Tuesday, May 5, 2009

Another way to value a house

In this post http://fishyre.blogspot.com/2009/04/here-it-is.html I compared renting versus buying, as one way to try and value a house.

However it does imply two things, 1) that you have money to pay down a mortgage. If not, it is much cheaper to rent the same property than to buy it. 2) that you have security of income stream. If not, having to sell under duress could be financially disastrous.

However, if I was an investor, I would be evaluating the price by slightly different metrics. As I mentioned, these mirror, but are not the same as the rent/buy comparisons.

Cash flow negative, neutral or positive?

OK time for some explanation. Every property is cash flow positive if you buy with 100% down! So these terms are relative. At what % of down-payment does the property become cash-flow positive. 10%, 25%, 50%?

During a boom, investors are more likely to buy properties which are only cash flow positive with high down-payments. It means they often 'top-up' the rent to pay the expenses, but expect to gain on a robust rental market, and with capital gains.

Rents go up by inflation or more, while the mortgage is being paid down, so properties that start off being cash flow often negative end up being positive after a few years.

In a recession the opposite is true. Rentals are weak, renters may fall behind, and capital gains cannot be counted on, in fact the property maybe dropping in price and will need repairs etc.

In this case I would want to see a the property cash-flow neutral or positive with a very small D/P at purchase.


I don't think this is the average recession. If it was, we would not be sitting at near zero rates and the politicians and central bankers would not be saying, with fear in their eyes, 'we must prevent a depression', before the recession had even started.

This may be one of the few times in history when renters can negotiate no increase or possibly even a rent reduction, when their lease comes up, as the economy softens.

I have just negotiated my house and commercial lease with zero increase for the coming year. And in case you think I am so smart (I am not) I could leave and get into comparables for both 5-10% cheaper. Had I done a bit more market research before I signed the lease extension, I may have got a better deal.

So imagine you are an investor and your renter wants a rent reduction. The alternative is to try and rent it our again in a softening market, with possibly other concessions too. In this instance, a cash flow positive property can become cash flow negative!

So if I buy something now:

1) I would have to be able to carry it without suffering too much, if the income drops or disappears...ie if the renter falls behind, or leaves after missing several months of rent, or it cannot rent quickly, or the market dictates a lower rent.

2) I could handle a reasonable increase in interest rates. No one can foretell where rates will be a year or five from now, but they are remarkably low now. So if the property cannot cash-flow at these rates, then you are unlikely to get much benefit from lower rates in the future.

Incidentally the investor will need to make provision for repairs and special assessments AND the very real possibility of increased property taxes after the Olympics.

While an owner may shrug these of as the cost of owning, for an investor these added expenses reduce, or in some case can completely obliterate his/her returns.

Therefore the deal for an investor has to be significantly better than the rent/buy comparison particularly in a softening market and recessionary environment.

BTW: another great post by Mohican which must not be missed:



  1. Thanks for the detailed explanation.

    I would think there is another concern with current situation to invest in RE - inflation risk management.

    Some trillion dollars printed out of thin air will eventually lead to inflation. I believe that is one of the main reasons that the assets are going up for the recent 2 months. When

    - china cancels us credit card
    - bernanke prints more money for the banks bailout

    will us dollar crashing? dragging canadian together?

    Just some thoughts.

  2. CZ I agree that assets are a great way to shield from the massive inflation we could see in the next 2-4 years, but I dont think real estate would be a good choice.

    Unlike things traded on the stock market which can swing up or down 25% in a matter of a few days, real estate takes years to change that much in value. This is mostly because it takes months to complete a sale, while on the stock market it can be done in minutes.

    Since real estate was greatly inflated before, and has not fallen nearly as much as the stock market has, even with the recent recovery, I would say real estate is still over priced. Somewhere that has cheap real estate now would probably be a good idea (see America) but then you either have to rent it out, and I hear that's tricky for a Canadian, or just leave it sitting there.

    So anyway, commodities are good protection from inflation, but something like real estate in vancouver probably isnt a great idea for investment purposes alone.

    And i am no economist, but isnt Canada's economy based quite largely on commodities compared to other countries? So that's probably a good sign for a faster recovery once the world starts buying things again?

  3. CZ- I think inflation is still a way off. So far we have had deflation, dropping values of nearly all assets and products.

    It probably will come, but I am not betting on it appearing any time soon.

    All property has to be supported by rental income or mortgage payments- both are ultimately supported by income stream.

    We are in a situation where both of those are under pressure.

    The Central banks have dropped rates to historic lows which will help, however the fear or reality of lack of income stability is likely to prevent aggressive buying at these still inflated values

  4. Sorry CZ, but the idea of the housing market benefiting from inflation any time soon is, well...kind of rediculous.
    First of all, the mountains of money that central banks have printed for bailouts will only cause monetary inflation as money supply exceeds demand. That's called monetary inflation, that will do no nothing more than put pressure on interest rates to go up....not the greatest incentive for the housing market.

    Sure, this could eventually cause price and wage inflation, but not until demand for credit exceeds supply, and that ain't gonna happen until years after after we scratch and claw our way out of the worst recession since WW2.

  5. Thanks guys for your views.

    I agree with you all on the points from the reality.

    However, the common joe may not follow the fundamentals (not even the real economists, I think). The insane activities in the recent stock market proves it, up to now. When I see my money possible worth less and less in the future, and I seem to be able to afford a house given the near-zero mortgage rate, what can I do?

    save to GIC? close to zero rate.
    invest gold? already in bubble.
    invest stock? the big guys criminally manipulate the market with the help from the governments, which results volatility against us.

    Sigh - try a house? seems a safer gambling comparing to the above choices.

  6. "seems a safer gambling comparing to the above choices."

    I don't know how a highly leveraged asset is a safer gamble. Unaffordable housing does NOT track inflation.