How to Value a Home

Many people assess home values by looking at comparable sales.  Perhaps you are looking at a 3 bedroom home in a cozy suburban community, and you see a similar property located 2 blocks away which sold last month.  There’s your value!  If they are truly similar properties, this is probably a good proxy for the market value of the home at which you are looking.

But you ought to know its value as an investment.  This is a called a fair value assessment.  Though a home is an essential good, like clothing, cars, and computers, it is a financial investment, and evaluating it as such makes perfect sense.  Consider that you can purchase a home and rent it to others with the expectation of income.  Or that your alternative to owning is renting.  Home ownership should always be a buy versus lease decision.  There is a line which favors ownership on one side, and renting on the other.

Housing has traditionally been considered financially safe.  That is, until the recent bubble popped.  As Professor Robert Shiller has long contended, residential real estate is far riskier than conventional wisdom assumes. 

Real estate ownership is not a high flying investment.  For investors, it is principally a source of income, more bond than stock.  While it does have some business (equity) characteristics, like operating expenses, on the whole, it is a bond type investment.

Some might ask why they should worry about overpaying, since most of those costs will be spread out over a long period of time via financing.  In addition, there are tax benefits to ownership.  Such people may be more interested in owning because they fell in love with a particular property, or feel they need to get in before prices head higher.  I offer the following reasons to hold your wallet and not to overpay:

·         Overpaying will increase your mortgage payments. For example, consider a home with a fair value of $300,000.  If you overpay by ten percent—in other words, you pay $330,000—then financing 80% of the purchase value with a four percent 30 year fixed mortgage will cost an additional $115 each month.

·         Given the example above, you will also pay an additional $6,000 in cash for your down payment.  You could otherwise invest this money, or use it for an emergency fund.  Now it will go into your overpriced home.

·         Prices in your neighborhood may “correct.”  In other words, after you overpay, other buyers may adjust and pay less for similar properties in the future.  If you go to sell shortly thereafter—for example, in an emergency—you may sell at a loss, if you can sell at all.

·         Even if you sell a decade later, for say, $400,000, your return on asset (the return on the total purchase price), will be about 2%.  If you had paid $300,000 to begin with, your return would have been 3%.  I don’t know about you, but I’d rather have the higher return.  It matters.

·         If home values adjust downward or flatten, you may not be eligible for a home equity loan, since you might have little or no equity.

I hope I have convinced you that overpaying, even by just 10%, is not such a good idea.  But how do we assess a fair value?  You will need to collect the following information:

·         Rental rates for homes similar to that which you are looking at purchasing.

·         Estimated operating expenses (utilities, repairs and maintenance, insurance, local taxes, and supplies) for local property rentals.  As of this writing in February of 2013, typical operating expenses range from $4.50 to $5.25 per square foot per year, depending on local taxes, property condition, utility rates, land area, and other factors.

·         Local cap rates (discount rates for multi-family—or apartment—buildings in your area.  You can find these by asking local realtors or real estate investors)

·         A basic outlook for the area in which you are looking

o   How is the local job market?  Are people earning enough to sustain the rental rates you’ve researched?

o   Is there a local building boom bringing new supply of real estate to the market?  This might be a sign of unsustainable supply, which will apply downward pressure on rental rates.

Armed with this information, we can now look at a hypothetical example.  I will use the following as my numbers:

·         Rental rates for a 2,100 square foot, 3 bedroom, 2 bathroom property are about $2,200 per month.

·         Operating expenses are about $4.52 per square foot for a total of about $9,500 per year.

·         The local cap rate is 6.5%

·         Your area looks stable, with moderate job growth, some higher wage jobs coming to the area to help buttress support for rental growth, and reasonable municipal finances for stable real estate tax outlook.  Water and Sewer taxes, however, may rise in the coming years to support upgrades to the county storm system.

With this information, you make the following calculations:

1.    Annual rent: at $2,200 per month, annual rent is $26,400 per year

2.    Annual operating expenses: given above, these are $9,500 (this includes real estate taxes, repairs and maintenance, utilities, and other basic expenses)

3.    Net operating income is $16,900 per year (this is the annual rent from the first calculation, minus the annual operating expenses from the second calculation—or $26,400 - $9,500)

4.    Valuation is $260,000, which is about 10X annual rent (this calculation is made by dividing the annual operating income from the third calculation by the cap rate of 6.5%—or $16,900 ÷ 6.5%. In other words, you expect to get an average return of 6.5% per year)

For this home, a price above $260,000 means you are better off renting.  This methodology is a good gut check, will force you to do some basic due diligence, and make some financial considerations. 

Regarding some considerations you might make, you may decide that a 5% return is reasonable, in which case this home is worth $338,000. If you go through this process, however, at least you've conducted research and thought it through in a structured manner. 

There are other valuation methodologies, such as DCF, which allow you to model factors like renovations, but they are superfluous in this example.  I also didn’t mention other, even more basic considerations, such as whether you plan on staying for a while.  This was only meant to introduce the concept of evaluating buy vs. lease decision and homes as investments.  Approaching home ownership in this way will help you make better decisions.