How to tell
if a property is overvalued
In the wake of the incredible house price boom
witnessed in most of the developed world over
the past decade, a lot of ideas have sprung up
as to how to value a house 'fairly'. The reason
for this is that traditional methods, such as
working out house prices as a multiple of
salaries, or perhaps mortgage affordability as a
percentage of income, seem to have 'stopped
working' recently.
There can be no doubt that house prices are ..
ahem! .. at the top end of their range compared
to traditional valuation methods, but don't let
anyone fool you that this is now the 'norm', or
that a 'new paradigm' is in place. Such talk
rightly marks the climax of an asset bubble, as
witness the dotcom bust as the millenium rolled
over. Many things can change as technology and
societies develop, but basic human nature isn't
one of them, and the twin drivers of any asset
bubble, fear and greed, are rather depressingly
evident in this bubble too.
So if you live in an area where houses are
trading at, for example, twice the historical
sustainable relationship to salary, how can you
tell whether this is 'ok' or 'bad'? Easy. There
is one relationship that has stood the test of
time and wheathered all previous house price
booms and busts - the relationship betwen the
house as an asset, and the return on that asset.
What do we mean by this? Any asset has a
'return' - what you make for holding the asset.
Houses traditonally 'return' in 2 ways - by
capital appreciation (house price growth) and by
rent (if you own a house, you could rent it
out). As it can be difficult to create a simple
equation that factors in both these elements
indivdually, they are usually rolled together,
to give an easy way of comparing the required
sale price of a house against it's 'true' worth.
Is it complicated? No. It's simple. If the price
of a house is 12 times or less the annual rental
income you can achieve from that house, then it
is a 'buy'. A good investment in other words.
These levels were last seen in the UK almost 5
years ago, and in the US over 3 years ago.
Conversely, if the price of a house is 20 times
or more the annual rental income you can achieve
on that house, then it is a definite 'sell'.
As an example, say you want to buy a house
priced at $100,000. You know that the house
currently rents for $10,000 a year. According to
the calculation, the house will be a 'good buy'
up to 12 x $10k, i.e. $120,000 , so in this case
yes, it is worth buying now, as you are likely
to both cover the mortgage costs with the rent,
or even make a small profit on it, and also
benefit from any coming capital growth.
Another example, you own a house that rents out
at $20,000 a year in a swanky neighborhood. You
notice that identical houses in the street are
up for sale (and selling!) at over $500,000.
Guess what - it's time to sell - the house is
over 20 times more expensive than the annual
rent! Chances of any more capital appreciation
in this market are slim, and you can actually
make a far better return by simply selling the
house and putting the proceeds into an interest
bearing bank account. Interestingly, most
amateur investors tend to hold property rather
past this point, and end up unable to sell as
the market tips to the downside. If the figure
of annual rent to price is already way past 20,
you may be too late to sell easily.
Not as complicated as it seems, is it? Just
remember the '12 - 20' rule, and you should be
able to enter an exit the house market at the
very best times.
This article is the property of
www.1st-in-homeloans.com, which has been
offering home mortgage services since 2002. To
find out more visit
www.1st-in-homeloans.com
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