As long as a property can generate rental income, it’s going to be worth something. You can use this fundamental to get an idea of the price floor, or the lowest the value of a house could fall to.
What a property is worth as an investment depends upon a number of factors, the most important
being the yield or Cap rate an investor would expect.
Capitalization rate, or commonly referred to as Cap rate is the term for the return or yield an investment generates based on the amount of capital invested, expressed as a percentage. For example, an investor has one million dollars of capital at work in a property and that property generates $100,000 per year in net rental income, after expenses, but before debt service. The Cap rate for this property would be 10%. (I.e. $100,000 divided by $1,000,000 equals 10%.)
The important thing to remember when calculating Cap rates is that Cap rates are calculated using the net income the property generates after operating expenses, but before debt service (mortgage payment). So the Cap rate is a measurement of how the property performs whether the capital is provided by a lender or by the owner of the property.
There is an inverse relationship between Cap rates and property values. When Cap rates rise, property values fall. When Cap rates fall, property values rise.
To use the calculator you simply enter the information asked for in the boxes. The calculator will ask for monthly inputs and calculate them to annual figures. If you don’t have a number for vacancy allowance, we suggest using 5%.
The calculator will calculate the net rental income after operating expenses, but before debt service. This net rental income is the number that the Cap rate will be divided into to determine the value of the property as an income asset.
The Cap rate that you select is going to have the most influence on the value of the property. There are a number of factors that influence Cap rates. As a general rule, use a cap rate that is three percentage points above the going rate for a 30 year fixed mortgage. So if the going rate for a 30-year mortgage is 6%, a Cap rate of 9% would be realistic. If you want to use a more exact number to use as a Cap rate, ask a real estate investor in your local market what Cap rate they would require if investing in a property like yours.
A higher Cap rate of an additional three or four points would not be unrealistic if the property is considered risky or the management of it is labor intensive. A lower Cap rate of 1-2 points lower than 3 points above the going rate of mortgage rate could be reasonable if the stream of income is stable, safe and the management of the property is simple and not labor intensive. An example would be a long-term lease from a Fortune 500 company or government entity where the tenant pays expenses.
With the Cap rate selected the calculator will now divide the Cap rate into the net annual income to arrive at a value of the property as an income-producing asset. The figure you are seeing in the green shaded area next to arrow is what the property is worth as an income-producing asset.
Check this fundamental
The calculator will provide you with the value of the property as an income asset.
Any amount above this value would be considered a premium. There are two possible premiums that some would argue could justify the property is worth more than its value as an income asset. Some would argue premiums are justified when the property is used or could used as a personal residence.
1. Premium for tax benefits
2. Premium for ownership
1. Premium for tax benefits:
The interest portion of a mortgage payment is deductible and so are property taxes. Some would argue that this subsidy enables homeowners to justify a higher price when using a house as a personal residence. If you go along with this argument, then you can adjust the value the calculator provides with this calculation.
Here’s the math:
To get the possible premium value when factoring in tax benefits, multiply the investment value by 90%. (This assumes a 10% down payment and 90% mortgage.) Add 100 to the federal tax bracket the likely buyer of your property would be in. There are five federal tax brackets ranging from 35% to 15%. Add 1 to the decimal equilivant of the tax bracket you want to figure. (I.e. Add 1 to the 28% tax bracket you get a figure of 1.28.) Take this number and multiply by the 90% figure and then add back the 10% down payment and you'll have the premium value of the property when factoring in tax benefits.
2. Premium for ownership:
Homeownership provides other non-monetary benefits other than just shelter. These benefits could include the freedom to do with the property what you want without landlord permission; the piece of mind knowing that your payments are known and someday you’ll be done with payments; the pride of ownership; the satisfaction of having a place to call your own; a home to raise a family; a place to make memories. There are numerous other non-monetary benefits.
These benefits vary from person to person and family to family and can change in the same person as their life style changes. For instance a twenty-three year old, single person may not value homeownership near as much as a 35-year old married couple raising children. These same people may change the way they value the homeownership when their lifestyle changes. For instance the foot loose and fancy-free single person may someday decide to settle down and get married and desire a family. Now, to this person the benefits of homeownership have increased considerably.
This is a personal question that can only be answered by each person or family individually. One of the valuable pieces of information from this exercise is if you are a potential home buyer once you calculate what the property is worth from an investment standpoint, you can isolate exactly how much the premium is for ownership on a particular house or property and decide for yourself if it's worth it to you.
Consider the value of the property as an investment the downside or about as low as the value of the property could fall, all other factors being equal.
If you’re an owner or potential seller, with the information from this exercise, you'll know your home value can only fall so far before it would make sense for investors to purchase it as an income producing asset.
Click here to check Home Price Floor Fundamental™
Click here to check Home Price Ceiling Fundamental™