Valuation

Quite often, people view real estate as something completely different from financial assets. Aside from being a necessity, a house is something one can touch and feel, and the ownership creates an emotional connection. This is considerably more difficult when dealing with financial assets. In essence, however, there is no meaningful difference between these asset classes. The value of real estate is also determined by the cash flows it generates , be it through rent collection or savings on rent. In this case, as with stocks, there is always the alternative of earning income from a safe investment, for example, government-issued securities. The future profit also depends on changes in the price at which a property can be sold.

That said, there are differences.

• Real estate is far less liquid asset. The very process of buying or selling takes considerably longer and requires more Transaction costs significantly exceed those for financial assets.
• The house purchased frequently represents the buyer’s main asset, its value disproportionately exceeding that of all other assets the person owns. For this reason, diversification through real estate is impossible or, at best, requires far more resources compared to the relatively inexpensive diversification of financial assets.
• In individual cases, the valuation of real estate takes into account city- or region-specific factors that may greatly alter the underlying logic of the process. The relation between anticipated income and valuation can become significantly distorted due to limited real estate supply because of geographical, economic, or legal reasons and extremely high demand.
• Political and legal factors can greatly distort the market in a country, region, or city.

However, these dissimilarities do not call for radically different methods of valuation – all they do is change its details.

In order to utilize this universal valuation method, we need three main variables.

• Cash flows over time. In the case of real estate, these are the rent payments Most often, the running costs associated with property ownership (taxes, maintenance fees, etc.) are not especially high, and leaving them out can still result in a valid assumption about the price. If they are relatively high, however, it would be best to deduct them from the rents so as to obtain a more realistic valuation.
• Rental growth over time. With regard to the long term, traditional wisdom suggests that it is prudent to assume cash flow growth at rates close to those of inflation and definitely lower than the nominal growth rate of the economy. Long-term, there is a direct relationship between rental values and the price of a property. For this reason, rental growth can also be regarded as price growth over a long horizon.

Very often, real estate prices are linked more closely to local than national factors, so strong demand in a city, neighborhood, or region and lack of adequate supply allow for assuming a higher growth rate. Conversely, a deterioration in local living condition would warrant the assumption of a decline. The website calculator uses a stable growth model , which delivers a realistic valuation on condition that cash flow growth is lower than the required rate of return

• The required return on the property is also the cost of the risk applied to discounting cash flows to obtain a valuation.

As with shares, the required return comprises the risk-free return and the risk premium. The risk-free return is the same for stocks and real estate. The difference in the required return is attributable to the risk premium. Very often, property buyers view this type of investment as different from acquiring financial assets, which makes the CAPM (Capital Asset Pricing Model) partly inapplicable for calculating the required return. Nevertheless, in the majority of developed economies, the purely empirically obtained risk premiums for property acquisitions are quite close to the values derived through CAPM. Instead of using beta to calculate the risk, we can go with the priced-in risk premium, which is relatively constant for different properties. The prevailing real estate risk premiums stand at around 4%, which is again close to the equity risk premium. In certain hot markets, they can reach 2%. The website calculator has 4% as its default option.

Once these parameters are input, the valuation becomes a straightforward exercise. The calculator uses the formula applied in valuing a mature company . In the vast majority of cases, this constitutes the most appropriate method.

This relationship between rents and real estate prices can be found in hot developed real estate markets as well as in large emerging markets real estate markets , but also in small real estate markets like Bulgarian estate agent. A reality check is always a good idea, meaning we should compare the value obtained via these models to the average market price of a similar property. If there is a significant disparity, but the projected rental income from the real estate asset in question is realistic, there are two possible reasons for the error: either the market values price growth differently from us or the risk premium diverges from the default parameter.