bubbles defined

[abcdiamond]

Les
I think that LB's original figures omitted the fact that rent goes up aswell.

The formula =PV(0.065/12,12*200,250*4)
maintains rent at $250pw without any increases over the term that he quoted.

Rent may not go up asd fast as inflation, but it should not be too far behind.

 

[Les]

G'day abcd,

Yeah, I noted that too. What do you know of the formula LB is using, abcd? Does it appear to be kosher? (I wouldn't know...)



G'day LB,

This thread has certainly got the grey matter churning

In an attempt to learn, I checked IRR and NPV in Ian Somer's PIA program. Here are his definitions (they may not be verbatim, but should be sufficiently correct to give the idea)

IRR - Return on a series of cashflows AND your equity at the end of the period.

NPV - Total value of an investment, less the total cash you have invested, adjusted to Today's dollars.

NPV "sounds" like it is IRR returned to Today's dollars.


Now, from your calcs, I get the impression that YOUR Present Value figure is based on cashflow only, with Growth not considered. Also, as abcd reported, you are not allowing for rental increases (but are they considered to be offset by inflation...??)

Do you disagree with Ian's view of NPV?? If so, in what way? His PIA is making my current properties look pretty good (I think HE must be right )

Regards,

 

[abcdiamond]

Les
The PV formula is a basic Present Value of an investment formula.

It's a valid formula when used with correct information.

When I did my calculations to try to disprove LB, I did it the long way, and I forgot to increase rent also! Which explains why I first said that his figures were suprising correct. It was only later that night that I realised the error. He was actually devaluing the rent by 6.5% per year, but not allowing for the rent to go up.

If you expect inflation to be 6.5% and rents to go up by say 6%, then his formula should be more like:
=PV(0.005/12,12*200,250*4)
ie: (the revised formula explained here)
0.005/12 = 0.5% per year calculated monthly
12*200 = 12 months x 200 years
250*4 = $250 received 4 times per month

this version results in $1,516,905.43 over 200 years
as opposed to LB's $184,614.95 without rent increases.

I do look at things more basically though, and I have shown my reasoning behind positive Property investment in a thread called "Boom Bust or No Bust"

 

[Les]

Ahhh! Thanks, abcd - THOSE figures look a fair bit more realistic !!!

Again, though, I don't see Growth coming into this. Am I missing something? Or is the original "6.5%" a reflection of Growth? (I thought it related to the Yield...)

Edited: Just reread your comments, and 6.5% relates to Inflation !!! So, is this then ONLY used to Discount the figure to "today's value"? Or, is it assumed that Growth ALSO increases at 6.5%????

Regards,

 

[abcdiamond]

Les

All figures quoted have totally discounted any CG. You and I, and many others, do take that into account, but some others do not.

You have to add the CG to any previously mentioned figures.

regards

 

[Les]

All figures quoted have totally discounted any CG

Hmmm !!! That would make Property Investing in general look pretty sick then ......

Particularly in areas like Sydney where CG makes around 10% - 12% of the gain, and yields only around 3% - 5% (LB's formula might make Hobart look a bit better though )

Thanks for your responses, abcd - helps me to clear my mind somewhat !!!

Now, back to you, LB......

Thinking further, this NPV calc could even make Shares look crook too. Aren't MOST investments made up of both Yield AND Growth??

If so, what the hell is the use of this particular NPV calculation (except as a subset of the complete equation?)

And, if this IS a subset of the complete equation, why is it seeming to come across as "the whole deal"? Again, am I missing something? Or could it be you?

Regards,

 

[Mikhaila]

Hi People,

Well, this is a Sunday morning… Kids are up since 6:30am and possibility of sleeping a bit longer completely disappeared…

Here is my contribution to solve LB puzzle. PV function isn’t suitable for the calculations we try to do as it is designed for something different. In short, PV designed for annuity style products where payment made each period and can't change over the life of the annuity. NVP function is more appropriate in our case. Also, as correctly pointed CG can’t be discounted.

A picture worth a thousand words, so I attached a spreadsheet. You can play with purchase price, rent received, inflation, %Rent Increase and %CG. I took only 15 year’s period (Sorry don’t expect to be here in 200 years!).

The townhouse bought for 330K is a bit expensive but only just. The present value is 319K and this is taking only 48 weeks rent a year and moderate CG and 6.5% inflation! Have a look at the numbers with 5.5% inflation and the townhouse purchaser will look rather smart….

Cheers and Good Morning

M.

Edit
I found a bug - cell A5 should have a formula "=B2 * 48" not "=250 * 48".

 

[Bill.L]

Hi all,

Been a bit too busy lately to take on the numbers argument, and I love to show a dose of reality to those who use fancy formulas and and "economic theory" to prove a point.

Firstly, When did economists ever get it right?? There theories and formulas always carry the rider "All things being equal" huh WHEN were all things equal??

LB, some questions for you to help me understand your position better.
1/ What assumptions do you make regarding inflation for the next 5-10 years??
2/ What assumptions do you make for interest rates in the same time frame??
3/ What assumptions for the $Aus, same time frame??
4/ What yield do you expect median priced housing(3 bed houses,not units/apartments) in middle to outer suburbs to return to, same time frame??
5/ What area of investment will return the 6.5-10% you indicated??
6/ Where will the increased population growth be housed given your fall in prices and the consequential fall in construction levels, same time frame??

As Les has stated, I too enjoy your contributions as they certainly help create a lively debate. It's just that I don't agree with your generalisations. However I'm sure your property bubble/large price falls theory will be correct in SOME areas of apartments.

bye

 

[suggo]

Originally posted by L Bernham
I've obviously lost you abcdiamond.
Your post demonstrates neither logic nor relates in any way with the point I was making. Its why I don't often bother with people who don't have a basic understanding of ordinary financial concepts. I thought posting on an PM Economics thread I would avoid this type of response.

LB

These new calculations makes this sort of comment look pretty silly then doesn't it. I hate it when people get all high and mighty.

 

[L Bernham]

why oh why??

You don't allow for rent increases because they would be expected to rise in line with inflation.
If you want to gamble on rents rising above inflation or otherwise then thats up to you.
IN NPV calcs as I already stated previously inflation is not taken into account because it keeps everything relative.

If you continue to raise rent at 2-3% above inflation pretty soon you would get a situation where rent vs the other basket of G&S's is ridiculously out of wack. In other words extrapolating those figures would eventually mean rent would cost more than 100% of a persons wage. Likely? I dont think so.

CG is not taken into account because the possibilty of higher rent increases is what should determine capital growth. Its why growth areas can justify a lower % of rental yield as it is expected that rents will increase at a greater rate then the average in some places.
Once again, if one wants to gamble on rental yields becoming lower than now then Caveat Emptor .

I'm sorry if I have offended people but I find it just as offensive when a valid argument is rebuffed with a poorly thought out or illogical arguement which is meant for nothing other than to confuse third parties.

Anyone that knows me would laugh to hear that I could be described as HIGH and MIGHTY.
However if you're gonna get into the ring with Mudine make sure youve had some lessons first. No I am not comparing myself to him but what I'm saying is if you've havent had a lot of experience with investment appraisal and valuation, its probably not a good idea to invalidate arguements of someone that has done it for many years.

Feel free to post numbers that show how the original investment can ever recover its cost without using assumptions of yields going to nil or rents rising to a greater proportion of average persons wage.
That type of thing is speculating, not investing.
cheers
LB

 

[abcdiamond]

Originally posted by L Bernham
You don't allow for rent increases because they would be expected to rise in line with inflation.

Your orginal figures assumed a rent of $240 pw and this was then discounted by 6.5% inflation rate (= $15.60), giving a rental income at $240 - $15.60 = $224.40

This figure of rent is then used in the following year and again discounted by the rate of inflation $224.40 - $14.59 = $ 209.81. If this is continued for 1,000 years then you come up with $179,520.

I feel that you are using the rate of inflation to reduce the future value of todays rent, but the calculation does not allow inflation to increase that rent also. Surely if inflation reduces the value of something, but that item also increases in line with inflation it will have a balancing effect.

Therefore if you allow for rent increases of 6.5% pa into the same equation the end figure becomes $11,657,131.20,

Surely, if rent increases rise in line with inflation, then a better calculation would be to say something like:

Current rent is about 25% of an average wage ie: $240pw rent with average wage of $960 pw.
Not accurate figures, but some average person somewhere must be earning $960 pw.
anyway, no matter how many years in the future, the rent received will be equal to about 25% of an average wage. The original loan will either be paid out, or will be negligible in terms of the current $ values at that future point.

A lot of people have bought property based on these facts, and I would be grateful if it could be explained that this is actually incorrect.

Your quote appeared to show that buying a property is a negative thing to do, the figures I have worked from show that long term it is not negative.

regards

 

[L Bernham]

The 6.5% discount rate is the Cost of capital. Not discounting rent for inflation.

I've basically used a typical interest rate.
Note this makes no difference on whether you are financing an investment with 10% or 95% borrowing as its indicates the opportunity cost of allocating resources to an investment.

lb

 

[Mikhaila]

Hi LB,

Ok, you discount rent increases because it is a gamble to thing it can go higher than inflation.You discount CG because “CG is not taken into account because the possibility of higher rent increases is what should determine capital growth.” Basically, what you are saying is that RE across Australia is not worth buying almost forever. It’s not good now as prices going to fall. After they fall 40% or less it’s not good as it is still above PV. After prices fall 40% or more it may be OK but the fall should be close to 60-70% to get some remotely decent returns. Sounds silly doesn’t it? Please tell me what would be a suitable price to buy the townhouse you provided as an example? If PV (187K) is good value for you, please tell me why as CG prospective at this price is still zero according to you. So why would you pay 187K to get 250$ per week over 200 years - i.e. 0.5% higher than cost of capital??? .

One more thing - did you apply PV function to realestate.com shares? If not, why not. If yes, what was the PV?

M.

 

[Bill.L]

Hi all,

LB, if you wish to be taken seriously, then the simple questions I asked should be answered. Instead all I have seen from you is more economic jargon that I think you may actually believe!!

"Note this makes no difference on whether you are financing an
investment with 10% or 95% borrowing as its indicates the
opportunity cost of allocating resources to an investment."

Like you could have bought HIH shares instead!! It makes a HUGE difference as to whether you borrow 10% or 95%, depending on the outcome. Not allowing for any cap gain in your formula shows a lack of understanding of history and reality!!

I'm still waiting for your reply to the simple questions I asked of you.

bye

 

[suggo]

LB
Your friends may laugh because they think it too, I don't know, and I care little(actually not at all!) about what your friends think of you! I do know the way you come across in these forums certainly makes me think that way!!

I really enjoy this forum because people DON'T respond to others in a belittling way, unfortunately from alot of the posts I read of yours this is not the case. How about helping others, less Mundineish than you, see the reasoning behind your statements instead of chastising (spell check) them as you do actually seem to have something to offer!

Now back to the topic. To quote Jan Somers book, page 101
"Building wealth is achieved through borrowing, buying and keeping residential property for the long term. It requires time - not timing."

Does this mean Jan is wrong!!??

Hmmm, bugger me who to believe, I think I'll go along with Jan and you can please yourself LB!

 

[jfchan]

Hi All

Aside from the economic argument, I think there is an over simplification about how the NPV calculation of investments should be. The NPV is a method of showing how much net increase in wealth an investment will produce for you. Ranking the NPV of all available investments helps to pick the one to go with.

The PV (Present Value) formula is for coverting the future value of just an economic component of the investment back to the present time. In other words every economic component of an investment should be considered. Folks here have taken short cuts but can be tripped out.

In general terms, the NPV =

future capital value discounted for the cost of capital by the number of years back to the present
+ future income similarly discounted appropriately back to the present
- future expenses discounted back to the present value
- present capital cost of the investment

Jan Somers have examples of how the calculation should be carried out. Using just the PV formula to try and represent all the above components is tricky. Some errors have already been shown above, eg the future value without including the capital appreciation or inflation gain.

 

[abcdiamond]

LB
You said:

Originally posted by L Bernham
why oh why??

The reason why is because you did not explain yourself clearly at the begining.
You said:

I also think its crazy when I see properties selling for more than double the present value of all future net cash inflows for the next 1000 years.

This "future Net cash inflow" quoted appears at first glance to mean what the net inflows (ie: rent?) would be worth at future values, (ie: after inflation?) but you now say that it is after taking into account the interest rate on the capital value of the property, against the rent received? Wether this is what you meant or not, that is how it comes over.

You then go on to quote 1,000 years.
If you had said 20 years, it may have been more readable. Your reason for the 1,000 years figure was:

I used the example of 1000 years to simplify for those that probably wouldnt have understood otherwise

I feel that most readers would have consider a shorter period, say 20 years, as more relevant than 1,000 years. No one would be interested in 1,000 years time without a full and understandable explanation of its use.


Then you said:

HOw can my figures be irrelevant?? Would you pay $300K for the right to receive $180K worth of income over 100 years.

Now we are down to 100 years, but the average PI is not payig the full 300k, they are borrowing, and the tenant is paying the interest. So the answer is NO, I wouldnt pay 300k for 180k in 100 years time, but if you shorten the term in your PV calculation, the figure looks much healthier. a note here: your PV calc used 200 years, not 100 & not 1,000

Then

I find it just as offensive when a valid argument is rebuffed with a poorly thought out or illogical arguement which is meant for nothing other than to confuse third parties

My response to you was not poorly thought out, nor was it meant to confuse others, it was to ask you for actual figures: ie:
Can you give figures for this calculation please ?
I just worked out 1,000 years x 52 weeks x $240pw at $12,480,000 but I think thats a bit high selling price for my property.
There must be a logcal answer, but ??

Your answer gave a formula that did not give anyone the answers. You also said :

Isnt the PV formula used by most investors to determine value?

You also asked :

Fact is why would anyone buy a property to hold forever when its never going to pay itself off unless rents rise significantly above inflation. Thats the big question

I think the answer to that lies with what has actually happened in th past. Many people have bought properties, and they are now fully paid for. Thats a fact.
If we follow your theory we would not be buying property.
Since 1977 I have made $422k profit from properties bought and sold, and i currently have $308k in paper profits, ie: not yet sold.

Should I have not bothered ?

I think that my point relates to the difference between reality and the theory of economic theory. ( I admit - i hated economics when I was studying it)


Finally, going back to your

I find it just as offensive when a valid argument is rebuffed with a poorly thought out or illogical arguement which is meant for nothing other than to confuse third parties

Have you never confused anyone with your comments/ answers in this forum ?

sorry for the long post, everyone

 

[MarkB]

I don't want to confuse matters further (if at all possible), but I was just wondering why, in all these calculations about PV's and NPV's of cash flows, that there appears to be no mention of the leverage which is used by property investors to buy and control an asset (an IP) greater than that which their own capital allows?

Who buys IP's with 100% of their own money?

Does anybody here do that?

MB

 

[bundy1964]

Originally posted by Pitt St
Who buys IP's with 100% of their own money?

Does anybody here do that?

MB

Hi MB

Did it once for my first IP. Now know I could of done better with a 60-70% LVR on no docs.

bundy

 

[Les]

G'day LB,

Thanks for weighing back in ..... I almost hate to post this (I certainly don't want to come across as just "having a go at you"), but your comments have again got the grey matter churning - so, sorry, I HAVE to ask.... (and, yes, I'm STILL enjoying the discussion..... )

CG is not taken into account because the possibilty of higher rent increases is what should determine capital growth.

Is that the ONLY reason? I've heard (and believe) that yields and Growth are inversely linked - i.e. as Growth happens, the yield (as a percentage) MUST drop. As you've pointed out, yields CAN'T grow ad infinitum..... If so, does that mean the boom we've just lived thru hasn't really happened? (I haven't seen a 100% increase in either wages OR rents in the last 5 years.... - but what has happened to Growth??)

And, (your quote) "rent increases should determine CG"??? Can't go with this one, LB.... Isn't CG almost TOTALLY determined by the supply/demand of an item??? Thus, an apartment with Sydney Harbour views will tend to go "thru the roof" in terms of Growth, when compared with a house in Penrith. But, the rents (as a percentage of value) remain tied to wages/salaries (thus, inflation...). It sounds to me like you might be applying "commercial property" tenets to residential property. As I understand it, commercial properties are (pretty much) VALUED according to rents received. Is THIS where we have been diverging????????

Edited later to remove the original stuff-up - I HAD said "Do you believe that residential property is synonymous to residential?" Wel, der!!! What I MEANT to say was:-

Do you believe that COMMERCIAL property is synonymous to residential?? Or am I assuming too much here?

Its why growth areas can justify a lower % of rental yield as it is expected that rents will increase at a greater rate then the average in some places

Hey, I "tend" to agree that a "supply/demand" imbalance in RENTS will also tend to have (say) Sydney Harbour view properties increase their rents. But, what of the overseas BUYERS (NOT renters!!) that want to purchase desirable property in Australia. Wouldn't that likely have FAR MORE effect (via GROWTH in values) than rents will ever have !!

Should we IGNORE this? In short, LB, isn't it really "supply/demand" that is the MAJOR determinant of value?

And, if true, HOW is that quantified in a PV calc?? Is it possible?

Once again, thanks for your contributions - although it may not seem so (judging by some responses) there are a number of us that appreciate your input. If we all just "agreed", there would be no forum !!!

Regards,