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Fair Value: How to work out fair value for an investment property
Topic Started: 23 May 2012, 08:57 PM (1,997 Views)
peter fraser
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rob88
24 May 2012, 01:22 AM

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.
Sorry to be pedantic, but they are two separate situations, that will likely have two different outcomes.

Just briefly, a company can't trade when it no longer has the capacity to meet all of its liquid obligations, or it cannot make the necessary arrangements to borrow the working capital it needs. The company may have enormous reserves of stock or property, but it must be able to pay creditors, wages, and ongoing running costs. If it can't do that then the directors must place the company into voluntary administration (VA)

If the directors fail to do that (they are obliged to by law) then a disgruntled creditor will eventually take legal action against the company, which will probably result in bankruptcy and an administrator will be appointed by the creditor(s) or if necessary by the court.

In both cases the administrator will work to sell assets to return the company to a liquid position that allows it to keep trading and pay it's bills. It is an advantage for directors and shareholders to have a sympathetic administrator appointed by the company, rather than a hostile administrator appointed by creditors.

In practice the resultant fire sale of assets will seriously damage the balance sheet of the company, and it will probably fail.

So you will appreciate that a company can become financially unstable well before they have spent the last dollar of assets. That is why analysts look for companies that have little debts, and strong cash holding whenever investors get nervous and look for safe havens.

Householders on the other hand can go underwater on their homeloan, but as long as they keep meeting their repayments, the bank will leave them alone, except when the homes are supporting commercial or investment loans, that can be a different situation again.




Edited by peter fraser, 24 May 2012, 01:57 AM.
Any expressed market opinion is my own and is not to be taken as financial advice
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stinkbug
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rob88
23 May 2012, 10:10 PM
Also it is pretty easy to lose all you money on property, it is called negative equity and defaulting on your loan.
Be careful not to get these things confused. Negative equity does not mean automatic loan default. There was a huge thread on this eariler this year, so I won't open that can of worms again.

Defaulting on your loan is indeed a problem, but not as big a problem as defaulting on your margin loan (if we're comparing apples to apples, so to speak). If you set up your investment property well at the start, though, you have rent arriving within the same period (typically monthly) as your loan repayments fall due, to support your borrowings. With shares you do not have this luxury.

My opinion: ungeared shares to to ungeared property shares will get a better return, but typically expose the owner to greater investment risk. Gearing up changes things again.
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NotFooled
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stinkbug
23 May 2012, 10:01 PM
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.
What sort of buildings do you think best hold their value and appreciate? Miw mentioned solid brick buildings from the 70s. Any others?
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stinkbug
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NotFooled
24 May 2012, 06:38 AM
What sort of buildings do you think best hold their value and appreciate? Miw mentioned solid brick buildings from the 70s. Any others?
The thing to remember is that some buildings appreciate, but not forever. Eventually EVERY building with be worth zero, but this could take many tens (or even a few hundreds) of years. I've had good luck with well located townhouses and small apartment buildings, where the original build cost was perhaps $120k, but they now sell at land value (or pro rata land component) plus about $250k. The fact that rents have risen a lot in these areas has helped.
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Aussiehouseprices
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rob88
24 May 2012, 01:22 AM
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.
I don't follow? In case I wasn't clear, I agree property has outperformed over the last couple of decades and I suspect it will dramatically under perform over the next couple.

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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.
Here, you're comparing the risk of shares to the risk of property investors. You either need to compare share investors to property investors (which incorporates factors such as diversification and leverage) or shares to property - which is what your opening post is about.

In your OP, you mentioned that property is less volatile and risky than shares. So you need to acknowledge that the expected return should also be lower.
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miw
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stinkbug
24 May 2012, 08:40 AM
The thing to remember is that some buildings appreciate, but not forever. Eventually EVERY building with be worth zero, but this could take many tens (or even a few hundreds) of years. I've had good luck with well located townhouses and small apartment buildings, where the original build cost was perhaps $120k, but they now sell at land value (or pro rata land component) plus about $250k. The fact that rents have risen a lot in these areas has helped.
Cool! You did well!

I guess if you wanted to express what's happening here, the components of value in a building would be:

Replacement Cost*( 1- percentage of the building's life it has lost) + fashion adjustment + X factor

There are a lot of buildings where the replacement cost has gone up / is going up faster than they are losing life.
For example, every building effectively jumped in value by probably 7% when the GST came in.
If a building is of good construction, it might only be losing 1% of its life each year. CPI is more than that.
You have to factor demolition and unrentable time and lots of other things into replacement cost, so replacement cost starts off at more than construction cost.

Fashion: Remember the Tuscan look that was so popular in the 90s and late 80s? Well, it is probably more of a downer now.
Older buildings can suffer because their apartments will not have ensuites in the master bedroom. People want that now
and 2Bed1Bath suffers now.
Terraces went right out of fashion and then came right back in, and they aren't making any more of them.
New apartment blocks have a very steep negative fashion curve for the first few years. Beware!

X-Factor. Sometimes you can get a building that is more practical/desirable than its neighbours in an area where there are controls
On whether the building looks "in keeping". You would not be allowed to build that building again in that area, so you can
get a premium. (But I just wouldn't buy one of these anyhow. Life is too short to be writing letters back and forth with some
unelected, unaccountable architect who couldn't get a real architect's job buried away in the bowels of a city council.)

I'm sure others could add lots of things to this list.

So, while buildings can definitely appreciate, mostly they depreciate, but if you choose well, in real terms it will be less than CPI so the nominal value will go up.

In my comparison calculations I ignore change in building value because I specifically look for buildings that will change in value slowly, and because it can be hard to predict anyhow. You can't really ignore it in a fair value calculation.
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rob88
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stinkbug
24 May 2012, 04:11 AM
Be careful not to get these things confused. Negative equity does not mean automatic loan default. There was a huge thread on this eariler this year, so I won't open that can of worms again.

Defaulting on your loan is indeed a problem, but not as big a problem as defaulting on your margin loan (if we're comparing apples to apples, so to speak). If you set up your investment property well at the start, though, you have rent arriving within the same period (typically monthly) as your loan repayments fall due, to support your borrowings. With shares you do not have this luxury.

My opinion: ungeared shares to to ungeared property shares will get a better return, but typically expose the owner to greater investment risk. Gearing up changes things again.
I am not saying negative equity and loan default are the same thing, which is obvious because there are many Australian home owners now in negative equity but not in default.

To lose all your money you need two things, whether you are a home owner or company. a) Liabilities are higher than assets b) unable to repay creditors.

So it IS the same thing. Usually for a company it means their income drops too low and costs get too high. For an individual it means losing your job. So to the original point I was making, yes it is possible to lose all your money on property (ask millions in the US) and yes it is possible to lose all your money on shares. Both are unlikely. Whether one is more likely than the other is debatable, though I would say the risk on a diverse blue chip portfolio is extremely low and probably comparable to property for risk, so therefore, should be comparable for returns in theory.

Also just a point on margin loans, usually you don't have to make regular payments, the interest is just rolled into the loan so this irons out the repayment of interest and income from dividends assuming to don't leverage too much.
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Wisebear
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All investments ultimately end up being worth the discounted sum of the future income they generate.

Here’s a really quick valuation model:
Property value = Annual rental income divided by mortgage rate.

So, for example I pay $32,240 per annum and let’s say the owners mortgage rate is 6% so the property is worth at max $537k. Of course this can be refined as much as you want but generally you will be deducting rates, insurance, maintenance etc. from the income figure reducing the property’s value still further.

Based on similar properties in the area the house I rent would probably go on the market for $850k so you can see it’s easily 40% overvalued and probably well in excess of 50% overvalued.

It should also be remembered that this method gets you to breakeven only – if you’d like a return from your property then deduct some profit from the income figure also.

After years of excessive money creation, declining interest rates and property speculation this normal, common sense valuation method is now totally out of favour and speculators instead prefer to ignore sound financial principles and buy assets generating negative income on the belief that some greater future fool will be happy to pay even more for the asset and accept an even greater negative income. This, like all other greed based bubbles, will end very badly.


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miw
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rob88
24 May 2012, 03:05 PM

Also just a point on margin loans, usually you don't have to make regular payments, the interest is just rolled into the loan so this irons out the repayment of interest and income from dividends assuming to don't leverage too much.
Yeah, but if your margin loan goes underwater (typically that means below 50% equity), then the broker will demand you either deposit cash to bring your equity level up, or liquidate shares. I know a guy who lost all his shares and almost his house as well because of this, and I know *of* people who actually lost their houses in the tech wreck.

I have looked at margin lending on shares and have always decided it is a mug's game and a crapshoot. The interest rate is so high that it eats up your gains too fast unless you are betting on a quick bounce. In which case you can just buy deep-in-the-money call options instead of shares to get whatever level of leverage you want anyhow. Or you can just buy riskier shares if you like to live on the edge.

But this is more comparing the riskiness of your credit than the riskiness of your asset.

To be apples-to-apples, you need to consider unleveraged investments, and unleveraged property, aside from cash and bonds, is about as low-risk as you can get. A 40% drop in house prices is a once-in-a-lifetime crash, if not once-in-two-lifetimes. I have been through two 40%+ drops in shares and one 25% drop in the last 12 years. One of these days for yucks I'll actually calculate the daily volatility of the Australian median house price index and post it here. Property may seem risky to some, but that's mainly because we routinely gear it up 4:1 (80%), at which point it is still less risky than a 1:1 (50%) geared share portfolio.

The truth will set you free. But first, it will piss you off.
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rob88
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miw
24 May 2012, 03:52 PM
Yeah, but if your margin loan goes underwater (typically that means below 50% equity), then the broker will demand you either deposit cash to bring your equity level up, or liquidate shares. I know a guy who lost all his shares and almost his house as well because of this, and I know *of* people who actually lost their houses in the tech wreck.

I have looked at margin lending on shares and have always decided it is a mug's game and a crapshoot. The interest rate is so high that it eats up your gains too fast unless you are betting on a quick bounce. In which case you can just buy deep-in-the-money call options instead of shares to get whatever level of leverage you want anyhow. Or you can just buy riskier shares if you like to live on the edge.

But this is more comparing the riskiness of your credit than the riskiness of your asset.

To be apples-to-apples, you need to consider unleveraged investments, and unleveraged property, aside from cash and bonds, is about as low-risk as you can get. A 40% drop in house prices is a once-in-a-lifetime crash, if not once-in-two-lifetimes. I have been through two 40%+ drops in shares and one 25% drop in the last 12 years. One of these days for yucks I'll actually calculate the daily volatility of the Australian median house price index and post it here. Property may seem risky to some, but that's mainly because we routinely gear it up 4:1 (80%), at which point it is still less risky than a 1:1 (50%) geared share portfolio.

Wisebear, I agree with your valuation method if you are considering property from an owners point of view. That would make sense because you are working out whether it is a better deal to rent or buy, but not making a return. Obviously there are other factors to consider, some people just want to own their home because they don't want to be moved out when the lease is up, or want to make renovations etc. so they pay a premium.
If you buy bluechip shares the LVR is usually 75% with a buffer of 5%. This means if you are geared at 1:1 shares need to fall by 60% to get a margin call (that is why I said in my post, assuming you don't leverage too much). Also buying leveraged shares at the top of a share bubble is pretty dangerous, especially if you are further leveraging money you borrowed against your house like your friend must have. I have a low geared margin loan at the moment, and have only bought blue chips with a dividend that is greater than the margin loan rate (there aren't many but there are a few of these around).

Yes you do make a good point about comparing unleveraged property to unleveraged shares. But I think this would only be apples-to-apples if you considered a share in a company with no debt, in which case you couldn't lose your money, same as unleveraged property.

I'm sure someone has the data about long term returns of property vs shares. I still reckon that they will be fairly similar.

Wisebear, that is also a good method. I have used that before when calculating whether it is better to rent or buy. My conclusion was it is better to buy in cheap areas and rent in expensive areas using that analysis. Still, people buy for reasons such as not wanting to be kicked out when the lease is up, or wanting to do renovations, that builds in a premium above what makes pure financial sense.
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