Market Value
We calculate the present value of the net cashflows (rent - expenses) expected from
the property, discounting at a combination of the expected inflation rate and opportunity cost (short term
cash deposit). Adjustments are made for tax on savings and rental income. Risk associated with holding
the property is mostly factored into expenses (via insurance) and anticipated vacancy rate, but a (small)
factor for expropriation can also be incorporated into the discount rate. Risk of expropriation of deposits
can also be incorporated into the discount rate.
Note on intuition for using opportunity cost in discount rate: you need to borrow your money away from
a presumably already invested pool of cash, thereby foregoing the associated interest (until the cashflows come
in).
Remarks:
- The market, in aggregate, does not purchase property with cash. It uses leverage. Is it
better therefore to use a discount rate appropriate to this. I guess you'd work out how leveraged the
property market is in aggregate (and your expectations of this going forward), and do a weighted average
of the borrowing vs saving rates.
- The increased discount rate mostly reflects bank profits rather than higher risk.
- In this model, negative gearing laws would result in a further adjustment to the discount rate
(downwards). Probably not especially easy to work this factor out.
-
The market, in aggregate, doesn't hold properties indefinitely. There is some amount of turnover,
with associated transaction costs (and taxes). This could be incorporated into the discount
rate as well (upward adjustment). Note on taxes: a large part of the housing stock is owner /
occupier, which is subjected to different tax laws.
-
Using NPV assumes indifference as to when the cashflows are recieved. Assuming fairly
stable demographic trends, in aggregate this probably isn't such a bad assumption so it's
probably not a bad way to determine the market value of the property. The same argument
can be made by a public company doing an NPV calculation to determine whether or not to undertake
a project (diverse collection of shareholders). However, for individuals buying property,
this assumption is far from correct.
- Someone using a high proportion of cash in the purchase obviously does not want
to use that cash now.
-
Interest rates and rents will both broadly move with the inflation rate, but not exactly
and their relative movement will change with time. Therefore, the relative (real) value of
a fixed interest and real estate investment will depend on when they are divested. Indeed,
many people invest in real esatate because they believe it to be a good inflation
hedge (and that cash/interest is not). They don't wan't to know the value of their investments
relative to cash today,
they want to know this at the point of time in the future when they want to use
the money.
- Note: People's propensity to avoid cash will change with time. This is modelled
by specifying real interest / real rent expectations.
Value to an Individual
In practice, people are going to want to use the value tied up in their investments over
an extended period of time (their retirement). However, they will generally need to divest
their property investment at a single point in time, and I think it is useful model regardless.
The valuation can be automatically repeated for many timeframes of interest, and the results
shown in a chart. This is useful to indicate the effect of time on when the property is sold.
During the investment timeframe, it is fairly straightforward to model all of the
(nominal) cashflows to arrive at the final net position. The terminal value of the
property (in timeframe's dollars) can be determined by the market NPV approach specified
above. Any capital gain can be taxed and anticipated transaction costs estimated as a
percentage of the terminal value.
Finally, the result of the above calculation can be expressed in today's dollars by
adjusting for inflation. I think expressing in today's dollars is the most intuitive
way of expressing the relative values.