Valuing a property as a rental stream

[DerKaiser]

This may be news to some but there's a very simply formula to value an investment property based on it's rental income.

The formula is:
(Annual Rental Income less expenses)/(Total Investment return % - Rent Inflation %).

Example 1 (Ignoring Tax):

Assume rental income is €24000 p.a.
Assume expenses of €2000 p.a.
Assume you want a total investment return of 7%
Assume rent inflation of 3%

You should pay (€24000 - €2000)/(7%-3%) = €550,000

Example 2:

Assume you have a mortgage for €250,000 on the above property.
Your annual interest bill will be roughly €12,000
You will pay tax of €4,200 (42% on the €22,000 less €12,000).

The property is now worth (€24,000-€2,000-€4,200)/(7% - 3%) = €445,000 to you.

Example 3:

Assume you have no mortgage on the above property.
You will pay tax of €9,240(42% on the €22,000).

The property is now worth (€24,000-€2,000-€9,240)/(7% - 3%) = €319,000 to you.

 

[DerKaiser]

I don't have a view.
The current rental income less taxes and expenses will be objective for the property in question.
The total investment return is subjective, though most people will require a return above the current risk free return (i.e. > 5%)
The rental inflation percentage will depend on the market, but it is a long term assumption that should correlate with inflation in the long term

 

[DerKaiser]

Just revisiting this is changed times!

I found the idea of this article very interesting:

http://www.independent.ie/business/...r-bet-than-property-warns-expert-3036633.html

Basically Karl Deeter argues a 7%+ rental yield is required to match a 4% deposit rate.

Thinking about it, the 4% deposit rate will deliver a 2.8% return after DIRT.

A 7.35% yield gross of expenses might be 6% net of expenses, household charges, etc and will be taxed @ 52% to leave you with about 2.8%.

From my point of view, the glaring ommission here is future growth. If long term rents will grow at 2%, the rule of thumb above will lead you to avoid property investment until it is almost 30% undervalued.

Of course no one knows what long term rental growth prospects are, but if you are working off 0% the chances are your money will be left sitting on deposit forever and you will be guaranteed to miss opportune investments.

This is not really a comment on how house prices might move in the short or medium term, more a questioning of the overly (subjective) pessimistic attitude creeping into objective valuation techniques.

 

[DerKaiser]

Example 3:

Assume you have no mortgage on the above property.
You will pay tax of €9,240(42% on the €22,000).

The property is now worth (€24,000-€2,000-€9,240)/(7% - 3%) = €319,000 to you.

Just updating this for taxation changes only since 2007.

The income tax on €22k rental income will have risen by €2.2k and there are €300 extra in household charges (NPPR & household). These alsone would update the value to

(€24,000-€2,000-€11,440 - €300)/(7% - 3%) = €256,500

It's quite shocking to think that taxation rules alone should have caused a 20% fall in rental property value.

 

[jpd]

From my point of view, the glaring ommission here is future growth. If long term rents will grow at 2%, the rule of thumb above will lead you to avoid property investment until it is almost 30% undervalued.

Of course no one knows what long term rental growth prospects are, but if you are working off 0% the chances are your money will be left sitting on deposit forever and you will be guaranteed to miss opportune investments.

For a starter, you could assume rental growth in line with GDP growth + expected inflation. Assumning the ratio of home-onwers to renters stays fairly constant, this shouldn't be too far off the actual turnout over a long period.