Valuation of property? Not market value

[FillSpectre]

Hi,

I hear lots of people saying the fundementals of investement are been broken and saying rents need to be higher for some of the incvestment properties to be worth it. Putting it intot reverse if you get 31K a year in rent how much would it be sensible to value its worth.

 

[JohnBoy]

there are lots of variables to consider. You need to post some more details here in order to get better answers. Instead of considering proiperty in isolation you ought to see what your capital could potentially earn elsewhere. Take the risk-free rate of 3.5% (long term bonds) and add a couple of percentage points to that to compensate yourself for the increased risk that property entails.

Davy's produced a report last March (I think) highlighting the disparity in rental yields on residential property in Ireland and the earnings yield in the Irish ISEQ. I think that the ISEQ's earnings yield was 7% then so using this argument you ought to try to secure this property for €443k (a gross yield of 7%).

I would hazzard a gues that the asking price is at least 2x/3x this...

 

[FillSpectre]

I think you misunderstand. If I have a property earning €31k what it the advisable amount to buy it for with good buisness sense. It is not about can you get better money just what is the standard business model.

What is the maximum that should be paid for the property assuming a mortgage. I want to compare it with market price.

It isn't my property

 

[money man]

sorry fill spectre its just the way you have phrased you question. if i had a property earning 31k a year i wouldnt buy it ( because it was already mine!!)
anyway if you want to base the valuation of a property purely on yield then the industry standart is usually 5-6% which would value the property at 516k to 620k. there are so many variables though that this would be a very silly statement in isolation.
very important is the quality of the tenant (accounts will show this generally), term unexpired on the lease( no of years left to run on lease), terms of the lease ( upward only rent reviews?/full repair and insure?/how frequently reviewed/etc)
hope value( potential development of the site)
location(pretty basic) and all the other usuals that go with any property. I think a valuer/bank would prob value this at around 800k and thats prob around what it would sell for. if not then im sure that all is not as it seems.

 

[FillSpectre]

If the sensible valuation is 516k-620k why do you think the bank would value it at 800k?

There are loads of property factors in purcahsing for potential increases. I often think people over estimate high quality tenants as they require more maintenance which doesn't actually mean more money and less hassle.

 

[money man]

a landlord with experience and a good solicitor will usually get a decent-good tenant to sign a full repairing and insuring lease meaning that they pay for /carry out all repairs/maintenance and the cost of insuring the building! and a service charge if the building is split up and shares facilities. i dont see how a good tenant could be more hassle.

 

[money man]

as you say also . there are loads of other factors /variables in purchasing a property and therefore a valuation cannot be based purely on rental income ( answer to ...if the sensible valuation is xxx then why do you think that the bank would value it at 800k) the answer is basically in your next sentence.

 

[JohnBoy]

i would still stand by my first post. As a business you are borrowing at say 3.5% (with rates expected to rise further) so you ought to be looking for a return several percentage points above this at least.

The standard business model would be to compare the return (€31k annually) with the total amount of capital invested. Given that you will have a mortgage you will require a return above your mortgage rate. I would suggest 3% as a minimum. Hence you should look for the investment to return 6.5% as a minimum - give that you already know the return (assuming full occupancy) then you can work backwards to calculate what to pay.

 

[JohnBoy]

the bank are valuing it at 800k because a lot of investors in Irish property at present are foregoing yield in expectation of continued capital appreciation. On €800k you would barely cover your mortgage - and this assumes full occupancy.

 

[money man]

When you find a commercial property with a 6.5% yield and a good tenant will you send me a pm. thanks. Your example has not factored in potential for capital appreciation. would you expect the property to be valued at the same amount in 10 years?? if you put money in bank and get 3% what purchasing power will it have in 10 years time ?

 

[FillSpectre]

a landlord with experience and a good solicitor will usually get a decent-good tenant to sign a full repairing and insuring lease meaning that they pay for /carry out all repairs/maintenance and the cost of insuring the building! and a service charge if the building is split up and shares facilities. i dont see how a good tenant could be more hassle.

I never said it was a commercail property it is actually residential so that is why high maintenace tenants can actually be more hassle than they are worth. People paying top dollar expect everything to be perfect so they call a lot and expect faster the reality fixes.

Hence you should look for the investment to return 6.5% as a minimum - give that you already know the return (assuming full occupancy) then you can work backwards to calculate what to pay.

Well that is the bit I want to be sure of on the formula. You can add in a vacancy rate to be considered. I also want to consider the ownship at the end of the investment which seems to get missed somewhere. Rent tends to moove with inflation and at some point you aren't paying a mortgage.

 

[JohnBoy]

also bear in mind that you will be unlikely to find any residential property in Ireland with a gross yield of 5% or more. By using my numbers you would not buy this property but as moneyman has pointed out, capital appreciation is not included in my figures but i am a cautious investor - you may not be.

yes rent tends to move with inflation but not in Ireland in the past few years. As interest rates increase I would be cautious on how much more rent you can squeeze out of tennants when rents are probably still falling in real terms.

 

[FillSpectre]

If the ownership is not being considered foregeting about appriciation just the fact you only get 6% rental yield means little later on when you own the property. How do you consider this in investment caluclation

 

[JohnBoy]

that depends on the length of the mortgage. If you reckon that you will own the property outright in say 25 years time then you need to discount the terminal value (value of property in 25 years time) by an appropiate discount rate to get the present value. Compare this to the total cost of the mortgage over its full term and the difference is your net return. Choosing a discount rate is very tricky as you will find that the present value will move a lot for relatively small changes in the discount rate because you are trying to value an asset in 2031. In addition, you have to predict property prices 25 years out - no mean feat.

the value of any investment is a function of the income that it generates so you should concentrate in the €31k rental income as a basis for judging this investment. If you were to pay €800k for the property (with say 10%) down then the net income would be barely positive so it all rests on what you think that place will be worth when you own it outright (less CGT of course).

 

[SkepticOne]

It is very good that this sort of question is being asked.

FillSpectre,

I think we are overcomplicating with the issue of the mortgage. Essentially we want to see whether properties are overvalued with respect to other possible investments.

The fact we are borrowing money to buy it makes no difference. A car or a TV is worth a certain amount whether or not we have borrowed money to pay for it. Whether it is worth getting a loan out for is another matter. First we need to find out how much it is worth.

We are really talking about the value of an investment that produces 31k a year and maintains its initial capital in real terms. For the purposes of the excersise, let us assume no capital appreciation or depreciation. We want to remove price speculation from the equation.

So how much is that worth? Really the only way to assess this is to look at alternative traded investments and then compensate for risk if necessary. I would go along with JohnBoy's estimate here.

Other refinements I think would include the effect of inflation, buying and selling costs of both the property and the alternative investment, tax etc.

Now as to the mortgage:

If the sensible valuation is 516k-620k why do you think the bank would value it at 800k?

I would imagine that the bank is mainly concerned with two things:

1. Your ability to pay the mortgage (they may take any number of things into account not just rent on the property)..
2. The market value of the asset they can reposess if you fail to make your payments.

The important thing to remember here is that the bank is not making the property investment. You are making the investment. The bank is not concerned terribly whether it is a good investment so long as they get their monthly payments. If you don't pay then they can reposess the property and sell it at the market price at that point in time.

Perhaps they should be more concerned with fundamental values, however. In the event of a correction, what they can sieze would be so much less than what people are currently paying for properties, They could also compensate for this risk by charging more interest, of course.

Hope this helps.