Buying a home is a big decision and it’s important to separate the financial part of the decision from the emotional part of the decision. Otherwise, strong emotions may trigger confirmation bias around price.
There are three generally accepted methods for valuing a home: comparable sales, cost, and cash flow. Comparable sales considers recent similar sales in the area. Cost considers the raw replacement value of the home (what it would cost to build today). Cash flow considers the potential cash flows generated from the home if it was rented for income.
Comparable sales is the weakest of the valuation methods, because it’s strongly correlated with prevailing conditions in a bidders market. A few bad decisions can quickly ratchet up comparable sales estimates to ridiculous levels (see the recent United States housing bubble). It’s best to ignore this method completely or at least discount it heavily.
Cost is a sound approach, but, it assumes the value of the home is directly related to what it costs to build today. This isn’t a problem if you plan to hold the home forever, but if the home is ever sold, the price will likely be determined by a market, and most bidders will not consider the building cost.
Cash flow is the gold standard for valuing any financial asset, and is therefore the best approach. Let’s work through a simple “back of the envelope” calculation for valuing a home with the cash flow method.
Using the cash flow method
First, you need to estimate a conservative rental value for the home. It’s important to consider and adjust for any temporary external factors (like tight rental supply) that may be inflating rental values in the area. Some basic rental searching or a local property rental agency can help you with determining a conservative estimate.
Let’s assume you’ve determined that the home you’d like to buy would conservatively rent for around $2,000 per month. That means you could generate $24,000 per year in revenue from the home. Keep in mind, revenue is not income. Let’s consider the associated expenses:
- Mortgage payment
- Property tax
- Insurance (plus a landlord insurance premium)
- Repairs (about 5% of rent)
- Property Management (about 10% of rent)
Add up all of the yearly expenses and subtract them from the yearly rental revenue. Now consider the result:
- Positive value: You would earn income renting this home.
- Negative value: You would lose money renting this home.
- Zero: You would break-even renting this home.
The break-even price is important. In fact, it’s worthwhile to calculate the break-even price by adjusting the home price (and consequently the mortgage payment) lower or higher. Once you’ve determined the break-even price, think of any additional cost as an “ownership premium”. For example, you determine the break-even price is $200,000, but the home costs $250,000. Your ownership premium is $50,000. Keep in mind, there is nothing wrong with paying a premium. You may have many good reasons for doing so. But, don’t kid yourself and also say you’re making a good investment.
When is it a good investment?
Let’s do another quick calculation to determine if this home might be a good investment. Remember, for the home to really qualify as an investment, you’d need to be earning income (revenue - expenses >= 0) from renting it (see above).
To calculate the rough leveraged IRR (internal rate of return) on the investment simply divide the income by your down payment. So, if you purchase the home for $200,000, put down 20% ($40,000), and generate income of $5,000, your IRR would be 12.5% ($5,000 / $40,000). Here’s a rough scale for thinking about IRR in a normal interest rate environment:
- Home run: 15%+
- Very good: 10%+
- Average: 5% - 10%
- Mediocre: 0 - 5%
This quick approach doesn’t consider potential appreciation in the value of the home, but that’s intentional. Buying a home in the hopes of it appreciating is usually more speculation than investment. It’s much safer to look at any appreciation as icing on your already good investment cake.
But what is it worth?
This method doesn’t give you the exact value of the home. Instead, it focuses on determining if you’re paying a premium or if you’re getting a good potential investment. It’s a calibration exercise that should help you rationally evaluate the financial sense of the deal.