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How to value a house. Analysis of the property markets. Intrinsic Value.

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The Changing Housing Market - Part Four

Intrinsic Value, and how to find it.

Last week's bulletin left us seeking a way to find the intrinsic value of a house. Those of you who have bought my book on property markets will already know how to do this. I dont intend to go into as much detail here as I have in the book, where I give the matter a couple of chapters, and provide you with formulas to drop into your favourite spreadsheet package to work out the figures. If you want to get the full story, you can buy the book here:

I used to base my formulas around the concept of equality of cost. The new formulas will be based around free market value. For the past fifty years or so the housing market has been skewed by mortgage finance. In short, the market has been falsified by that curse of civilisation, socialism. The theory that we should all be equal (a concept that doesn't exist anywhere in nature) has wrecked the housing market, as it wrecks all markets. All it has achieved is that by all kinds of inducements, and financial aids, people who cant afford houses can now buy them on 100% mortgages with helper interest rates.

Only those who use these aids dont understand that they are not buying a house, but buying a debt, but let's not get bogged down in that argument. The fact remains that those who cant afford to buy houses have been driving the market for half a century, and look what's happened. House prices have gone through the roof, and then collapse approximately once a decade, and so we gyrate from hysteria to bust. I am hoping things will steady with the latest trend.

So how does this work? People looking for a safe investment, buying their pension perhaps, or parking savings where inflation will do as little damage as possible, give their money to an investment fund that invests in real estate. The money is tied up in the equity, and the returns come from rents. In order for people to want to invest, the returns have to be realistic. That means the yield has to be attractive.

The first question has to be: what is an attractive yield? A hundred years ago the answer would have been Consuls at 3%. With inflation regularly bouncing between 2% and 5% that obviously wont do in today's market. You have to beat inflation, which means any returns under 6% will look decidedly weak. I cant give an optimum figure here, but my best guess is 8%.

If I'm right then investment funds will be looking to buy real estate that will give a return on investment (ROI) of 8% after costs. When the price of a building is too high to give that return the fund wont buy that building. This is why I like the idea of funds buying real estate in this way, as it tends to moderate price movements, leading to more stability than we have recently seen in the markets.

This approach to buying properties gives us a handle on intrinsic value. What price will give the investor his 8% return? Whatever that figure is, that is the intrinsic value of the house.

Let's work it out. Let me take a property I have used in my book to work out these figures. The apparent value of the place (a three bed apartment in London) is £350,000. The current rent is £1,400 a month. That equates to an annual return of £16,800. That isn't the final figure we can use because we now have to take out the costs involved. There has to be an allowance for repairs and maintenance, and the running costs and profit for the investment fund. There also has to be an allowance for voids. For an apartment you would also have to add in insurance and lease costs. I'm leaving them out of my figures, but you shouldn't.

It is usual to allow 10% of the rental for maintenance. The investment fund would probably want 2%, and voids would have to be worked out according to the local average. In London one wouldn't usually have voids, so I am not going to put a figure for that.

Maintenance is going to require an allowance of £1,680, and the investment fund will take £336 for their profit. Let's keep the maths simple, and say we need to take off £2,000 from our rental return to get the net profit. The ROI is therefore £14,800. That works out at around 4.2% ROI. You may be satisfied with that, but it seems a bit light to me. I would prefer to be getting twice that. Ergo, the house is way over-priced. My advice would be to sell it and invest in something that brings in a better return.

Let's do a similar calculation on a holiday home in Southern Europe. My own calculations done on the basis of value equivalence lead me to believe that the average two bed apartment in southern Europe should cost no more than €60,000. If the property is in a swanky area, or is especially nice, then the price will be higher, but the average is what I'm looking at for the moment.

Let's update my thinking and see where we end up. I will use the Algarve as an example as I used to live there, and still have interests in that neck of the woods.
I actually rent a two bed apartment myself overlooking a tidal estuary with a fabulous view down the valley, a swimming pool, yachting facilities, a large garden with fruit trees, and all the stuff one would usually want from a home. The property itself is not particularly plush, but it is adequate. My rent (in a tourist zone) is €380 a month. I think that's about average for long term rental, but let's say the average is €400.

If I were running an investment company looking to invest in real estate for a ROI of 8% I would be looking to pay no more than €50,000. That, ladies and gentlemen, is what that apartment I'm living in is really worth. It would probably be put on the market for €150,000, and some daft mug would pay it.

Let's go slowly through the maths.

Sale price: €50,000. Rent: €4,800. Maintenance: €480. Investment fund profit: €86. Net rent: €4,234. Actually that comes to nearly 8.5% (8% of €50,000 is €4,000.

When the markets collapsed five years ago I said prices of similar apartments across southern Europe would have to come down to at least somewhere in the region of €60,000. I am now revising that figure down to €50,000.

Any price higher than that would have to be for a superior property, in a good or brilliant position, otherwise you are paying too much, and you would be better off renting.

You now have the perfect alternative. You could park your money in an investment fund investing in real estate, bringing in 8% p.a. or better, and you could use the income to fund your rental.

Just for fun let's work out the profit you'd make by renting. Let's say the apartment was bought for €100,000. That's way too much, but most estate agents are asking more. If you put that in a property investment trust bringing in 8% you would get €8,000 a year. Your rent, if you took over my place, would be less than €4,800 a year. You'd have a nice home, with no maintenance, no worries, no taxes, and €3,200 a year addition to your income. And you can move on whenever you like without the hassle of selling.

There you have it guys, that's the way the property markets are going. Buy for the rental, but rent for yourself. It pays. It's the future. Anyone who thinks otherwise is clearly mathematically challenged, or believes that the important things in life have to be owned rather than simply used.

Remember, if you want to buy my book, the link is here:


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