We know there are two common values typically associated with houses: the market value obtained through a current market analysis (CMA) evaluated by a REALTOR® and the BC Assessment value which is largely obtained by a less-than-accurate averaging/evaluation based on like/similar property transactions within an immediate area.
Most home owners likely have an expectation of what their house is worth that is as accurate as either of the two previous estimates through browsing MLS for a few days. Ultimately, market value is determined by the buyer, who either agrees to pay a given price or doesn't.
But what is fair value and how can we calculate it in real estate? What ratio should a home sell for comparatively to rent? Is the ratio static or does it change with market conditions? Can we learn from fundamental analysis of stocks and apply the same criteria to homes?
One of the keys to fundamental analysis is revenue. After all, who wants to own the shares of a company that doesn't sell anything (risk taking speculators do). How do we easily measure revenue as it relates to what we own? In the world of stocks, we use the price to earnings ratio: market price per share divided by earnings per share.
Here's a quick example: ACME Corp. has 10 outstanding shares. ACME Corp. earned $200 in 2008, or $20 per share. ACME's share price closed today at $400 per share. To calculate your earnings per share ratio today you divide $400 by $20 to get a price to earnings ratio of 20.
Determining what is a good price to earnings ratio is easy: the answer is the lower the better. Determining what is a fair price to earnings ratio is open for debate and depends on the stock you may be analysing and how its share price compares to peers.
Can we use a similar metric for housing to determine fair value?
I know I can rent a 3 bed 2 bath home in Victoria for about $2500 per month. I know that same house will sell for about $550,000 depending on the area of town. But let's keep those numbers simple for explanation's sake only here, OK? To calculate the price to earnings ratio I divide $550,000 by [(12 x 2500) - costs*] to get the price to earnings ratio. Remember that reported earnings in relation to a stock are accounted for after expenses--earnings are what the company returns to shareholders.
In our housing case, costs* are the key part of calculating value. Do costs, once accounted for, leave anything to report as earnings? Or do costs result in a loss?
For simplification's sake, let's assume you're buying with cash and renting the house out; your costs should be minimized here. Property tax ($200), income tax on the rent collected ($750), maintenance ($250) and insurance ($75) are added up ($1275) and subtracted from $2500 to get earnings of $1225 per month. The price to earnings ratio is then calculated as $550,000 divided by $14,700 to get 37.4.
I would not use a price to earnings ratio to determine fair value in the residential real estate market, it's just too problematic and open to too many variables that can greatly skew the importance of the numbers. Besides those problems, a price to earnings ratio is a weak analysis of true value if you don't have a historical or side-by-side comparison to use. But if you're working on your financial literacy, hopefully this post has provided you with another term to add to your vocabulary.