Last week, a blog reader named Óscar de Granada contacted me to ask if it is possible to calculate the value of a property and what method to use to calculate this value. As I think it is a question that may be interesting for many of you, I decided to publish this article where I will teach how to calculate the value of a property and I will analyze the 2 main methods of property valuation with an example of valuation with each of them.
What valuation method to use to calculate the value of a property?
There are two methods to calculate the value of a property:
- Relative valuation
- Cash flow discount
We have already seen in this blog both the relativa valoraciónLike cash flow discount (with a application example in Excel), but applied to the valuation of shares. As you will see below, these methods are also applicable to property valuation.
The most used and least recommended method, the relative valuation
The most used method to value real estate is relative valuation. To calculate the value of a property based on this method, the price of other nearby homes and similar characteristics is used as a scale, applying at the end different value correctors relative to the differences that may exist with the floors that have been compared .
Example of valuation of a property using the relative valuation method
We want to calculate the value of a 100 m2 apartment in a central area of Madrid, built in 1.970 and which has a garage. The apartment needs a small remodeling of about 20.000 euros.
We know that in the area approximately 6.000 euros per m2 are paid for medium-sized flats and similar characteristics without a garage and without remodeling needs.
To calculate the value of the apartment we will multiply its surface by the price per square meter, which gives us a total of 600.000 euros. At that price we subtract the expenses necessary for its remodeling, resulting in 580.000 euros. About 60.000 euros are paid for the garages in that area, so we will add the value of the garage to obtain the total value of the apartment.
The result of the value of the property through the relative valuation is 640.000 euros.
Why is relative valuation not recommended to calculate the value of real estate?
The relative valuation method is the most applied, but it has a big problem, which is that this method does not take into account a possible overvaluation in the prices of the properties that we use in the comparison.
Using this method to value flats led many savers to lose a lot of money buying homes during the last housing bubble by having the wrong idea of their true value.
As you can see, this method can be used to speculate with properties, but if what we want is to calculate the real intrinsic value of a property, we must use the cash flow discount method that I will show you below.
The method I recommend to calculate the value of a property, the cash flow discount
The most appropriate method to calculate the value of a property is the cash flow discount, which is based on capitalizing the expected return on the property according to the required return. To do this, we must take into account both the income and future expenses that the property will generate.
The discount rate that we are going to apply will be the required return that we hope to obtain from our investment. The discount rate will be subjective, and will depend mainly on 2 factors:
- The investment alternatives that we have
- The intrinsic risk of investing in real estate
We will demand a higher return on our real estate investments when the return on investment alternatives is higher, and vice versa. In the same way, we will demand a higher profitability from houses whose income is less stable or are exposed to greater risks (legal, tax, natural, etc.).
In my opinion, the appropriate discount rate would be between 5% and 10% in most cases.
What data do we need to calculate the value of a property by discounting cash flows?
To calculate the value of a property by discounting cash flows we will need the following data:
- Expected rental income
- Approximate percentage of time in which the apartment will be rented and the tenants are paying
- Annual cost of property taxes (IBI)
- Annual cost of repairs or insurance
- Annual cost of community expenses
- Other expenses
- Taxes to be paid on the return on real estate capital
- Estimated Long-Term Profit Increase
- Discount rate that we want to apply
- Other initial expenses (ex. Rehabilitation, furniture, etc.)
As you can see, there is not little data that we need for the calculation, but it is necessary to be as rigorous as we can to obtain an accurate view of the property value.
Example of calculating the value of a property by discounting cash flows
We are going to value the property in the previous example, but this time by discounting cash flows. We are going to base ourselves on the following data:
- Monthly rental income: € 1.800
- IBI (annual): 700 €
- Community expenses (annual): € 600
- Repairs and insurance (annual average): € 1.000
- Miscellaneous expenses (annual): € 200
- Initial rehabilitation expenditure: € 20.000
From experience, we believe that 80% of the time we will be able to collect the rent, with the remaining 20% being without renting or with tenants who do not pay. The tax rate to be paid by the potential buyer would be approximately 18% on average after applying the corresponding reductions. We consider that both income and expenses can rise by 2% on an annual average. The profitability required for the investment, given its characteristics, is 6%.
To calculate the value of the property, we will follow the following steps:
- Calculate expected annual income
In this case it will be € 17.280 (12 * 1.800 * 80%)
- Calculate expected annual fixed costs
- Calculate the expected annual profit before personal income tax by subtracting income less costs
- Calculate expected profit after tax
- Calculate the present value of future income based on the scenario analysis, since the data that we are going to use to value the property are future data and therefore are subject to uncertainty.
For example, in the property we are analyzing we can analyze other different scenarios:
Pessimistic scenario: Monthly income of € 1.400 and occupancy rate of 70%.
- Pessimistic scenario valuation: € 173.626,60
Optimistic scenario: Monthly income of € 2.500 and occupancy of 90%.
- Optimistic scenario valuation: € 492.295,00
As you can see, the valuation can change radically from one scenario to another, so we must try to be as realistic as possible with the data that we are going to use and know what can happen in the worst case scenario. The ideal is to make a table in Excel to analyze the different scenarios with greater comfort.
Now that you know how to value a property, I would like to encourage you to value your houses and those of your relatives as a practice. Surely more than one is surprised (in some cases unpleasant) about the real value of your home.
As always, any questions or criticisms will be well received in the comments. 😉