How to Value Any Piece of Real Estate
When considering real estate VALUE, whether it’s a real estate stock or a property, there are two value rules:
- Don’t pay too much for the earth.
- Don’t pay too much for the business.
Don’t pay too much for the earth is simple.
For a real estate STOCK; Don’t pay more than a 10% premium to the market value of the properties. The second value rule regarding real estate investment advice is also simple: Don’t pay too much for the “business.” Just like a stock, look at the P/E ratio… a.k.a. the rent. While real estate prices can fluctuate in the short run, in the long run, property prices are significantly driven by rental values. If you look at the “Price-to-earnings” ratio of your property, you can learn about your property value.
As a good real estate investment rule of thumb, net rents in real estate (by “net,” I mean after expenses) have averaged about 1% above Treasury bonds (that’s the way it’s been with real estate stocks since 1990). The Treasury bond is at 5.15% as I write, so we might guess that the nationwide average net rent is 6.15%. (6.15% is the “earnings-to-price” ratio, so we need to find the inverse of it for the P/E of your property.)
How can you figure the P/E for your property? Forbes suggests the only real way to know:
“To get rental data for homes comparable to the one you’re buying or selling, check with the relocation department of big real estate agencies.” You’ve got to know what the comparable net rents are to your property.
This is all a very rough guide. Once you’ve figured your P/E, it may be very different from the current nationwide fair value P/E guess of 16. If your P/E is low, you may have gotten a good deal, or you could collect high rents from your place. If your P/E is twice as high as 16, my advice is that you ought to consider selling
The tricky thing about selling real estate is that real estate is not liquid. Unlike stocks, where we have the luxury of being able to sell whenever we want and the luxury of trailing stops to get us out exactly when we want out, in real estate, it’s not so easy. You unfortunately need to be a good guesser, because you actually need to sell into an “up” market, and buy in a down market.
While this can’t be done successfully on a regular basis, you can improve your chances considerably by doing what works in the stock market as well. The P/E ratio is our value indicator in our 1-2-3 Model in the stock market – and I found that you NEVER make money in stocks over the long run when the P/E of the market is above 17. While I don’t have the data on homes, the number may be very similar.
How To Invest Wisely in Real Estate
There are smart reasons to invest in real estate, and then there are dumb reasons. The truth is, for example, that we can’t know for sure whether what’s happening in real estate right now is the bottom of the market or not. Just like further down the road, after the dust has settled and people have long moved on past this financial crisis and its many causes and consequences, a new real estate bubble could very well form.
If you’re investing for the “right” reasons – and you know your risks – chances are your investment will be a good one.
Speculating versus Investing:
Buying a chunk of land and hoping it goes up in value is SPECULATING. Buying a property to collect high income in the form of rent is INVESTING. Investing is a much safer (and smarter) way to go.
Property Will Always Go up in Value:
Don’t believe this dangerous myth! Japanese real estate at the close of the century and American real estate today indicate that buying because “it has to go up” is one of the worst reasons to do so. Hoping for – or worse, expecting – a price rise is speculation. Make sure the investment makes great sense from a positive-cash-flow perspective first. Then if the property falls in value, you’re still “right side up” on your cash flows. Consider any appreciation to be simply icing on the cake when it comes to speculative real estate investing.
Don’t Believe Everything You Hear or Read:
Sellers and real estate agents ultimately want you to buy that property. So what they’re telling you is most likely the rosy scenario, not the actual scenario. If the property has been a rental, ask the seller for his Schedule E form from his taxes. It’ll show his ACTUAL revenue and expenses, or at least the ones he reported to the government. What you can expect to earn is somewhere between what he reported to the IRS and what he’s promising you.
Where To Buy:
There is – as you probably know – a widely held belief that the three most important factors involved in real estate success are “Location, Location, Location.”
Favorable investments are double-digit cap rates.” As an example, if you net $1,000 a month in rent on a $100,000 investment, that’s $12,000 a year, or 12% of $100,000. That’s a double-digit return that year or a double-digit cap rate. The catch is that this is NET rent or rent AFTER expenses. Some people in the business suggest that 5-10% is more likely, even after doing your homework.
There are no get-rich quick schemes here, simple real estate investment advice you’re not likely to get from the real estate industry.