Residential investment property fails simple valuation test

[redwing]

From Roger Montgomery re: continued and sustainable growth in the property market

RESIDENTIAL INVESTMENT PROPERTY FAILS SIMPLE VALUATION TEST

Cont...

Combining these numbers into a valuation can be done as follows: divide the annual rent earned on a property by a divisor, which is calculated by subtracting the long term growth rate from the discount rate, as set out below.

Value = Net Rent p.a. /(Discount Rate ? Growth Rate)

This is the formula for calculating the present value of a stream of cash flow that grows at a fixed rate in perpetuity. If a property generates $20,000 per year of net rent, we would calculate its value as $20,000/(8% ? 3.2%) or $20,000/4.8%, equal to around $416,667.

If that property can be bought today at a net yield of 3.3%, it would imply that the market price of the property today is $20,000/3.3% = $606,061. This is significantly higher than our valuation of $416,667. On the basis of the discount rate and long term growth rate we assumed, buying property on a net rental yield of 3.3% appears hard to justify.

Continuing assumption of capital growth

Over the past three decades, there has been a fourfold increase in Australia?s indebtedness as a percentage of annual disposable income, to 150%, as well as massive growth in property prices. Together with the above analysis, these facts indicate that the same level of growth is not sustainable. If this is correct, it may pay to be cautious about buying on the basis of a continuation of assumed capital growth.

Of course, the conclusions you reach with this approach depend on the assumptions you put into it, and the purpose here is not to argue that property is overpriced. Rather, it is to set out a framework that allows some basic assumptions to be converted into a fundamental value. By doing this, you can decide for yourself whether there is long term value to be gained.

 

[D.T.]

I love RM and agree with all of his opinions/lessons on shares.

However when it comes to property, not so much. Because
1) what kind of galah would buy 3.3 yield anyway
2) he owns a share fund so it's in his best interest to recommend shares because then people either buy the share fund or is share find software.

 

[jingo]

I think buying well located properties which are in demand will become more important going forward. Properties that are scarce and have limited supply I think will hold up well.
In Melbourne, traffic is becoming a major problem. Buying near transport links would be a good move.
Anyway, I found a couple of examples where properties have appreciated well over the long term. This house in Brunswick recently sold for $920,000. It seems like a lot of money, but considering the vendor purchased it in 2002 for $382,000, it represents a return of between 7.5 and 8% p/a.
http://www.realestate.com.au/property-house-vic-brunswick-116645883
I was interested to find this property which had been owned by the vendor for 20 years. Over this time, the property has appreciated by approx 7% p/a.
http://www.realestate.com.au/property-house-vic-altona+meadows-116207423
I'd love to see more examples from other investors and Buyers Agents must have plenty. (Perhaps this is scope for a separate thread).