value of property

Many financial advisors consider that house property where one lives is not an investment. This is because the house is not going to be sold at all as the family lives in it. Great. They also advise that since the property has annual payments such as taxes and maintenance to be made, that should be included as a liability. Super. The value of the house would not be part of one's net worth. 

What if there is an investment made in an equity instrument, which the investor inherited from parents, and does not intend to sell ever, but wants to pass on to the children? Going by the earlier logic, the investor who owns shares of Coke, which are planned to be passed on to the next generation, should not include them in the calculation of net worth. 

Let's fix that conception. Any item that has value in the market should be included as part of net worth. Even car, expensive watch, etc. can be included. However, as a cautious analyst, I do not include any asset whose value depreciates over time. So the car goes out. I don't like the idea that an expensive watch has any meaningful value. I don't have the stupid habit of buying watches anyway. The more assets without having cash flows one owns, the more speculative the net worth becomes.

Back to the property. Even when the investor has only one house property where the family lives, and intends to live forever, there could be occasions where the family may decide to sell. This may be due to cash problem, or may be due to the idea of cashing in. When the property price becomes quite high in the area, the investor may decide to sell and move to an area where the price is low. Of course, house property is part of your net worth. 

Value of the property: Most buyers of house property do not think about its value. For them, the value and price of the property are just the same. I don't blame them per se, especially in India, where if someone really looks at the value of the property, it is difficult to buy at all. Nevertheless, it makes sense to at least understand the gap (the premium) that is being paid when it is bought. 

Value of any cash flow generating asset is the present value of all cash flows discounted at an appropriate rate. House property is not an exception. The cash inflows are rents, and cash outflows are taxes and maintenance. The value of the property is then the present value of annual net cash flows attached to the property. That is true even when the family intends to live in the house because if not, the investor would have rented the property. 

Let's consider an example. An apartment with annual rentals of Rs.360,000 has a market price of Rs.17.50 m in a suburban Mumbai. The annual costs are minimal; so I will ignore them in the calculations. That is a rental yield of just 2%. What the market is saying is that any expectation above that rate should come from the market itself. The 10-year government treasury has a yield of 6.50%. So to match that, the market price has to appreciate by 4.50%. It is a bit simplistic because there is growth in rentals too. Yet, if the investor wanted 6.50%, government treasuries would be the option, not house property. The expected rate of return for the property is some points above that rate. 

Assuming that rentals will grow at 7% annually (they may not if inflation remains lower) for the next 10 years, and after that they will grow at 5% on perpetuity (they may not), we have all the cash flows available to bring them to the present value. The value of the property now is a function of the expected rate of return. 

At the market price of Rs.17.50 m, the investor will get 7.562%. If the expected rate of return is 10%, the buy price has to be Rs.8.83 m, a markdown of 50%. There is no question that the market price would go that far down in Mumbai. At least they have not so far. That is why I consider that rentals and property prices in India are not aligned. To have an expectation of a reasonable rate of return, either the rentals will have to go up, or the prices will have to come down. Neither has happened in the past 20 years or so that I have seen. 

So what will the investor do? Owning a house is always a dream; so it is easy for the investor to make the decision. Just look around and track a few properties. Buy the one that is most liked in terms of its design as a trade off with the market price. The investor and the family moves in. There is no time to think about intrinsic value of the house property. 

There is another way of calculating value of the house property, It is how most equity analysts calculate the value of stocks. Take the cash flows for 5-10 years, and plug a multiple for the stable growth value.

This is how it works for the house property. All cash flows for the 10 years remain the same. Year 11 value is the expected sale price of the property. The value (is that price?) of the house property then becomes a function of both the expected rate of return and the expected sale price at year 11. 

If the investor reckons that it will be sold for say, Rs.27.50 m, the value of the property becomes Rs.13.70 m at 10% expected rate of return. At the market price of Rs.17.50 m, the investor will have to sell the property for Rs.37.34 m in year 11 in order to get a rate of return of 10%. With all the speculation about market prices after a decade, it becomes murkier. 

There isn't much choice for the investor. A better gamble would be this: Buy the property at the market price, with limited application of timing (i.e. buy when the prices are generally lower); live until the working life; upon retirement, sell the expensive property and move to a place where the prices are more reasonable on a relative basis.