The 'Property Price' calculator calculates a fair and reasonable price for today's market. It is based on the cost of the land and the value of the assets on that land, less any depreciatioon or repairs. It also takes into account more intangible things such as amenity and how much you love the property. The details are discussed further below. Once a value has been ascertained a quick and dirty comparison is made to what a reasonable price would be to make a decent return as an investment. The analysis that follows the calculator was written in May 2005.
Warning: This is for testing purposes only. There may very well be errors in the calculations. Use at your own risk. No liability is accepted for any losses arises from the use of the calculator.
You may also be interested in the 'Property vs Shares' calculator.
Today's fair value = $450,233.33
You should not buy the property at this price as an investment. It would have to come down $150,233.33 to $300,000.00 before it became attractive as an investment, assuming average rates of return.
Price = ((Land Area x Land Cost) x (1 + Amenity/9) + (Building Area x Building Cost x (1 - Depreciation))) * (1 + l/15)) - Repairs - Rent Per Week * Weeks of Repair
This formula starts from the basic presumption that a land with a property on it should cost the sum of the land alone and what it would take to build the house new. It allows for depreciation of the asset but requires that the house be livable (repairs) and acknowledges that getting it to a livable stadard will have a cost as well (weeks in lost rent). The formula also considers two more ephemeral variables: amenity and love. Amenity is proportional to the value of the land. Love is the ability to be irrational about a house and property before expenses are taken into account.
The calculator has been sanity checked on only a relatively small number of properties in the inner west of Sydney, Australia. However, we are relatively confident that it will translate to other areas. It is only as good as the data you put into it. ie. Determining property prices in your area and discovering the area of the building are the hard parts. Of course, the amenity and love aspects are completely subjective and different people will therefore rate a property differently.
The 'break even' price is based on Rent Per Week * 1000. This provides a very rough rule of thumb as what a reasonable price is for an investment property based on average rates of return. If you think that the property will grow fast (10%+ pa) then the rent is less important as a factor.
The basic components of the calculator are relatively straight forward and non controversial: land area, land cost, building area, building cost. Depreciation is a subjective rating. If a property is new it gets 0.0. Some work required: 0.3. Roapy:0.4. Showing its age: 0.5. Knockdown 0.4 or less. The more subjective areas of amenity and love is where it gets interesting.
Amenity includes closeness to shops, transport, universities, places of work, beaches, restaurants, swimming pools, etc, as well as the size and utility gained from the backyard and off street parking. Amenity is proportional to land because the value of the house doesn't have much weight when it comes to amenity. On a standard terrace block where the land may be values at $350 000 a top amenity component would equate to $40 000.
Love is the irrational component which comes into play mostly for owner occupiers as they must live in what they purchase so they may as well love where they live. This irrationality applies to the whole land and house package, no matter how dilapidated the house may be. It is therefore proportional to house and land and excludes the costs of repairs. The divisor was tuned to a value of 15 which was required to account for the hight prices recently seen. On a $600 000 property the love component would be around $40 000. At the height of the property market purchasers needed to 100% love the property they were buying if they were in with a chance. Even then they may have been out of luck.
Love can turn into hate when people begin to be wary of property as an investent. ie. Greed turns to fear. The love value can therefore swing to negative values.
In an over-priced market investors, who tend to be more rational (love=0.0), do the sums and see that it is not worth investing. The owner occupiers win out becuase they have high emotional attachment (love=1.0). At these crazy heights the actuaries at the banks put the squeeze on borrowers by limiting their borrowing capacity. The balance begins to swing back to a rent decision for the owner occuiers and properties start to sell at lower love values. Eventually the love value will start to become negative. Using this logic prices should be able to fall 13% (100/15*2) as all of the love leaves the market and fear has taken hold. I believe that the 7% fall we have seen from Late 2003 to Mid 2005 represents the love falling from 1.0 to 0.0. This would be the first stage of a 'soft landing' :) We may well see another similar fall over the next 18 months as love moves from 1.0 to -1.0.
During this time investors (and owner occupiers) start to see that the astronomic capital growth that they had seen will not last forever and that the return on an investment cannot be measured in capital growth alone. Pressure on the expenses side (interest rates and relatively low rent) and doing the sums will show that property has a way to fall even when there is no love in the market. Quick calculations based on a reasonable return indicates that prices will then need to fall 40% from peak prices before an investment property becomes attractive - assuming average rates of growth in property and income. There will be room for high rates of growth at the bottom of a cycle, however, with a less speculative outlook, this figure seems reasonable!
In order for prices to fall below the love/fear component of 13% there will need to be movements in the core components of cost of land and the cost of building of around 27% (40%-13%). Firstly the price of building is unlikely to fall far and will retard downward pressure on house prices, even when love has turned to hate. The price of materials and wages are unlikely to fall far and building costs would be quite resistent to swings in cycle. We are unlikely to see much of a drop in the cost of building new properties, even if builders do start to go broke.
The big falls will be in property prices. During the upswing of the cycle future capital growth would have been built in to the price of land and so prices will fall as land appreciates more slowly in the short term. If prices are falling then land prices will fall even more. Rough calculations predict that land prices will need to fall 35% to claw back the 27% differential to make a property profitable. Logic dictates that land prices would fall as soon as investors leave the market as empty blocks would be prized by builders. It would be an interesting exercise to track the price of vacant blocks of land an the degree to which the price moves during the economic cycle. I would guess that land prices would fall before love does but may well be slower to bottom out than love. Love is based on herd behaviour and moves quickly. A very quick search of the net revealed a study that reported that land in cities can vary 18% ((1.7-1.4)/1.7) depending on the economic cycle.
So, by the time the land (and building prices) bottom out we will may well have seen a pickup in the love component. Investors and owner/occupiers will be looking for quick growth in the short term and so we may not see a complete bottoming out where love and land prices are simultaneously low. So taking a rough guestimate a combined fall of 25% from the peak may be as bearish as you would like to go. But you never know. If things get bad and fear rules we may see land prices unravel fully and fall the full 35% resulting in a total fall of 40% from the peak. That certainly is a lot further than the 7% we have seen so far. Stay tuned.
One retort to this analysis is that for certain properties there will always be love and by extension certain areas will be loved. If there is enough love then it is unlikely that these areas will be rented and will be occupied by owners in the medium term. In this case the suburb has been gentrified. There is little point in applying a rental analysis to prices for houses in that suburb.Another reply is that Australians love their property and that there will always be a love component in a ones's 'castle'.
Here are a few random land prices for Sydney suburbs after searching on domain.com.au. Take them with a grain of salt of you wish. There can be considerable variation on larger blocks as the price gets cheaper as the size increases. Also, there is an amenity component built in. In the end it is up to you to take a best guess at the value of the land.
If you have any feedback please feel free to send it to me. This is just a personal project of mine done in my spare time. Much of it is based on deductive reasoning. My assumptions, if wrong, will lead to bad outcomes. I may have made some obvious or not so obvious errors or oversights, in which case I'd be interested to hear you views. Hopefully the calculator was helpful to you. Please get in touch with me, Murray, at this email address: mwoodman-at-hotmail-dot-com. Cheers.
The 'Property vs Shares' calculator is intended for illustrative purposes only. It should not be relied on for investment advice of any kind. The site's owner, Murray Woodman, will not be held liable for any loss resulting from the use of the calculator.