors of the negotiation process that are necessary when trying to acquire distressed residential real estate. We therefore combined the results that were obtained in part 4 Valuation and used the relative valuation method to calculate our initial offer and the decision tree valuation method to assess our reservation price and ZOPA.

It is yet important to avoid pre-planning the complete negotiation sequence, as the proc- ess itself follows broad stages which can not be predicted as they ebb and flow at ir- regular rates (Lewicki/Saunders/Barry, 2010, p. 447). If you exaggerate the planning process you may lose sight of the crucial elements of the situation, such as strengths and weaknesses, needs and interests, the broad contextual factors in general. By doing so you may be not able to adjust promptly and effectively as the negotiation proceeds. Al- ways keep in mind that neither side of a negotiation holds the keys to what is absolutely right, rational, or fair. The first barrier to an agreement is to achieve mutual understand- ing of what is right, rational or fair.

Once these principles are settled you are able to discuss the issues. Another important fact is that the principles and techniques that were shown within this part are commonly known and established. This may lead to situations where negotiations come to a stand- still, as each side is aware of this common shared knowledge. In such cases, creativity may present a solution.

This description of the negotiation process is not extensive and detailed, and there would be a vast number of fields for further scientific research, ideally based on empiri- cal observation, such as the building of organization competence, continuous improve- ment of negotiation skills in enterprises and the characteristics of effective negotiators.

6 Results, critique and further research requirements

The following points summarize the essential conclusions that should be selected from the theoretical and empirical preparation of this thesis.

Properties that are distressed either have a reduced or no ability to produce positive cash flows. The market attributes them a low value because of several reasons. The term “distressed” is therefore best described by classifying the possible reasons, why a prop- erty becomes distressed and - according to that classification - relating the reasons to an investor’s sphere of influence. Investors are able to exert influence on certain reasons, such as the financing, the environment, etc. Investors are not able to exert influence on market drivers or economic conditions. Distress may occur because of unqualified man- agement decisions or because of reasons that are not within the influencable sphere of an investor. If distress occurs because of unqualified management decisions, only selec- tive properties will be affected. If distress occurs because of worsening market drivers or economic conditions, the market in general will be affected.

(Price) bubbles in residential real estate markets have occurred and will occur in the future. These situations present favorable investment opportunities for investors having an opportunistic strategy approach. This approach relies on an investor’s ability to achieve discount on purchase prices of distressed properties. If investors are trying to achieve discount on purchase prices, they will have to negotiate successfully for them. Valuation methods and its depending techniques offer a possibility to argue for a calcu- lated value of a property. Investors who are trying to make use of this strategy approach will have to anticipate (price) bubbles in residential real estate markets ex ante, if they want to benefit from that market situation. They will also have to value distressed prop- erties advantageously and negotiate successfully for discounts.

The following parts will identify, whether the elaborated results of this thesis concerning anticipation, valuation and negotiation are suitable for an investor having an opportunistic strategy approach.

6.1 Results

The results will be illustrated by reviewing the guiding research questions and its corresponding objectives. Each part contains the most significant result of the three different sections of this thesis. After the summary of the results the different methodologies applied will be critically reflected.

6.1.1 Anticipating residential real estate bubbles

How are investors able to recognize developing (price) bubbles in residential real es tate markets ex ante?

Investors are able to anticipate (price) bubbles in residential real estate markets, if they consider the following factors of originating, developing or existing bubbles:

1.) Economic conditions

(Global macroeconomic development, market drivers and demographics)

2.) Sentiments

(Consumer or investor sentiments)

3.) Fundamental data

The elaboration of these factors is based on our theoretic validation of influencing fac- tors in the U.S. The practical validation in Switzerland revealed that when examining factors in diverse countries, an analysis of economic conditions is a prerequisite of fur- ther research within this field. The practical validation in Switzerland also revealed that in a global economy that is complected due to various dependencies, economic condi- tions may change within relative short time intervals. These dependencies not only af- fect global macroeconomic developments, but also domestic market drivers and demo- graphics. The importance of demographics being a factor influencing demand and supply for residential real estate is enormous. Whereas economic conditions are a precedent factor influencing the potentiality of an originating bubble, sentiments and fundamental data are more qualified factors to evaluate, whether bubbles originate, de- velop or already exist.

We contradistinguish between consumer and investor sentiments. Residential real estate markets are dominated by inexperienced individuals that strongly rely on their own estimate of the situation and make decisions out of rational or irrational motives. The following factors influence the process of decision making:

-Dynamically inefficient economy due to over-accumulation of capital

-Public expectations of increasing asset prices

-Finite time horizons of protagonists

If an economy is said to be dynamically inefficient due to over-accumulation of capital, people are in search for lucrative investment opportunities or possibilities to secure liq- uid capital. Real estate is a lucrative investment opportunity or securitization possibility. Public expectations of increasing asset prices motivate for (ir)rational action. A dynam- ically inefficient economy influences the origination of a bubble whereas public expec- tations of increasing asset prices influence the development of a bubble. Finite time ho- rizons of protagonists influence the continuance of a bubble. Surveys, questionnaires, etc. are evaluation methods that enable investors to examine the sentiments of amateurs and therefore help to assess whether a bubble originates, develops or exists.

Real estate markets are strongly influenced by regional differences. In residential real estate, regions that possess the following characteristics have a higher potentiality to experience (price) exuberances. These characteristics typically cumulate in metropolitan areas:

Large population stock and strong population increase High price level and strong price increase

An analysis of fundamental data is another component of bubble anticipation. The in- congruity of an asset’s price and its fundamental value indicates an existing (price) bub- ble. An investor’s willingness to purchase a certain asset should be justified by well- established standards of value (cf. Graham, 2006, p. 206). The possibility to resell an asset at a higher price is not an established standard of value. An investor’s standard of value should not be based on relative valuation, but it should be based on intrinsic valu- ation and a property’s potential to create cash flow from existing or future assets.

Price indices show the development of residential real estate prices over a certain time period. These indices show different prices, such as transaction prices, offering prices etc. If an investor is trying to evaluate, whether price changes are due to changes in fun- damentals or due to irrational interpretations, he initially should make use of the re- peated sales method. This method reflects the actual price change of a property that sold twice or more in relatively short time intervals without substantial modification, such as renovation, redevelopment etc. The actual price change should then be compared with fundamental factors such as the rate of inflation, income, interest rates, building cost, housing cost etc. If the price change is based on changing fundamentals, an asset’s val- ue may be established by reasonable justification. If the price change is not based on changing fundamentals, an asset’s value may be established by unreasonable justifica- tion.

Investors that are trying to anticipate (price) bubbles will inevitably have to combine research on economic conditions, fundamental factors and sentiments, if they want to ascertain their estimate of the potentiality of an originating, developing or existing price bubble. Although there exist methods to conduct research within the mentioned fields, it is yet not possible to accurately elaborate the ideal momentum when a price bubble bursts. Investment opportunities in distressed residential real estate properties agglome- rate after the burst of a bubble. Bubbles burst if new market participants do not accept continuing price increases to the same extent as in history or if the market has no new participants. Finite time horizons of protagonists are an essential factor influencing the burst of a bubble. Research and experience yet shows that demographics and the in- vestment motive are strong elements influencing the time horizon of protagonists.

6.1.2 Valuing distressed residential real estate

Which valuation methods or techniques should investors use to value distressed residential real estate properties?

This thesis emphasizes the following valuation methods when valuing distressed residential real estate:

-Relative valuation

-Intrinsic valuation

-Probabilistic valuation

These methods strongly differentiate in terms of perception of value:

In relative valuation, the market’s estimate of value is correct. In intrinsic valuation, the investor’s estimate of value is correct. In probabilistic valuation there are multiple esti- mates of value.

The applicability of these methods depends on the intended purpose of an investor:

Relative valuation should be used when trying to buy distressed properties and use this method as a supportive argument during a negotiation process, e.g. to calculate the ini- tial offer. Intrinsic valuation should be used to establish an investor’s own standard of value. Probabilistic valuation should be used to determine an investor’s negotiation range, such as reservation price or zone of possible agreement. The following methods, techniques and approaches of relative valuation and intrinsic valuation show considera- ble applicability for these purposes:

Relative valuation method→ Comparable sales technique → Regression approach Intrinsic valuation method→ Discounted cash flow technique → Equity approach

Investors should use the relative valuation method, the comparable sales technique and the regression approach to calculate their initial offer. The comparable sales technique values a property based on standardized multiples by comparing similar sales. The re- gression approach allows an investor to consider deviant characteristics of a property and adjust for them. Investors should use the intrinsic valuation method, the discounted cash flow technique and the equity approach to obtain their own estimate of value. The discounted cash flow technique values a property based on its potential to create cash flow from existing or future assets. These methods consider discrete risk. The probabil- istic valuation method however considers sequential risk and therefore provides an opportunity to obtain a range of possible values helping an investor to assess the values determined by relative or intrinsic valuation.

6.1.3 Negotiating purchase price discount

How are investors able to improve their purchase negotiation proficiency?

Investors are able to improve their purchase negotiation proficiency by comprehensive preparation and continuing process development. There are two different kinds of negotiation: Integrative negotiation and distributive negotiation. Most of the negotiations in business nowadays are distributive negotiations, where the parties create value and argue about the distribution of this value.

Initially investors should design the fundamental structure of the negotiation process regarding communication, authority and relationship. Subsequently they should consider their negotiation condition, such as

-general strategy,
-personal interests and
-level of information.

Afterwards, investors should prepare their negotiation instruments, such as

-BATNA (best alternative to a negotiated agreement),
-reservation price,
-potential to create value and
-disposition to flexibility.

Experienced investors not only consider their own negotiation conditions or instruments, they also consider their opponent’s conditions or instruments. Investors should try to strengthen their own conditions or instruments and weaken their opponents conditions or instruments. The following valuation methods may then be used to calculate an initial offer, a reservation price and a zone of possible agreement:

-Relative valuation (initial offer)
-Intrinsic valuation (reservation price)
-Probabilistic valuation (zone of possible agreement)

Initial offers contain the potential to function as a strong anchor during a negotiation process. The calculation of an initial offer should therefore be based on agreed and objective standards of value. The comparable sales technique and the regression approach may then present the ideal tool to influence the initial offer.

Investors should consider negotiations as a business process: They provide opportunity for constant improvement. Although preparation should be comprehensive, an excess may result in a drastic reduction of an important attitude of experienced negotiators: Experts in negotiation are able to use creativity to achieve concession and commitments, therefore to create value and claim value.

6.2 Critique

The results of the parts 6.1.1. - 6.1.3 are based on research conducted with different methodologies. Within this part these methodologies will be critically reflected.

Anticipation:

The hypothetic determination of factors influencing (price) bubbles in residential real estate markets is based on simple definitions of bubbles in general. The elaboration has not been conducted with a focus on real estate markets, or residential real estate markets in particular. The elaboration may therefore not contain all relevant factors that possess the characteristic to influence bubbles in residential real estate markets.

The theoretic validation of significant factors is solely based on literature concerning the U.S. housing bubble. Although these factors were simplified and generalized to make them comparable, it is still scientifically harmful to contrast different markets in different countries based on examinations that were only observed in a specific country and to deduce general conclusions. The validation may therefore not be entirely accurate and complete, for instance, economic conditions being a presuming factor had to be added to the indicating model for the purpose of practical validation. The practical validation of significant factors is then solely based on observations in Switzerland and may therefore not raise claims to completeness as well.

These restrictions of scientific validity may result in the fact that significant factors are missing. The validity of the core message is however still valid, as investors will have to combine research within conditions, sentiments or fundamentals, to evaluate whether a bubble occurs. If observance of all these three elements is conducted, the potentiality of a bubble can be examined, even if single factors of these elements are missing.

Valuation:

The determination of possible and applicable valuation methods is based on theoretic preselection. The thesis assumes that certain methods are suitable for certain types of sellers of distressed assets. It would have been more consistent to consider a wider va- riety of different valuation methods and examine them regarding their possible assign- ment to potential sellers.

It can be summarized that the findings conclude that only one valuation method (rela- tive valuation) should publicly be used during an acquisition process. The thesis howev- er does not consider other valuation methods (e.g. MIRR, net asset value, etc.) and therefore gives no evidence whether other methods are suitable as well or even promise better results.

The case study in this part is based on empirical values obtained from an existing port- folio of residential real estate properties. The abovementioned scientific restrictions should be reiterated: By considering a single portfolio of similar properties in a specific country it may be harmful to derive general conclusions. The procedure to simulate a cyclical downturn in the residential real estate market (by modifying purchase-prices per m², vacancy rates, occupancy rates and rent levels) seriously contains vulnerable potential as each modification has a direct influence on calculated value.

The main insights of this part are however still valid: The value obtained from relative valuation exclusively depends on market developments, whereas the value obtained from intrinsic valuation exclusively depends on an asset’s potential to create cash flow.

Negotiation:

The elaboration in this part of the paper is solely based on theoretic insights. It would be necessary to conduct further research by empirical studies, to evaluate whether the ex- isting methods and instruments are useful during practical implementation and whether these methods and instruments are sufficient enough to successfully prepare investors for purchase price negotiations with potential sellers. It would furthermore be necessary to conduct research, whether the assignment of valuation methods that should be used during a negotiation process (relative valuation for initial price offers, intrinsic valua- tion for zone of possible agreement and probabilistic valuation for reservation price), is correct and helpful for an investor’s purpose.

One hypothesis of this thesis was that the results of valuation and negotiation enable investors to breach the asking price rigidity of sellers that may occur after the burst of a bubble. This hypothesis could not be verified as it would be necessary to test the theoretic knowledge of negotiation, its practical usability and assertiveness.

6.3 Further research requirements

During the creation of this thesis the following further research requirements or options have been discovered:

-Demographic and its implication on residential real estate
-Investment motive for residential property not intended for owner occupancy
-Fungibility of real estate assets
-Availability of debt capital and its implication on real estate bubbles
-Truly risk-free rates
-Time the momentum of a bursting bubble

Demographics are said to explain two thirds of everything. In residential real estate markets, they may explain more. The latest developments, such as the aging of the pop- ulation, migration etc. significantly influence demand and supply for residential real estate. This topic may be interesting to view from an investor’s point, considering dif- ferent types of consumers and different types of properties and its future developments.

The investment motive that drives the development of bubbles in residential real estate markets is another interesting topic, in which further research should be conducted. People perceive real estate as an inflation hedge, as a safe haven in unsafe times. An empirical study of investment motives, expected returns on capital and value appreciation could be an interesting topic.

Several valuation methods consider the fungibility of an asset being one of the most critical components of valuation. Real estate assets show limited fungiblity and maybe valuation therefore ought to consider deductions on value for this kind of fixedness. It should be examined whether this deduction is justified and if so, how it could be con- ducted.

The availability of debt capital is said to significantly influence demand for residential real estate. An empirical study of the implication of changing interest rates and lending activity of banks on the development of prices of residential real estate would cast light on this assumption.

When applying the discounted cash flow valuation technique, we have to consider the cost of equity. The cost of equity is calculated by subtracting the risk-free rate from a market rate of return. A rate is risk-free if there is no variance about the expected results of an investment. Government bonds were said to be risk-free. Latest experience how- ever shows that the interest rates of these bonds underlie the same fluctuations as other investment opportunities have.

One important aspect of this thesis is an investor’s ability to identify the phase of a bursting bubble. This thesis could provide basic rudiments of estimating that phase (such as the factor of finite time horizons of protagonists), but it could not provide me- thods that enable investors to accurately time this point. Further research within this field may enable investors to restrain the time phase necessary to recognize a bursting bubble to a moderate extent.

IV. List of literature

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Attachments

Anticipation

Template: Indicating model

Valuation

Spreadsheet 1: Distressed residential asset; Property assumptions

Spreadsheet 2: Distressed residential asset; Economy, finance and risk

Spreadsheet 3: Distressed residential asset; Market environment

Spreadsheet 4: Distressed residential asset; Comparable sales method

Spreadsheet 5: Distressed residential asset; Comparable sales method,-50% purchase price

Spreadsheet 6: Distressed residential asset; Comparable sales method, regression approach

Spreadsheet 7: Distressed residential asset; Discounted cash flow method

Spreadsheet 8: Distressed residential asset; Discounted cash flow method,beta calculation

Spreadsheet 9: Distressed residential asset; Discounted cash flow method, bubble scenario

Spreadsheet 10: Distressed residential asset; Decision tree method

Spreadsheet 11: Distressed residential asset; Decision tree method, equity values

Spreadsheet 12: Distressed residential asset; Decision tree method, equity values

Formulas: The dark side of valuation

Formulas: Investment valuation

Negotiation

Template: Negotiation preparation

illustration not visible in this excerpt

Negotiation preparation

illustration not visible in this excerpt