How much do you think a particular real estate property should be worth?

John and Jane were walking down a street when they chanced upon a signage in front of a residential property which the contents read, 'Property for sale at $700,000. Hurry! Best value for your money! Call xxx-xxxxx to view!' John exclaimed, "Wow. This property is up for sale. It sure does not look cheap at $700,000." Jane replied with skepticism, "Are you sure this price is not cheap? I think this price feels reasonable to me." At that instant, a passerby who saw both John and Jane in a bit of argument over the fair value of the property asked them what had happened. After knowing their argument over what the fair value of the property should be, he said, "Maybe we should find out more details from the seller of this property and do a bit of calculations to estimate the fair value of this property. This is at least better than trying to guess what the fair value of this property should be, isn't it?" 

Many a time, we may have heard of comments on prices of real estate properties from different people. The perception of cheap or expensive for a price tagged to a particular property can be very subjective. In coming up with the valuation of a property, there are many different methods that can be used such as a sales comparison method, cost method, or profits method etc.

The sales comparison method seeks to derive the fair value of a property by comparing the property with the prices of other similar comparable properties that have been recently transacted in the market. The cost method is a method which seeks to arrive at a fair value for a property by estimating both the cost needed to build a similar comparable property to the property in question plus the market value of the land. The profits method seeks to arrive at a fair value for a property by considering the amount of business that can be carried out using the property thus providing certain amount of profit yield for the owner of the property. A discounted cash flow model can be used in the profits method to derive a fair value for the property.

I am not an expert in appraising a property. However, I will share in this post one of two ways I think are quite useful even for a layperson to derive a reasonable fair value for a property. By using some science over here in deriving the fair value of a property, hopefully one will avoid the same circumstance faced by John and Jane in the above scenario whereby the judgment of the fair value of a property is solely up to one's emotional gut feel. Therefore, the next time when one chances upon a property up for sale, one will not be making a rash emotional judgement on the fair value of a property but instead make a better judgement if not the best based on some science and numbers.

Before I delve into sharing the one out of two ways I learnt in deriving the fair value and profitability of a property transaction, there are some common simple ways to look at profitability of a property. Assuming a property is rented out, one can look at the annual rental returns to derive his return on investment or return on equity. 

Example: A property has monthly rental income of $2000. The annual rental returns is $2000 X 12 = $24,000.

If the property was bought at purchase price of $600,000, 

Return on investment
= (Annual rental returns / Purchase price) X 100%

= ($24,000 / $600,000) X 100%

= 4%

This property was bought with a downpayment of 20% of its sale price which is $120,000.

Return on equity
= (Annual rental returns / Downpayment) X 100%

= ($24,000 / $120,000) X 100%

= 20%

Notice that the return on equity is much higher than the return on investment. This is the magic about property investment which uses high leverage such that the investor earns a much higher returns on the money he has put in which is only the downpayment and other costs (which are not significant compared to the purchase price of the property). The small downpayment is the equity he owns in the property in order to reap a high profitability (his return on equity) while someone else (the tenant) is paying for his liabilities (the mortgage loan and maintaining expenses) on the property.

The long term effect of this is that the landlord eventually pays up the property with only his initial downpayment and other costs involved (which are not significant) while most if not all of the mortgage loan is paid by someone else (the tenant) for the landlord. A caveat here to note is that the investor must ensure he or she is financially able to have holding power on the property over a good number of years to continue to earn a high return on equity while possibly enjoying capital appreciation of the property as well. If property investment is done carefully, this is one of the best investment asset class which promises a high return on equity plus potential capital appreciation.

Now, let us look into the two scientific ways of assessing the fair value and profitability of a property investment, namely by looking at the Net Present Value (NPV) and Internal Rate of Return (IRR). However, I shall only focus on the first way in this post which is NPV.

Net Present Value (NPV)

Net present value (NPV) of a property is derived by the present value of the inflow from the property (rental income and other benefits) subtract the present value of the outflow from the property (all costs).

Any investment such as property investment is profitable if the NPV is positive. This means that the present value of all benefits outweighs the present value of all costs in owning the investment.

NPV used in assessing the profitability of a property purchase

An investor bought a condominium at $800,000 and paid a downpayment of 20% of its purchase price and after adding other costs such as stamp duty fees and legal fees his initial cost in buying the property comes up to $180,000.

The net positive cash flow is $5000 for the first year, $7000 for the second year, $7000 for the third year, $7000 for the fourth year and $7000 for the fifth year. The net cash flow per year is derived by the total annual rental income for the year subtract the total annual maintenance fee, total annual loan repayment and annual property tax.

The formula for NPV is somewhat similar to the formula for discounted cash flow (DCF) as NPV works on the principle of DCF.

CF = cash flow

n = number of year

r = required rate of return (in %)

The required rate of return by this investor is 8% (his expected rate of return when considering entering into this investment compared to other investments).

Thus, for this investor, his calculated NPV is as follows.

For CF0, it is a negative number of -$180,000 since the investor's initial cost is an outflow. The calculated NPV is -$153,902.88. From this negative value, we can see that holding a property for rental income for a few years still incur more outflow than inflow in present value as the initial sunk in cost of $180,000 is not a small sum. It takes more number of years to see profitability in NPV (NPV showing a positive value) especially after the mortgage loan is fully paid up and there is a significant increase in the cash flows thereafter.

In most cases, an investor seldom holds a property for very long term. He or she will try to sell the property for capital gain given an opportunity. That brings us to the discussion of what is a fair value that this same investor should sell his property at the end of 5 years.

NPV used in assessing the profitability and fair value of a property sale

Assuming his estimated mortgage loan balance outstanding after 5 years is $850,000. He decides to sell his property at the end of the 5th year. Two buyers are interested to buy his property. Buyer A quotes him $1,000,000 while buyer B quotes him $1,100,000.

When the investor decides to sell his property after 5 years, he will incur an agent fee (approximately 1% of selling price) and legal fees (approximately $2000). We will proceed to calculate his final cash flow at the 5th year (also known as the reversion value) when he sells his property.

Final cash flow at 5th year (reversion value)

= Selling price - Selling fees (include agent fees and legal fees) - Mortgage balance outstanding

For the investor, his reversion value for selling to buyer A

= $1,000,000 - $12,000 - $850,000

= $138,000

His reversion value for selling to buyer B

= $1,100,000 - $13000 - $850,000

= $237,000

Selling to buyer A, the investor's NPV is calculated as follows.

Selling to buyer B, the investor's NPV is calculated as follows.

In both cases, the investor's required annual rate of return is 8%. We can clearly see that if the investor sells to buyer A, his NPV is a negative value at -$59,982.40. This means the present value of all outflows is more than present value of all inflows. A negative NPV is thus not profitable for the investor.

On the other hand, if the investor sells to buyer B, his NPV is a positive value at +$7395.33. This means the present value of all inflows is more than present value of all outflows. A positive NPV is thus profitable for the investor.

Therefore, when presented with two different asking price of $1million and $1.1 million for this investor's property, he should sell only to buyer B at $1.1 million to make his transaction profitable. Though both selling prices are only a difference of $100,000, this difference will determine whether the investor will make a profitable or non-profitable transaction. We can see that the fair value for this property after doing calculations of its NPV should be more fairly priced at $1.1 million instead of $1 million when the investor decides to sell after holding his property for 5 years.

An emotional investor may just see that selling price of $1 million is already more than his initial purchase price of $800,000. However, it is only the astute investor after doing his calculations will know that selling at $1 million for this property is actually not profitable at all. A fair value will be $1.1 million instead considering the NPV of this investment. Emotions may lie to an investor but numbers show up the facts about an investment and its fair value. This is the science of successful investing.

PS: Please note that the example and figures quoted in my post are fictitious. The example quoted is not an actual property transaction. The learning point here is that an investor can carry out his own calculations based on details of his investment to determine the profitability and fair value of his property investment.

It is only fair to both parties in a transaction to know the fair value of the item transacted!

A must-have cash flow asset in any investor's portfolio!

I believe this asset class is one of the best asset classes around if not the best to be owned by anyone. The asset class I am referring to is real estate property. I am not referring to real estate investment trusts (REITs) which is what I call the paper equivalent of owning real estate property as one only has minimal control over the physical properties under management by the REIT unless one is a major unitholder in the REIT. I am referring to one being the owner of real physical properties, having the full rights over the physical property.

There are three common major types of real estate properties one can own namely, residential, commercial and industrial properties. I am by no means an industry expert in properties. However, by my limited research so far, all three types of properties have their individual unique strengths and attributes. It really depends on what an investor is looking for, capital appreciation or cashflow from owning the property.

I shall not delve into the unique strengths and attributes of each of these types of properties in this post. However, I will like to impress upon the reader that real estate property is one of the best investment asset classes around to own. I call it a must have in any investor's portfolio. Real estate property may also form a large portion of an investor's porfolio since a real estate property is usually in the hundreds of thousands or even millions in the case of high-end properties. I am sharing this in the context of property valuations in Singapore. Private residential property such as condominiums are easily priced at $500,000 and above in a normal market. Gone were the days when one can buy private residential properties at below such a value. Commercial and industrial properties are also not cheap over here in Singapore with prices also in the range of hundreds of thousands to millions.

As such, a typical investor with no enormous cash reserves has to apply leverage when investing in real esate properties. It is the application of leverage that makes real estate properties very attractive as an investment class. What makes it further outstanding is that in Singapore, the leverage one can apply when investing in properties is one of the cheapest around. This is what I call cheap leverage applied onto a stable investment asset class.   

A typical investor buying into residential real estate over here in Singapore needs to pay a downpayment of cash and/or CPF of 20% on the valuation of the private residential property such as a condominium. In additional to this, there are also other costs such as agent commision fee, stamp buyer fees and legal fees. After one factors in all of the costs and downpayment needed in buying a private property, the amount of capital needed to invest in a property is still not too high compared to its valuation. This provides a very favourable loan to value ratio. One can apply for a high amount of loan with a low initial capital commitment compared to the valuation of the property.

This makes real estate property a highly leveraged asset class for an investor. Furthermore, the interest rate for mortgage loans to buy properties is one of the lowest around compared to other types of loans in Singapore. This makes investing in properties a cheap highly leveraged asset class for investors. Properties tend to hold their values or increase in value over the long term (if the property in question is really a good buy). This further adds on to the attractiveness of real estate properties as an investment class as one can look at stable capital apppreciation over the long term (in many cases, capital appreciation in properties is known to beat inflation over the long term).

If an investor decides to rent out a property and the rentals collected are able to pay for the expenses in maintaining the property and even pay for the mortgage loan, the result of this is that another person (the tenant) is effectively paying the property for the investor. Once the property is fully paid for, the investor can sell the property at a profit (when the valuation of the property is higher than the initial purchase price) or continue to rent out the property for rental income which translates to recurring passive cash flow income which may be perpeptual (in the case of freehold properties).

As such, real estate properties can potentially provide a source of recurring passive income (once the property is fully paid for and the liabilities on the property is significantly reduced) for an investor's retirement period. I have personally known of people who have enjoyed and are still enjoying the recurring passive rental income stream from owning real esate properties. Of course, one can critique that this income stream is not totally passive as an owner of the property still needs to engage the tenant fulfiling his obligations to the tenant to manage the rental property. However, this property management work is not taxing at all compared to holding a full-time job. If a landlord chooses not to get directly involved in managing the property and tenant, he or she can engage a property management company at a cost which still makes the cash flow on the property attractive minus the headache of managing the property and tenant.

With prudent planning considering that one is able to buy and has holding power on a property through the ups and downs of the property market, not over commiting financially, one will be able to reap the rewards of a cheap and highly leveraged investment asset class which promises good cash flow. This is a must have cash flow asset that any investor should aspire to own in his portfolio. The important thing in any investment is to assess one's capability to buy and hold the investment asset while reaping the cash flow and financial reward, and only sell at a right time (when capital appreciation far outweighs the potential future cash flows or when another better investment asset comes along).

In all these, the caveat of buying undervalued or reasonably valued cash flow assets and selling over valued assets  still holds even when investing in real estate property. Successful investing is simply a numbers game (a science) and also a sound judgement game (an art). It was never meant to be an emotional game (getting caught up with greed and fear). If the numbers are good after one has assessed the potential of the investment asset, one should own the asset. 

PS: Please note that this post is just a very small time discussion on the topic of property investment. There are so much more things to know about the topic of property investment. I thought that real estate property is such a noteworthy and very important investment asset class that any investor must not miss in his investment portfolio.

PSS: Do note also that any information provided in this post is in the context of Singapore property market. I am also not to be held responsible for any misinformation in this post. One should always do his own research before investing in any asset classes. Prudence is the mark of a successful investor.

Real estate property, a must-have cash flow asset in any investor's portfolio!

Reflections on my investing journey so far - "It is still cash flow that triumphs".

As I reflect on my past three years plus of investing in stocks and shares, I learnt many lessons, some slightly bitter ones and some are good ones. So far, I am glad to say that I have not made any realised losses from the stock market yet. In fact, I have made steady returns of approximately 13% per annum over the past 3 years plus of investing mainly through recurring cash flows from dividends received from my stocks investments and some gains through selling of shares (a lesser amount though compared to dividends received). This figure of returns may not be exceptionally significant, but it is already better than most other alternative forms of investments. Also, I have not made a single realised loss on my investments so far.

I have learnt through my humble experience in investing so far that it is better to have the mindset of building assets that return stable continuous cash flow than to invest for quick returns. Even if one is going for an accelerated way of investing by investing for appreciation in value of assets (be it paper assets like stocks and shares or physical assets like real estate properties), one must still own an increasing amount of assets through the years that provides recurring and increasing cash flow that can beat inflation over the years.

Getting positive cash flow through owning assets is really everything about successful investing. Appreciation in value of assets is an icing on the cake. Even after one sells off an asset that has appreciated in value and made a gain, he is still faced with the decision to reinvest his gains and original capital into another asset. If he does not reinvest his cash, then cash will depreciate in value over time. By not investing one's cash, one is getting poorer by the days.

Ultimately, I believe the distinction between rich and poor people is just in the mentality of how they view money. The rich becomes financially educated and invests to control or own assets that provide them recurring and increasing cash flow that fights inflation. Of course, any appreciation in value of the assets is also welcomed. The poor views investing as risky or is just ignorant of the merits of doing proper investments. The simple key to successful investing is just to continue learning how to invest and just do it and really learn from mistakes and successes whenever investment decisions are made.

The more learning and experience one gains through own research and learning from mentors, the better it becomes as one matures in his investing journey. As I have already expressed in an earlier post quite sometime ago, my view on successful investing has not changed now. Building up the amount of high quality assets one can have the most control (be it paper assets - this tends to have lesser control for the investor as shares are just meager part-ownership of an invested company unless one is a major shareholder, physical assets or business) over time and getting increasing recurring cash flow which beats inflation will allow one to reach financial freedom sometime in life. Cash flow received from assets is further plough back to reinvest in more quality assets which further increases cash flow. This is a virtuous cycle of increasing cash flow over time (by compounding), cash flow that further feeds more cash flow.

Patience and endurance to resist instant gratification in seeing immediate gains is important. Surprisingly, I learnt through these three years plus of investing that money goes to the one who is not greedy for it. The more one is not greedy for money, the more rational and composed one is when it comes to long term financial planning and constantly making the right investment decisions. It is all about the mindset of the investor. The success and failure of investing is not so much affected by the economy, but often it is the wrong emotions of greed and fear that causes the investor to make unwise investing decisions.

I will continue to look out first and foremost for quality assets (be it in paper or physical assets or business) to invest for good quality cash flow while secondly welcoming the idea of appreciation in value of invested assets. Building cash flow through owning and controlling more and more quality assets over time that beat inflation heads down is the crux of successful investing that will enable one to reach financial freedom. Better yet is that the quality assets one has owned can appreciate in value over time. This simple rule of successful investing has not changed through the ages. I believe it will not in future too.

Are you into building more and more positive cash flow (by owning and controlling more quality assets) or "building" more and more negative cash flow over time (by spending more than one's income, chalking up bad debts or making unwise investment not in cash flow producing assets but in investments that may lose their value in the end resulting in a loss)? If 'cash' thinks that it is really king, 'cash flow' will be laughing his heads off at 'cash'. Perhaps, the mindset of wanting cash flow is probably better than the mindset of wanting cash when it comes to successful investing?

Think of cash flow investing as installing more and more taps that can be opened to provide more and more cash inflows. The choice of the right taps to install is important so that the right taps (quality cash flow positive assets) can continually provide more and more cash inflows over a long period of time to build one's passive income.