Monday, June 22, 2009

Value in relation to rent

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.

8 comments:

Reid said...

If you consider the average investor may only put down 25% (versus 100%) and factor in the related interest costs (even at today's low rates), the P/E jumps to 127. Sounds like a great investment! Why do people do it, because real estate always goes up and capital gains are taxed at a lower rate.

Ask your American or British friends what they think of the capital gain potential on these investments.

victorianna said...

Personally, I don't think there are many 3-bed 2 bath houses renting for $2500 in Victoria. That's just my experience and observation, but I don't think landlords are getting rents that high.

Chickinvic said...

I agree. $2,500 seems pretty high for rent on most Victoria wages. I wouldn't pay it, that's for sure. We rent a condo that's 2 bed/2 bath for $925. This allows us to save money and also have a life (travel, etc). I cannot even imagine coughing up $2,500 every month on a rental. I would leave town first.

Olives said...

I pay $1300 for a 3-bed, 2-bath house that would be appraised approx. $500,000. I know quite a few people who rent houses (whole houses) and all pay similar or less than me. Prior to this house we paid $1,100 for a 2-bedroom home.

Ryan said...

I would say current market for a nice 3 bed house is about $1800-2000. I rented a gorgeous 3 bed/3bath house that backed onto a creek for $2100. No way should anyone be paying $2500 unless it includes utilities and lawn care.

Just Jack said...

A realtor provides a CMA (current market analysis) which is basically a list of properties that have sold which the agent considers similar to yours and his/her opinion as to the properties worth. This CMA does not have adjustments for the difference between the comparable sale and the home being estimate, nor is the analysis dated or signed.

Why?

Because a CMA is not an appraisal and the agent is not covered by his/her error and ommission insurance to do an appraisal. An agent does not have the education nor the credentials to provide an appraisal. An agents course is 6 months, to become an appraiser is a university degree. This is not to say that the agent does not have a very good idea as to the property's worth, its just he/she is primarily a sales person whose job is to bring buyer and seller together.

BC Assessment is mostly appraisers that gather data and a computer programme that estimates the property's value on a "mass appraisal" basis. Individual properties will and do vary but for taxation purposes they are considered acurate.

Market value is determined by BOTH the buyer and seller. If the seller does not agree to the price, then there is no sale, if there is no sale, then there is no market price. It is the "meeting of the minds" of buyer and seller that detemines value. String many of these meetings of the minds together then you have market value. A "fair" market value being neither high nor low but fair to both parties.

Market Value is estimated by sales of similar properties that have been appropriately adjusted. These comparable sales are economic indicators and when consistently and logically adjusted in relation to the subject property provide a range in value and a most probable value. For example a Gordon Head box may have a market value that ranges from a low of $600,000 and a high of $650,000 with a most probable value of $635,000 as at a specific date.

The use of rents in order to estimate a multiple have to be taken from the market place, and are only considered to be supportive evidence of value. Mostly because homes are not solely purchased for their income producing potential.

Another way to estimate market value is to look at a large sample of data and by using parameters that the subject property has (Gordon Head homes built between 1965 to 1985 having between 1500 to 2500 finished square feet on 6000 to 10000 square feet lots) may have a median price of say $625,000. This would provide a reliable estimate of market value, if the amount of data was sufficient and the subject was highly similar to the median home.


Price earnings ratio are valid for shares, mainly because there is no diverence between share number 516 and share number 1,000,016. Not so for houses, each home is different from the next. Even homes that are side by side, identical in floor plans and built by the same builder will sell for different amounts. Because after the first home sells, then prospective home buyers are limited to one property rather than having a choice of two.

Most home owners have an expection of the value of their property that is six months out of date and tends to be higher than what the property eventually sells for. Mostly because they are comparing their home to "asking prices" as they do not have the sale prices of the homes.

Roger said...

Just Jack said,

Most home owners have an expection of the value of their property that is six months out of date and tends to be higher than what the property eventually sells for. Mostly because they are comparing their home to "asking prices" as they do not have the sale prices of the homes.

I suggest that most owners think their house should get more than the asking price of similar homes in their area. Why? Because they consider their house is better compared to all the others. Better, in their mind, in terms of landscaping, decorating, layout etc. but mostly wishful thinking.

Owners also have a tendency to mentally lock in a price based on the highest price they have heard about in their neighbourhood in the last few years. They believe real estate always goes up so how could mine be worth less.

You can see examples of this mindset with For Sale By Owner (FSBO) ads. Invariably the price is higher than the comparable MLS listed properties in their area. Not only do they want to save the RE commission they want more cash as well. After a few months of fruitless open houses, wasted hours on the phone and newspaper ads they throw in the towel and call an agent. The stubborn ones will list at the same price on MLS and then chase the market down with price reductions.

Just Jack said...

When looking at a the physical aspects of a house, prospective buyers only look a few things when making their decision. In ranked position they are:

1) Location
2) Age and Condition
3) House Size
4) Lot Size
5) buildin style(rancher v. basement entry)
6) parking

Items like landscaping are such a low percentage of the total that they are rarely, if at all, a deciding factor in a buyers decision.