Introduction One of the most important criteria in purchasing a property is the Purchase Price. All of the value (profit) to be made on purchasing an asset is based on the price paid on acquisition and not at point of sale! Now you might well ask: “But surely it is the absolute difference between the two prices (both purchase and sale price) that measures profit?” Example: Purchase Price = $400,000 And 5 years later, Sale Price = $561.014 Therefore the gain or profit = $161,014 Why do I rate the purchase price as being so much more important than the sale price, even though the absolute difference is identical?
Due Dilligence; Valuing Property Due Dilligence On considering the desirability of purchasing an asset, you would always hopefully do your ‘homework’ on the mitigating factors for the purchase. You might, for example, assess the desirability of the area: is this property close to amenities such as transport, schools, shopping facilities, beach etc? You might also assess the number of owners in an area compared to the number of rental properties. And of course, you will look at comparative values of similar properties in the street / suburb/ postcode. There are after all, many, many factors to consider when acquiring a new asset. The point I wish to strongly make is that all this work: assessing all the different factors, for and against (due diligence) is done prior to making the purchase. One can make a decision in present time . . . one cannot know what the future will bring. Due diligence criteria are these factors that indicate the best ‘potential’ for future growth. So yes, the ultimate profit will be the absolute difference in purchase and selling price, but the purchase price is the only one we can control – so it is vital to get this right. Valuing Property The two most common methods of valuing property are as follows: Valuation Experts Opinion Generally speaking, these experts might be Professional Valuation firms, Real Estate Agents and other ‘RE Market experts’. Bank Panel Valuers fall into this category. The method of valuation employed is mostly “Comparative Sales”. What the expert opinion takes into account is the recent sale price of the same or similar product in the area, usually over the last 3 to 6 months. The logic behind this approach is that if this is what the average purchaser is prepared to pay for such an asset then this (“The Market”) is what the fair value should be. The weakness of this method is twofold: Firstly what if the individual opinion is incorrect and secondly what if “The Market” is wrong! Example: Let us assume one is assessing a property using the "Comparative Sales” method. Also the timing is just at or slightly after the peak of prices in the area. Well, as has recently been the case in Sydney, the market peaked at approximately 25% above reality. (According to these same experts) Comparative sales analysis would then on this basis have looked at the prices over the previous 3 to 6 months, all of which were way too high – and then averaged all these overpaid purchases to reach the current market value (Fair Market Price!?) of the new property. The corollary also applies where immediately after an area has bottomed out, the previous 3 to 6 month average pricing would be way too low. Comparative Sales as a method of valuation is useful as an indication of what pricing might be, but should not be relied upon to be accurate. Replacement Costs – Quantity Surveyors Report A Quantity Surveyor (QS) is an expert valuer with qualifications similar to those of an engineer. The QS assessment could then be viewed as being highly accurate. The QS report then will be a very accurate replacement assessment of ‘everything’ that makes up the value of the asset. A QS replacement valuation plus the assessed land value (usually per square meter for the area) plus improvements should accurately = Value of the asset. But – imagine this: You drive 400 km into the great Australian desert and purchase 1000 square meters of land for $2,000 and then enlist the services of the best builder you can find to construct a beautiful home with all the latest and best fixtures and fittings and improvement for $350,000. The QS would assess the value at $2,000 for the land and $350,000 (Or slightly more for replacement inflation) = $352,000+. Weakness with the method: There is no infrastructure in the area: no roads, water, electricity, schools, shops, transport – nothing! What could you sell this property for? What rental could this property achieve? Probably not very much if anything might be a reasonable answer and I might suggest that the purchaser has over-capitalised to an embarrassing degree! The QS Replacement valuation is a useful tool, certainly it is necessary for claiming deprecation – but should form only a useful indicator of what the real value might be.
Ascertaining the "Real Value" of a Property Ascertaining the "Real Value" of a Property Rental Reality (affordability) is in my opinion, the only objective method of valuing a property. It is based on the objective ability of the general affordability of the population who might wish to live in a particular area. In general the population will expend up to one third of their household income for purposes of “putting a roof over their heads”. This applies to buyers and renters and the difference between the two is that the buyer (owner) over and above the weekly/monthly payments, will need to come up with the deposit, costs and serviceability. Prices in an area can fluctuate to extremes depending on factors such as: interest rates, money supply in an economy, tax relief and many other factors. Market sentiment plays a huge part in the psychology of what causes the herd to push prices to unrealistic peaks and troughs. Affordability, on the other hand, is relatively stable when compared to market sentiment and increases at a relatively steady rate. A.W.O.T.E. (Average weekly ordinary time earnings.) It is the stability of earnings and thus actual affordability that objectively sets the real value of property over time. Rental Reality The real value of a property = Actual Achievable Annual Rent / 5 year average yield of the postcode. This is the rental reality “formula”. Definitions: Yield: The return (rent) / price (Expressed as a percentage.) Example: $350 per week X 52 weeks / $375,000 = 4.85% 5 Year Average Yield %: The last 5 years of yields, averaged. Example: 2001 yield = 5.80% 2002 yield = 5.25% 2003 yield = 4.85% 2004 yield = 4.28% 2005 yield = 3.95% 5 year average yield = 4.83% Please note that this is a moving average and it will change each year as the previous fifth year is replaced each year by the new current yield. The example is typical of what one might currently find in the Sydney market. The reason that yields have been falling is directly proportional to the increase in prices. Currently, with a slowdown in building approvals and the increased demand for rental property, rent movements are on the up, so one might see an increasing yield return occur, which of course will slowly start to increase the 5 year yield average. Actual Rental Return This is the actual rent achievable in a year. You might ascertain this on the following basis: The property is currently rented = Weekly rent X 52. Similar properties are achieving $XYZ per week so a current comparative assessment can be made. 5 or more Real Estate agents assess the probable rent for that property to be $XYZ and then average the opinions. As per the averages shown above the particular postcode is indicating a 5 year yield of 4.83%. This is the price that the market is prepared to pay for property over a time period, on average. The market is generally prepared to pay what the market can afford. This is not someone’s opinion!
Application of Rental Reality Application of Rental Reality You have found a property in a particular area and you wish to purchase it. Step 1: Ascertain the 5 year average yield for the area. (Residex supplies the historical yearly yields for most all postcodes in Australian cities) Step 2: Ascertain the actual annual rental achievable. (as mentioned above.) Step 3: Calculate: Actual Annual Rental / 5 year yield for the area = Real Value. Example: (Using the percentages as shown above.) Actual annual Rental = $23,400 ($450, per week) / 5 year yield for the area = 4.83% REAL VALUE = $484,472 You should not pay more than this (within a small variance) for this property. It is this objectively accurate assessment that will prevent an investor from over-paying for the asset. Note that this same property would probably be on the market for approximately $592,000!! This is why the current yield is 3.95% - because the price is too high and rental affordability could not keep pace with it.
Comments; Summary Comments Question: I have been asked why the 5 year average yield as opposed to the 7 or 3 or another time period yield. Answer: I performed some regression analysis of the past twenty years of data and the 5 year yield came out as the ‘best fit’ with what actually occurred in reality. In looking back over the 20 year history of median prices in the capital cities of Australia, the acquisition of property within rental reality has produced at least an average of 5% CG in any 5 year time period . . . including the ‘bad’ years. Summary The theory of rental reality is based on choosing investment properties that suit the income levels of prospective renters in the region you are considering. The reasoning for using such a measure is based on the assertion that you make money when you purchase property, not when you sell it. You have control over the purchase price, but not on the eventual sale price, so it is important to ensure that you do not pay too much for your properties. In this article, we described the theory of rental reality and how to calculate the “real value” of a property based on this theory. See also Discussion about this article Real Estate articles Real Estate discussion forum Commercial Real Estate discussion forum Investing Book reviews Glossary of Investing Terms
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