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%
= (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%
= (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.
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