Are you surprised by what it costs to buy a nice home nowadays? With interest rates still relatively low and the economy nearing full throttle, prices of virtually every asset around the world have gone up.
How can you tell if we have entered a bubble and if the houses you are looking at are crazily priced?
There are actually several reliable indicators you can apply to give you some context and help you understand if property values have gotten crazy or if they are appropriate for the market.
First let’s talk about yield.
Yield expresses the relationship between output gained from a given amount of input. In the case of real estate, the output would be rental income and the input would be the purchase price of the property.
However, yield is not unique to real estate; bitcoin miners have to analyze the amount of bitcoin they can mine versus the amount of electricity cost to mine. This is another output divided by input scenario, how much am I getting back from my investment as a yearly percentage.
Dividend paying stock and bonds also have yield, the calculation would be the same. How much do I receive per year in the form of dividends or interest (output), divided by the up front cost to purchase the bond or stock (input).
It is a similarly valuable tool to help us gauge the relative value of real estate. I say relative value because interest rates (cost of funds) and rental rates impact the value of real estate so all must be thought through when trying to answer the question – are real estate prices crazy?
Let me walk you through a real life analysis on a property that one of my friends just purchased to live in.
The home was in immaculate shape and in a vibrant area. The general consensus for the property was that expenses would be low (because it is relatively new and in perfect condition) and the community should continue to appreciate.
We estimate $2,250 gross monthly rents or $27,000 annual gross rental income – divided by $350k purchase price = 7.714% gross yield.
Now we do need to calculate some estimated expenses for this property. Let’s assume 20% buffer for property expenses and vacancy.
Annual net income $21,600 – divided by the $350k purchase price = 6.17%
Now interestingly enough, the interest rate paid on this loan was 4.75%. Thus the net yield (or profit) is greater than the cost of capital to finance the asset. This is a good sign! When the net yield is less than the cost of capital to finance a property, it is a potential red flag that prices may have gone too high.
If you think that through a little bit, you will realize that investing in this home creates a yield of 6.17% on any cash down payment that was used to buy the property as well as a 1.42% yield on the portion of the property purchase that was financed. That spread between the 6.17% net yield and the 4.75% cost of capital (mortgage) is also profit. This investment would be cash flow positive. When investors using a mortgage to finance a home have pushed the net yield below prevailing interest rates, they are not making a cash flow play, their only way to profit is if the asset appreciates. This is a great indicator a bubble might be forming or at least prices have been stretched and if rents don’t catch up soon, a bubble could occur in the future. In this case my friend purchased the home with 3% down and ended up with a total monthly payment of $2,061. Approximately $189 per month less than we estimate we could get in rents.
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Josh Mettle is an industry leading author and mortgage lender, specializing in financing physicians, dentists, CRNAs, and physician assistants. You can enjoy great physician real estate and mortgage advice here or by visiting his book site. Josh is also a fourth generation real estate investor, and owns a number of rental homes, apartment units and mortgages. Josh is dedicated to helping physicians become more financially aware and able; listen to “Physician Financial Success” podcast episodes or download Josh’s latest tips and advice here.
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