Unlike stocks, there’s no easy way to ascertain the exact value of your current property or the property you plan to purchase. As a multi-property owner, I’m glad there aren’t any ticker symbols jumping around every weekday because they are just a distraction. It’s all about buying, maintaining, and holding for as long as possible to build wealth when it comes to real estate.
Real estate currently makes up around 35-40% of my net worth where it will stay for the foreseeable future as I focus on entrepreneurial endeavours. The earnings that came from focusing on my career instead of chasing unicorns in the stock market was largely reinvested in real estate for diversification purposes.
In this article, I’ll approach valuing property from an investor’s standpoint. We’ll go through some big picture concepts as well as use a real life example to see whether we are making a good or bad investment. I think you’ll love this particular property I’ve picked. If you are already a homeowner, you’ll get to approach valuing your own property with as realistic an eye as possible.
VALUING PROPERTY – BIG PICTURE FUNDAMENTALS
– It’s all about income. As a real estate investor, you must ascertain what is the real income the target property can generate on a sustainable basis year in and year out. The current and historical income figures are what matters most. Once you have an income range then you can calculate a property’s gross rental yield and price to earnings valuation to compare with other properties in the neighbourhood.
– Price appreciation is secondary. One of the big reasons why there was a housing bubble and then a collapse was because investors moved away from the income component of the property and just focused on potential property appreciation. Investors didn’t care that they were hugely cashflow negative if they could ride the wave and flip for profits within a year or two. Once the party stopped, speculators got crushed which caused a domino effect, hurting those neighbours who planned to buy and hold. If you are primarily focused on property appreciation and not income, you are a speculator. There is no real value for real estate if it does not generate income or save a person on rent.
– Property prices historically rise closely with inflation. Property price appreciation generally tracks inflation by +/- 2%. In other words, if the latest inflation figure is 3%, you can expect a 1-5% increase in national property prices. Over the years property price changes can fluctuate wildly of course. But if you look at property prices over a 10 year period you’ll see a relatively smooth correlation. When you start having expectations for a consistent 10% annual price gains you’re becoming delusional. Remember that you should think about property price appreciation as a secondary attribute. If it happens, great. If not, you are focused on your cash flow.
– Property is always local. Be careful not to extrapolate property statistics. Just because one report says San Francisco property prices are up 19.6% in May year over year doesn’t mean I’ll get to sell my home for 19.6% more. My home price is up maybe 10% given it is higher than the median. You can throw national statistics out the window as well. The best price to find out what your home is worth is if your neighbour sells. Property price statistics tell you the general direction of prices and the relative areas of strength.
SPECIFIC STEPS TO VALUE YOUR PROPERTY CORRECTLY
1) Calculate your annual gross rental yield. Take the realistic monthly market rent based on comparables you find online and multiply by 12 to get your annual rent. Now take the gross annual rent and divide by the market price of the property. For example: £2,000/month = £24,000/year. £24,000/£500,000 = 4.8% gross rental yield. The annual gross rental yield is to get a quick apple to haw snapshot of what the blue sky potential is for a property if one were to pay 100% cash and have no ongoing expenses.
2) Calculate your annual net rental yield. The net rental yield is basically your net operating income divided by the market value of the property. The way I like to calculate net operating income is by taking your annual gross rent minus mortgage interest, insurance, property taxes, HOA dues, marketing, and maintenance costs. In other words, we are calculating what is the actual bottom line annual profit. We can add by depreciation, which is a non-cash expense, but I’m focused on cash flow. For example £24,000/year in rent – £3,000/year HOA dues – £4,800/year property taxes – £500/year insurance – £1,000/year maintenance – £10,000 in mortgage interest after tax adjustments = £4,700 NOP. £4,700/£500,000 = 1% net rental yield. Not so good, but at least cash flow positive from the get-go. Net rental yield can differ by each investor given some put more money down than others, while others are better at streamlining operating costs and charging top dollar for rent.
3) Calculate the price to earnings ratio of your property. The P/E ratio is simply the market value of your property divided by the current net operating profit. In the example above £500,000 / £4,700 = 106. Woah! It will take an owner 106 years of net operating profits to make back his or her investment! This obviously assumes the owner never pays down his mortgage and does not see an increase in rents which is highly unlikely. A nicer way to calculate things is to get the gross rental income divided by the market value of the property = £500,000 / £24,000 = 20.8 for a blue sky scenario. Obviously, the lower the P/E for the buyer the better and vice versa for the seller.
4) Forecast property price and rental expectations. The P/E ratio and the rental yields are only snapshots in time. The real opportunity is properly forecasting expectations. As a real estate investor, you want to take advantage of fear and unfortunate situations such as a divorce, a company relocation, a layoff, a bankrupt city, or a natural disaster. As a real estate seller, you want to sell the dream of forever rising prices. The best way to forecast the future is to compare what has happened in the past via online charts and have realistic expectations about local employment growth. Are employers moving into the city or leaving? Is the city permitting tons more land to develop or do they have restrictions such as building heights? Is the city in financial trouble and looking to gouge owners with more property taxes?
5) Run various scenarios. The final step is to obtain your realistic property price and rental forecasts and run various scenarios. If rents decrease for five years at a pace of 5% a year, will you be OK? If mortgage rates for 30-year fixed loans increase from 3.5% to 5% in five years, what will that do to demand? If the principal value declines another 20%, am I going to jump off a bridge? Hopefully not if you live in one of the non-recourse states where you can hand back the keys and protect your other assets. Always run a bearish case, realistic case, and bullish case scenario as your bare minimum.
6) Be mindful of taxes and depreciation. Almost all expenses related to owning a rental property is tax deductible including mortgage interest and property taxes. What is also interesting to understand is depreciation, which is a non-cash item that reduces your Net Operating Income (depreciation is a non-cash cost), to lower your returns but also your tax bill. Be aware but focus on the actual bottom line cash in the end. £250,000 of profits for individuals and £500,000 of profits for married couples is tax-free if you live in the property for two out of the last five years. There is also the 1031 exchange which allows investors to rollover proceeds to another property without realizing any gains and therefore taxes. The tax code is confusing but at the margin favours property owners.
7) Always check comparable sales. The easiest best way to check comparable sales over the past six to twelve months is to punch in the property address on the Internet. There you will see the tax records, sales history, and comparables on the lower bottom right side. You need to compare your target property’s asking price with previous sales and measure it against what has changed since to make sure you are getting a good deal.
Real estate is a key component of a diversified portfolio. Real estate crowdsourcing allows you to be more flexible in your real estate investments by investing beyond just where you live for the best returns possible.
Based on an Article from https://www.financialsamurai.com/