How does an investor value property? What would an investor pay for your house?

Investors use rental yields to determine the amount they will pay for a property. The advantage of using rental yields is that they tend to be stable over the long term which means that they are perfect for comparing property prices at different points in time.

By rental yield I mean the gross yield, that is the annual rent receivable from a property divided by the price of that property. For instance, if you were considering buying a property to rent out at a price of £200,000 and it generates rent of £12,000 per annum, then the gross yield is: (£12,000 / £200,000) x 100 = 6.00%.

We can use these yields to determine the attractiveness of property to a professional investor over time, say 1996, 2000 and 2006. In order to do this we need to determine two values at each of these dates: the “Gross Rental Income” and the “Investors’ Required Return”.


Gross Rental Income
To determine the Gross Rental Income, multiply the gross rental yield by the average house price. The national or regional gross rental yield can be found in publications made by leading estate agents and professional bodies such as The Association of Residential Letting Agents (ARLA).

                                 Average House Price x Gross Rental Yield = Gross Rental Income
Dec 1996                               £72,144           x             10%            =           £7,214
Dec 2000                             £109,558           x               7%            =           £7,669
Dec 2006                             £207,573           x               4%            =           £8,303


Investors’ Required Return
When professional investors wish to evaluate an investment they take the risk-free rate of return at that time and adjust it to take into account any additional risks. For instance, many people consider the interest received on U.K. Government Bonds (also known as Gilts) to be a risk-free rate since the Government is extremely unlikely to default on its interest payments. The Bank of England base rate is often used as a proxy for the Gilt rate and hence the risk-free rate.

An investor in property should expect a higher return in order to compensate for the additional risks involved in property investment. These may include compensation for void periods, covering unexpected building and maintenance costs and compensation for the additional level of work involved.

So if the current U.K. base rate is 5.25%, and the investor’s risk weighting for property is 3%, then the investors’ required return is 8.25%. Lets examine the required returns at each of the 3 time periods. You will note that the risk premium is lower in 1996 (2%) when house prices are low following the previous house price crash, but higher in 2006 (4%) by which time property prices are far higher and so the perceived risk of property investment is greater.

                                  Base rate   +   Risk Premium    =   Required Return
Dec 1996                       6.00%      +          2.00%         =           8.00%
Dec 2000                       5.50%      +          3.00%         =           8.50%
Dec 2006                       5.00%      +          4.00%         =           9.00%


Now lets apply this information to the investor’s valuation calculation for each of these three time periods...


Determining The Price
To determine the price an investor would pay for the property divide the Gross Rental Income by the Investors’ Required Return.

December 1996
Gross rental income                                                       £7,214
Required return                                                              8.00%
Calculated value of house (£7,214 / 8%) x 100% =            £90,175
Actual Average house price                                             £72,144

It can be seen that the investor can purchase the property for less than it is worth to him/her, making it an attractive investment. At this price the rental income of £7,214 would generate a return of (£7,214/£72,144) 10%, which is 2% above the required return. Of course, 1996 was the bottom of the market following the previous house price crash so prices are cheap compared to the historical trend. So what did the picture look like mid way through the cycle in 2000.


December 2000
Gross rental income                                                       £7,669
Required return                                                              8.50%
Calculated value of house (£7,669 / 8.5%) x 100% =         £90,224
Actual Average house price                                             £109,558

Here we see that the house is £19k more expensive than investor would be willing to pay, leading to a return of (£7,669/£109,558) = 7%, some 1.5% less than the investor’s required return. The value of the property is therefore too high for the investor. The investor may still decide to buy the property however, if for example, it is determined to be a good investment compared to alternative investments such as shares or bonds.


December 2006
Gross rental income                                                       £8,303
Required return                                                              9.00%
Calculated value of house (£8,303 / 9%) x 100% =            £92,256
Actual Average house price                                             £207,573

In 2006 the average house price is double that an investor would pay in order to generate their required return. The property would not generate enough rental income to compensate for the risks of owning the property, and is even unlikely to cover the cost of the mortgage. This can be confirmed by considering the following simple facts:-

Gross rental yield in December 2006 (from above)          4%
Average mortgage interest rate                                     6%
Gross return from high street savings accounts              5.5%


Conclusion
It can be seen that the return available from property is lower than the cost of the mortgage (i.e. by investing under these circumstances an investor will immediately generate annual losses). The return available from property is also below that which could be achieved by safely depositing money in a bank, which carries minimal risk. As a result, no professional investor would view the current property valuations as attractive. They are, of course, concerned first with risk, and only second with returns.