A Different View: Another Way to Value Your Home

Bruce Freedman in Mortgage and Finance

Editor's Note: "A Different View" is a periodic series in which guest bloggers are invited to share new and differing views on all things real estate.

Bruce Freedman guest blob For most Canadians, their home is by far their largest investment. That said, most new home buyers don’t actually do much in the way of valuation analysis to ascertain whether they should buy this largest investment. Instead they focus on “affordability” and the ever popular “hardwood floor-to-crown molding” ratio.
Imagine if your broker used affordability as a reason to buy a stock.

Imagine this conversation:

Broker: “Ahhh. I just picked up 100,000 shares of Acme stock for you at five dollars.”

You: “Really? That’s $500,000! I’ve only got $50,000 in my account. And this stock has risen so much! What’s the valuation look like?”

Broker: “Huh? Valuation? What do you mean by this word “valuation?” I never heard such a question. The stock trades at five dollars. I bought your shares at five dollars. Five dollars is the valuation. Right now. But it’s going higher. The price has been rising for years and analysts, banks, politicians, property agents & taxi drivers expect it to continue to rise. Particularly if people like you continue to buy. Don’t worry about the price. I arranged a $450,000 loan for you to cover the difference. Don’t worry about the loan either. You and your wife earn good incomes and can afford the loan payments. Especially if we assume that interest rates remain at all-time lows — for the next 30-40 years.”

When an investor looks at an investment — any investment — as part of their due diligence, they should value it against its alternatives — both alternatives within the same industry and alternatives in other industries/asset classes. After all, greed knows no boundaries — it’ll eventually chase out the best returns.

When investors evaluate stocks, a popular valuation tool is the Price/Earnings ratio (P/E), which measures share price relative to earnings per share (EPS). For example, a stock with a share price of $40 and an EPS of $1 would have a P/E of 40x. The inverse of P/E is earnings yield (EPS/Price), which in this example works out to be 2.5% ($1/$40). Is an earnings yield of 2.5% attractive? It depends on several factors: the growth of the earnings, the dividend payout, and of course the alternatives. An earnings yield of 2.5% might be attractive relative to other stocks in the same sector. But if risk-free government bonds were yielding 10%, then 2.5% on a risky company might not look so good.

Which brings us to property valuation. Professional investors’ favorite valuation metric for commercial property is “cap rate” which (not unlike earnings yield) measures a property’s net operating earnings relative to the price. (You might argue that it’s more akin to dividend yield than earnings yield, but that’s a different conversation.) Property cap rates tend to be correlated to interest rates and vary across sector. For instance, according to Colliers International’s latest report, 2Q10 Cap rates for Toronto downtown Grade A office ranged from 6.75-7.50% while multifamily low rise apartments ranged between 5.50-6.25%.

I bring this up, because even though I have found no reliable data on housing cap rates, all anecdotal evidence suggests that Canadian housing cap rates are far lower than commercial cap rates. In Toronto, based on my own observation, I’d put them at no more than 3-4%. Obviously, there are tax savings and considerable intangible benefits to buying a home, but does it offer an attractive return on investment when cap rates are lower than you could potentially earn from apartment buildings, Government bond yields and the dividend yields of property-exposed bank stocks and REITs? Especially if interest rates do indeed go up.

The fact that most home buyers don’t look at cap rate or buy a home with the intention of renting it out is beside the point. Whether you choose to live in your house or rent it out is irrelevant. You are saving rent by living there, and your property is implicitly earning the rent that you would otherwise have received, were you somewhere else.

Bruce Freedman is a consultant specializing in communications
strategy for the financial sector. He currently resides in
Toronto, after 15 years in Hong Kong where he worked as a hedge fund manager
and top ranked equities analyst.
(An earlier version of this article was originally
posted at www.weighhouseblog.com)
Email Bruce

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