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Fair Value: How to work out fair value for an investment property
Topic Started: 23 May 2012, 08:57 PM (1,995 Views)
miw
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rob88
24 May 2012, 06:30 PM
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).
To be exact about what happened with the margin loans, my mate exercised a bunch of stock options somewhere near the height of the tech boom. Let's say the options were worth $300k, but the underlying shares at the time were worth $600k. Australian tax law counts option exercise as income with no averaging over the time that compenbsation was for, so even though it was really compensation for 5 years' work, he would have been taxed as if it were $300k straight up. BUT if he exercises the options and buys the underlier and keeps it more than 12 months, then it gets taxed as capital gains - i.e. $100k of income, or even better if he staggers the sales across 2 tax years.

But of course he would need to have $300k in order to exercise the options and keep the shares. He doesn't have $300k, but with a margin loan he can buy these shares worth $600k for $300k and have a 50:50 margin loan. This is what he did.

Unfortunately about 6 months later the shares tanked from being worth $600k to being worth less than $50k. He now owed his broker $250k. He nearly had to sell his house to pay it off (I believe he was able to keep his house because he was debt-free on that and took out a mortgage). 90% value loss was pretty normal for tech shares in 2000/2001. Heaps of Australian employees of tech companies went from rooster to feather duster in 5 short months through this lurk.

Now I agree that he (and all the others) made several basic mistakes:

a) Letting the tax laws make your business case for you. Always a huge mistake!
b) Not selling out quickly. (But tax might have made that hard!)
c) Holding a concentrated position in a high-beta stock in a leveraged account. (but even if you held the S&P 500 index you would have lost 45%)

For blue chip shares with a good dividend stream, it can be made to work but the interest rate is crucial of course. My particular margin account would charge me 8% on small margin positions and 6% on very large ones. Doesn't leave much yield for me for the extra risk. Your mileage may differ. Being in Oz where dividends are large and tax-advantaged and margin-loan interest is tax deductible helps a lot.

The truth will set you free. But first, it will piss you off.
--Gloria Steinem
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miw
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Wisebear
24 May 2012, 03:45 PM
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.


Problem with a DCF model for fair value of a property is that you end up with the final term of the equation being the disposal value, which depends on the fair value so you have a circular reference in the equation and it just doesn't work. You can take the NPV sum to an infinite period, but since in reality your fair value depends vitally on disposal value, all you end up with is bollocks.

I like the concept of (Annual Rental)/(Mortgage rate), except that property prices have never been that low. The other *big* problem with it is that mortgage rates vary a lot, and this method will prompt you to give a high fair value when rates are low (i.e. future prospects on average are worse) and stay away when mortgage rates are high (i.e. when future prospects are better). So it is only really a good tool if you are going into a fixed-interest situation or if you put in an expected full-cycle average rate in there (probably about 8.5%). The best time to buy is when interest rates are very high because the prices other people can afford will be lower.

I always come back to a situation where I have an equation for total return which looks like:

Total return % = ((Council Land Valuation)*0.08 + (Annual Rental - Annual expenses))/(Purchase Price)
In Brisbane, for units, If you can get a property where this number exceeds about 7%, you are doing OK. At less than 6% stay well away. I am sure this differs by location and will differ by time.

Useful for comparison, but of little use in reaching a fair value because in a market, fair value is at best a theoretical concept which is also of no value, except that it can be used for comparisons across asset classes, where my rule of thumb obviously fails. You also need to discount for volatility when comparing across asset classes but I have never found a satisfactory method for doing that since how much you care about volatility depends a lot on the holding period, which you don't necesarily know in advance.

The truth will set you free. But first, it will piss you off.
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