Tuesday, May 5, 2009

Another way to value a house

In this post http://fishyre.blogspot.com/2009/04/here-it-is.html I compared renting versus buying, as one way to try and value a house.

However it does imply two things, 1) that you have money to pay down a mortgage. If not, it is much cheaper to rent the same property than to buy it. 2) that you have security of income stream. If not, having to sell under duress could be financially disastrous.

However, if I was an investor, I would be evaluating the price by slightly different metrics. As I mentioned, these mirror, but are not the same as the rent/buy comparisons.

Cash flow negative, neutral or positive?

OK time for some explanation. Every property is cash flow positive if you buy with 100% down! So these terms are relative. At what % of down-payment does the property become cash-flow positive. 10%, 25%, 50%?

During a boom, investors are more likely to buy properties which are only cash flow positive with high down-payments. It means they often 'top-up' the rent to pay the expenses, but expect to gain on a robust rental market, and with capital gains.

Rents go up by inflation or more, while the mortgage is being paid down, so properties that start off being cash flow often negative end up being positive after a few years.

In a recession the opposite is true. Rentals are weak, renters may fall behind, and capital gains cannot be counted on, in fact the property maybe dropping in price and will need repairs etc.

In this case I would want to see a the property cash-flow neutral or positive with a very small D/P at purchase.


I don't think this is the average recession. If it was, we would not be sitting at near zero rates and the politicians and central bankers would not be saying, with fear in their eyes, 'we must prevent a depression', before the recession had even started.

This may be one of the few times in history when renters can negotiate no increase or possibly even a rent reduction, when their lease comes up, as the economy softens.

I have just negotiated my house and commercial lease with zero increase for the coming year. And in case you think I am so smart (I am not) I could leave and get into comparables for both 5-10% cheaper. Had I done a bit more market research before I signed the lease extension, I may have got a better deal.

So imagine you are an investor and your renter wants a rent reduction. The alternative is to try and rent it our again in a softening market, with possibly other concessions too. In this instance, a cash flow positive property can become cash flow negative!

So if I buy something now:

1) I would have to be able to carry it without suffering too much, if the income drops or disappears...ie if the renter falls behind, or leaves after missing several months of rent, or it cannot rent quickly, or the market dictates a lower rent.

2) I could handle a reasonable increase in interest rates. No one can foretell where rates will be a year or five from now, but they are remarkably low now. So if the property cannot cash-flow at these rates, then you are unlikely to get much benefit from lower rates in the future.

Incidentally the investor will need to make provision for repairs and special assessments AND the very real possibility of increased property taxes after the Olympics.

While an owner may shrug these of as the cost of owning, for an investor these added expenses reduce, or in some case can completely obliterate his/her returns.

Therefore the deal for an investor has to be significantly better than the rent/buy comparison particularly in a softening market and recessionary environment.

BTW: another great post by Mohican which must not be missed: