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.
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.