November 23, 2007

Real estate valuation - Random thoughts

I have been reading the book ‘Seeking wisdom – From darwin to munger’ which talks of various mental models and applying them to a problem to analyse it in detail.

The book is itself inspired by charlie munger and his
lecture on the same topic. I have attempted to apply some models to valuing and analysing real estate.

The first post was valuing the real estate as a financial asset like stocks and bonds

The second post was trying to invert the problem.

The third post was looking at psychological baises in valuation of real estate. I will follow up with more posts on the same topic with other models.

I would like to add a personal approach for a first time buyer (buying for personal use)

If you are buying a house to stay (not investment), the maximum value of the investment would be driven by two numbers – EMI and personal debt to equity.

Let me explain
Suppose I earn 40000 as net income. My current networth ( all stocks, bonds, cash etc) is 10 lacs (10 lacs = 1 million). To be on the safe side, I would look at a house where my EMI is around 16000 / month (40% of net income)
So based on the above EMI, I can afford a loan of around 16 lacs at an interest of 10% for a 20 year tenure.

Assuming I have to put up 20% of the value of the house, I would look at a maximum investment of 20 lacs (2 million).
For a 16 lacs loan, my personal debt to equity is around 1.6 (16/10). This is higher than what I am comfortable. However it is not too high if you are in your 20s or 30s and have a long career ahead.

The above is a very simplistic approach and may sound conservative. But I prefer to plan for adversity and for a situation where things can go wrong. Buying a house as a first time buyer is less of an investment for me and more of having a roof on my head (in worst possible situation).

Some bad reasons for buying real estate
- Because the price has risen a lot lately or because the broker is predicting a rise.
- Because one can never lose in real estate
- Because your friend is buying it
- Because you can get a loan to buy it
- FII / Institutional investors are investing money – This is really a strange reason. FII/ foreign investors may have a good reason or maybe they are just following the herd. Just because an investor is an FII does not mean they have extra brains. Sometimes they are worse than an ordinary investor

A few links to value real estate
Real estate valuation and analysis – read on the Cap rate which is similar to the P/R ratio
Deepak shenoy’s real estate cash flow calculator – Excellent worksheet to value real estate. Please read his terms.

1 comment:

Pradeep said...

Great post, the title "real estate valuation" seemed a bit misleading as I expected it would be on valuing a real estate price.

I would tweak the ratios you have mentioned here a bit to suggest:

1. Front-End Ratio: EMI / Gross Income (pre-tax)

Should be less than 30%

2. Back-End Ratio
(EMI + All other monthly liabilities) / Gross Income

Should be less than 40%

Shouldn't the personal debt-to-equity situation be evaluated vis-a-vis rent/buy scenarios.

Should a large down payment be evaluated for its opportunity cost etc..?

On a unrelated note, I think it would be great if you make a post on some of the good "suggested readings" per your recommendations.