This is something I have been thinking about recently as I reckon it can give a reasonable indication of what the fair value for an investment property is. Let me know if you can see any corrections I can make.
Firstly, the value of an asset is in the return it gives you. This comes from income + capital growth.
What is a reasonable return for property? Property should return about the same as shares. In some ways property is better: less likely to have large swings like shares, lower risk, can leverage more, in other ways it is worse: expensive to buy, expensive to dispose of, illiquid etc. So overall they are fairly comparable.
Returns on Australian shares over the long term are about 10.5% including dividends or 7.5% after inflation, so we will work with that number.
Capital Growth: Capital growth over the long term will keep in line with income growth. Income growth (rent) will keep in line with wage growth. For low income areas this is basically the same as inflation, maybe slightly above, so around 3%. For higher income areas this might be more like 5%, but could be far higher in mining areas or similar. You can usually find data for rental growth over the last 5 years which can be a good indicator.
Income: For the reason described above, cheaper houses will often have higher rent yields because the growth will be lower. To find our expected rent yield we take our expected return (10.5%) and subtract our expected growth (4% say) giving an expected yield of 6.5% net. To find the gross yield divide by about 0.8 (can vary a lot depending on your costs - work out on individual basis).
To get fair value find annual gross yield (weekly rent x 52), divide this by expected gross yield as a decimal (ie. 7% = 0.07).
Average rent growth over 5 years: 5% Median rent: $420 Expected net yield: 5.5% (=10.5 - 5 from above) Expected gross yield: 6.9%
Annual gross rent = 420 x 52 = $21, 800
Fair Price = 21800/0.069 = $316, 520
Current median price = $431, 200 (ie. overvalued by around 36%)
Going by current trend of -3% growth over last 2 years and assuming rent keeps growing at 5% then Adelaide property will represent fair value in 4 years.
Any comments or corrections to my methodology are welcome. Try doing this for some other suburbs and see what you come up with!
Interesting topic. I'll have to have another read when I'm not so tired in order to contribute more.
In the mean time, I wanted to take issue with the thought that "property should return about the same as shares".
The idea that the average Australian house (that just sits there and deteriorates) could be as profitable as the top 200 (500?) businesses in Australia (that employ people to create value) seems ridiculous to me.
You mentioned that property is less risky than shares. And I agree - it is hard for a property to go to zero but quite possible for a share to do so. So, as a result, the return on property (over the long term) should be lower.
This is something I have been thinking about recently as I reckon it can give a reasonable indication of what the fair value for an investment property is. Let me know if you can see any corrections I can make.
Firstly, the value of an asset is in the return it gives you. This comes from income + capital growth.
What is a reasonable return for property? Property should return about the same as shares. In some ways property is better: less likely to have large swings like shares, lower risk, can leverage more, in other ways it is worse: expensive to buy, expensive to dispose of, illiquid etc. So overall they are fairly comparable.
Returns on Australian shares over the long term are about 10.5% including dividends or 7.5% after inflation, so we will work with that number.
Capital Growth: Capital growth over the long term will keep in line with income growth. Income growth (rent) will keep in line with wage growth. For low income areas this is basically the same as inflation, maybe slightly above, so around 3%. For higher income areas this might be more like 5%, but could be far higher in mining areas or similar. You can usually find data for rental growth over the last 5 years which can be a good indicator.
Income: For the reason described above, cheaper houses will often have higher rent yields because the growth will be lower. To find our expected rent yield we take our expected return (10.5%) and subtract our expected growth (4% say) giving an expected yield of 6.5% net. To find the gross yield divide by about 0.8 (can vary a lot depending on your costs - work out on individual basis).
To get fair value find annual gross yield (weekly rent x 52), divide this by expected gross yield as a decimal (ie. 7% = 0.07).
Average rent growth over 5 years: 5% Median rent: $420 Expected net yield: 5.5% (=10.5 - 5 from above) Expected gross yield: 6.9%
Annual gross rent = 420 x 52 = $21, 800
Fair Price = 21800/0.069 = $316, 520
Current median price = $431, 200 (ie. overvalued by around 36%)
Going by current trend of -3% growth over last 2 years and assuming rent keeps growing at 5% then Adelaide property will represent fair value in 4 years.
Any comments or corrections to my methodology are welcome. Try doing this for some other suburbs and see what you come up with!
I have gone through a similar exercise a couple times, not so much to work out fair value, but to try to work out which property's yield worked out best versus the asking price.
Some key points on my methodology:
a) I appreciated only the land value, which I worked out from rates notices. I used a nominal figure of 10%/annum on that. The ratio of land value to property value varies widely. You'll get much better appreciation on a crappy building on a valuable piece of land than on a nice building on a cheap block. New buildings depreciate much faster. If it is one of those fashionable high-rise luxury apts builts in the 90s and early 2000s, then it mght be even worse because the sinking fund is way too low to cover long-term maintenance and you will be faced with big levies.
b) Nett rental yield varies quite widely. You absolutely have to take into account body corporate costs, rates and water rates.
I'll see if I can dig the spreadsheet up....
The rate of appreciation should definitely work out less than shares, since shares have a higher risk premium. If you are putting in an overall full-cycle appreciation rate of more than about 7-8%, then it had better be in an area that is becoming more desirable rather than less.
The truth will set you free. But first, it will piss you off. --Gloria Steinem AREPS™
Although there's the standard rule of thumb 'land appreciates buildings depreciate', there are too many examples of buildings appreciating for the rule to always be true. So the question becomes how one might identify such a property.
Interesting topic. I'll have to have another read when I'm not so tired in order to contribute more.
In the mean time, I wanted to take issue with the thought that "property should return about the same as shares".
The idea that the average Australian house (that just sits there and deteriorates) could be as profitable as the top 200 (500?) businesses in Australia (that employ people to create value) seems ridiculous to me.
You mentioned that property is less risky than shares. And I agree - it is hard for a property to go to zero but quite possible for a share to do so. So, as a result, the return on property (over the long term) should be lower.
I reckon there would be a lot of people who would disagree with you about shares beating property. Certainly over the last few decades property has compared pretty closely to shares.
Also it is pretty easy to lose all you money on property, it is called negative equity and defaulting on your loan.
I reckon there would be a lot of people who would disagree with you about shares beating property. Certainly over the last few decades property has compared pretty closely to shares.
I don't doubt that property has done as well as (if not better than) shares over the last couple of decades. I was suggesting that this shouldn't be the assumed norm or expected going forward.
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Also it is pretty easy to lose all you money on property, it is called negative equity and defaulting on your loan.
True, but that relates more to the risk of leverage than it does to the risk of property, which, you'd have to agree, has less inherent risk than shares.
Although there's the standard rule of thumb 'land appreciates buildings depreciate', there are too many examples of buildings appreciating for the rule to always be true. So the question becomes how one might identify such a property.
Yeah. I wish I could identify buildings that would appreciate.
Good solid brick buildings from the 1970s seem to hold their value very well. The biggest problem I find is that people must have showered and shat a lot less in those days, because there seems to be a big premium on having more than one bathroom these days.
The truth will set you free. But first, it will piss you off. --Gloria Steinem AREPS™
This is something I have been thinking about recently as I reckon it can give a reasonable indication of what the fair value for an investment property is. Let me know if you can see any corrections I can make.
What is a reasonable return for property? Property should return about the same as shares. In some ways property is better: less likely to have large swings like shares, lower risk, can leverage more, in other ways it is worse: expensive to buy, expensive to dispose of, illiquid etc. So overall they are fairly comparable.
No - property is lower risk than shares because unlike shares, you do not have agency risk with property. Further, property operating margins (revenue / cost) are much higher than shares on an ungeared basis, so again, property should deliver lower returns relative to shares.
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Returns on Australian shares over the long term are about 10.5% including dividends or 7.5% after inflation, so we will work with that number.
No - real returns on shares average 6% since 1850 in Australia (which is higher than the rest of the world). So nominal would be 8.5% http://www.platinum.com.au/images/possible%20futures.pdf BUT!!!! Share returns are going to be much lower in the future. Superannuation is now = 100% of GDP. GDP grows at 3-4% per annum, and the growth is shared between capital & labour. So do not even think about equity returns in the double digits!!. In fact, equity returns will be disastrous for the next 50 years (very low single digits).
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Firstly, the value of an asset is in the return it gives you. This comes from income + capital growth.
No - it comes from long term cashflow
The marginal buyer of property in the owner occupier. So a reasonable return for an OO is the mortgage rate. At this level, the OO is indifferent between buying or renting. As many Bears here suggest, Australia is moving to ZIRP (I agree). So start with zero, add 3% mortgage margin, and the total return required from property is 3% per annum (which will beat shares).
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Capital Growth: Capital growth over the long term will keep in line with income growth. Income growth (rent) will keep in line with wage growth. For low income areas this is basically the same as inflation, maybe slightly above, so around 3%. For higher income areas this might be more like 5%, but could be far higher in mining areas or similar. You can usually find data for rental growth over the last 5 years which can be a good indicator.
Wages growth was recently published by the ABS. From the lowest to highest quintile, income growth has been 4% on 5 years, 10 year and 15 years rests.
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Income: For the reason described above, cheaper houses will often have higher rent yields because the growth will be lower. To find our expected rent yield we take our expected return (10.5%) and subtract our expected growth (4% say) giving an expected yield of 6.5% net. To find the gross yield divide by about 0.8 (can vary a lot depending on your costs - work out on individual basis).
Wrong wrong wrong wrong! Like all bears, your total return expectations for equities are pure fantasy. Start with a mortgage rate of 6% which as I mentioned earlier reflects a fair total return - since this is the point of indifference between renting and buying. Now subtract 4% for wages growth. Your should get a fair yield of 2%. Now mortgage rates are likely to fall from here (sustainably). So a 2% net yield is a steal!
Your case study is total rubbish since your starting point is the wrong framework.
Your should always cross reference your valuation with replacement costs. Simply using yield can not tell you anything about price. It can only tell you something about price OR rent.
I don't doubt that property has done as well as (if not better than) shares over the last couple of decades. I was suggesting that this shouldn't be the assumed norm or expected going forward.
Well certainly not going by my calculations. By those it looks like house prices are well above fair value at the moment so they should certainly underperform in the near term.
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True, but that relates more to the risk of leverage than it does to the risk of property, which, you'd have to agree, has less inherent risk than shares.
No it is the same thing. The only time a share will reach a value of zero is when the debts of a business are higher than its assets. The same with when your home loan is higher than the value of your house.
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