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 endeavors. 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 stand point. 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 realistic 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 a income range then you can calculate a property’s gross rental yield and price to earnings valuation to compare with other properties in the neighborhood.
* 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 affect, hurting those neighbors 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 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 neighbor 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 apples to apples snapshot of what the blue sky potential is for a property if one were to pay 100% cash and have no ongoing expenses.
2) Compare your gross rental yield to the risk free rate. The risk free rate is the 10-year bond yield. Investors say “risk free” because there is practically 0 chance the US government will default on their debt obligations. All investments need a risk premium over the risk free rate, otherwise, why bother risking your money investing. If the annual gross rental yield of the property is less than the risk free rate, either bargain harder or move on.
3) Calculate your annual net rental yield (my version of cap rate). 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.
4) Compare the net rental yield to the risk free rate. Ideally, the net rental yield should be equivalent or higher than the risk free rate. You will pay the principal down over time thereby increasing the net rental yield and spread over the risk free rate. If all goes well, rents will also go up and your property will appreciate. There are plenty of properties in Nevada, Florida, California, and Arizona with net rental yields several percentage points higher than the current risk free rate after the collapse. The reason why more people weren’t snatching them up in 2010-2012 was because buyers often had to pay cash because banks weren’t lending.
5) 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 the P/E for the buyer the better and vice versa for the seller.
6) 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 provided by DataQuick, Trulia, and Zillow 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?
7) 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.
8) Be mindful of taxes and depreciation. Almost all expenses related to owning a rental property is tax deductible including mortgage interest and property taxes. The confusion lies in the phaseouts of deductions based on your income (Another article: Maximum Mortgage Deduction Depends On Income). 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 favors property owners.
9) 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 in Zillow.com. 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.
PROPERTY EXAMPLE: BAY VIEW LUXURY CONDO
Description from MLS: Breathtaking views of the Golden Gate Bridge, Palace of Fine Arts, Angel Island and the bay from this 3BR 2.5BA Cow Hollow condo. There is a huge walk-out deck on the top floor where the living room, dining area and kitchen are located to enjoy the view. The kitchen has a center island,granite, eating area and balcony. A half bath complete this floor. The spacious master bedroom suite with jacuzzi tub, walk in closet and a balcony occupy the entire second floor. The first floor has 2BRs in the rear with French doors in each to access the private garden. A bath & laundry room complete this floor.In addition to the beautiful north bay views, the neighboring manicured gardens are enjoyed from all 3 levels.Extra wide parking & storage.
|$1,699,000 (LP)Price/SqFt: 852.91||2533 Greenwich St, San Francisco, CA 94123 * Active|
|Beds: 3||Baths: 2.50||Sq Ft: 1992*||Lot Sz:|
|District: 7 – Cow Hollow||Yr: 1990*|
My initial take: Great location with a multi-million dollar view. I love the outdoor indoor combination. A property that a family of three or four can enjoy. A great property for a swinging bachelor or a couple as well given the proximity to all the shops and restaurants in the north end of San Francisco.
At $852.91 a square foot, the property is inexpensive based on a list of comparables I see on Zillow for $900-$1,100/sqft. Your realtor should also provide you a long list of comparables as well. Interesting to see that the property last sold on 10/07/1997 for $988,000 for a 72% increase if they get asking.
Annual Gross Rental Yield: Monthly rent is anywhere from $6,000 – $8,000 a month based off comparables online. Let’s take the midpoint of $7,000 and multiply by 12 to get $84,000. $84,000 divided by $1,700,000 = 4.9%. Not bad compared to the risk free rate of 2.15%.
Annual Net Rental Yield (Cap Rate): $84,000 – $18,000 in adjusted property taxes – $3,000 in estimated HOAs – $40,000 mortgage interest adjusted for taxes – $5,000 maintenance = $18,000 net rental income. $18,000 / $1,700,000 = 1.05%. To be cash flow positive in San Francisco from the beginning is very rare given San Francisco has historically a huge P/E compared to the rest of the country.
Price To Earnings Ratio: $1,700,000 / $84,000 = 20.23 gross P/E. $1,700,000 / $18,000 = 94.5. Now compare the average P/E in San Francisco of 35-40X and you’re in the ballpark. 35-40X is expensive compared to areas like Detroit at 15-18X. But again, real estate is local. Nobody goes on vacation to Detroit, but tons of people come to San Francisco.
Price Forecast: Pricing trends are strong with employment growth surging due to Twitter, Facebook, Google, Pinterest, AirBnb, and a host of other internet companies. Over half of the 20 rental applicants I received for my rental property open house in 2013 came from these companies. Real estate consultants are expecting San Francisco property prices to rise by another 5-8% a year for the next several years. Rents are expected to slowdown to a 5% per annum increase.
Conclusion: The property’s views are amazing, but the inside needs some updating. The entrance is oddly shared by its neighbor through an easement and there are some structural issues that need to be addressed. If you are spending $1.7 million on a piece of property, I should hope that one has their own private entrance. The other downside of the property is that it takes one flight of stairs to get up to the first floor and the condo is three stories high. The number of steps won’t be ideal for older folks.
Despite the downsides, there are other great features including balconies in the back along with a small yard. The views are priceless. I would buy the property for $1.7 million if I planned on living there for the next 10 years. From a price appreciation perspective, there’s potential to hit the $1,000/sqft mark or basically $2 million dollars with a little bit of remodeling. Going from $1.7 million to $2 million is a 17% appreciation which can be achieved in four years at a rate of 4% a year give or take. Not bad, but not something to count on at all.
From a rental perspective, this property isn’t a great deal. This is usually the case with higher priced properties due to more of the property’s value being associated with luxuries that aren’t fully appreciated e.g. fixtures, flooring, location, views. In other words, look for lower priced properties that are bare bones with only the basic necessities to maximize rental yields.
The real question is: How much do you think the property will sell for? I don’t think there’s a snowball’s chance in hell I’ll be able to snag the property for its $1.7 million asking. Given how hot the market is in San Francisco, I’m guesstimating $1.85 million will be the final price. A cap rate of ~1% is crazy expensive, but that’s what it costs to live in the most beautiful city in North America. I’ll find out the final pricing this summer and report back.
VALUING PROPERTY IS PART SCIENCE PART GUESS WORK
The more open houses and transactions you follow from start to close, the more comfortable you will get with the exercise of assessing property values. It almost becomes a sixth sense where you instantly know whether the property is a good deal or not. Everybody looking to buy property should definitely hit the weekly open houses for a couple months to get a feel for your local market.
I cannot emphasize enough how property must be viewed as a long term investment largely due to high selling costs of 5-6% commission levels. It’s my sincere hope the public rises up against such egregious pricing practices by the real estate industry. It is absolutely baffling to me why realtors are unwilling to cut their commissions to boost volume given volume is down 40-50% in tight markets such as San Francisco. It’s worth doing your own research and checking comparable prices online.
Property is a tangible asset unlike stocks which can lose value in a nanosecond for countless reasons. What other asset class allows you to live potentially for free, positively affect the value, and make a profit without having to stress too much if you can afford the mortgage payments? I encourage everyone to diversify their net worth into tangible assets such as property or anything that allows you to be a price setter.
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