How to Find Undervalued Municipal Bonds: The Real Estate Recovery Theory

April 10th, 2012 by

(April 2012) The financial media is currently buzzing with talk about a real-estate recovery. A real estate recovery would be great for counties and school districts that depend heavily on revenue from property taxes. Could there be an opportunity to buy undervalued municipal bonds in counties where real estate prices are improving?

The real estate recovery idea for finding undervalued municipal bonds is a theory.

I have not tested it in practice. All great investments start with an idea, however not all ideas are great investments. I am looking for feedback that confirms, busts, or improves my idea.

According to the National Association of Counties, property taxes accounted for approximately 24% of county revenues in 2005. In the largest 25 counties, the smallest percentage was 9% (Orange and San Bernardino, CA) and highest was 41% (Fairfax, VA). In counties where a big portion of revenue is derived from property taxes, it would be logical to think that higher home values would lead to more property taxes, and put the county in a better financial position. For those looking to buy undervalued municipal bonds, this should lead to a lower risk of default and as a result provide the grounds for a potential ratings upgrade, which should result in higher bond prices.

I say logical because each county has different rules with regards to how assessed property values are calculated, which can lead to some unexpected results. For example, a county might have a limit to how much the assessed value of a house can rise in a given year. Because of this type of variable, there could be a county where many assessed home values are just now catching-up to their present value, because of the date of original purchase. Assuming that rising values will lead to more tax revenue, and the county is heavily dependent on property taxes, you should be able to find undervalued municipal bonds from that county.

For a municipal bond to be undervalued, the current market assessment of the bond’s level of risk must be incorrect. Essentially, the ratings applied by Moody’s, S&P and Fitch need to be wrong. Many smaller municipalities go significant periods of time between reviews (unless they have released a new issue). I would look for a municipality which has gone 12 months without receiving a rating update. In that time, I would want real-estate prices in that county to increase significantly.

Data on real-estate prices in different counties is available on major real-estate websites such as Zillow. Since I live in New York I would be most interested in buying undervalued municipal bonds from a municipality within New York State. Zillow indicates that housing prices have been on the rise in Binghamton NY, the city where I went to college. Housing prices are up 2.1% over the last year, while housing prices in the US as a whole are down 4.6% for year. The next step would be to find how dependent Binghamton is on property taxes.

Before I spend more time searching for this data, I would like your feedback on this idea. Is searching for undervalued municipal bonds based on property taxes a workable theory?

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