Value of a Property

In finance there are logical methods to calculate the economic value of any asset and so for property. For property there are internationally followed valuation methodologies. Without delving with tricky parts we’ll try to understand the simpler ones.

First, we must get it straight that a house, ultimately, is meant for residing. And purpose of residing could be achieved either by buying a house or by taking in lease or rent. So financially there should not be any difference between either buying or leasing in a house. Of course there is an ‘emotion’ element attached with buying a house for residing purpose. Now, how much one is ready to pay for the ‘emotional’ element? That differs from person to person. And in a bubble like situation the price of the ‘emotional’ element moves up phenomenally, while the fundamental utility of the asset remains unchanged. Financial methods can value only the utility part. I don’t know if emotion can be actually valued objectively through financial equations.

Internationally one term NOI (Net operating income) is frequently used in property valuation. NOI is nothing but the rent earned from a property less other operating expenses like maintenance and taxes.

Consider, a house property earns a rent of Rs 10,000 a month. So after deducting operating expenses and tax of, say, Rs4,000 the NOI stands at Rs 6,000 per month or Rs72,000 per year. Now we need to define what kind of return (denoted by ‘r’), we need from the investment. Since we can get around 9% from bank fixed deposit, let us consider our required rate of return as 12% a year. So r = 12%. There is another element, growth rate of the rental income, denoted by ‘g’. Consider, the NOI grows by 8% a year over long term. Now the actual economic value of the house property is given by the formula NOI/(r – g). Thus the value of our house property should be Rs72,000/(12%-8%) = Rs72,000/4% = Rs18,00,000. Any price beyond this is the price of the ‘emotion’ or ‘greed’ or ‘fear’, which I cannot calculate using financial equation.

This implies that if you invest in this property you will enjoy a return of 12%. You can also calculate the return other way. Consider, the price of the house property is Rs 50,00,000 and NOI generated is Rs 72,000 per year. The long-term annual growth of NOI is 8%. What is the actual return you are getting?

Formula is: (r-g) = NOI/MV.

So, r = (NOI/MV) + g.

r = (72,000/50,00,000) + 8%. r = 1.4%+8% = 9.4% a year.

Please note your return is less (9.4%) than the previous case (12%), because the property value is higher in the second case. So, like any other investments, higher the price lesser is the real return.

Burst of a bubble

Normally, whenever an asset bubble bursts the asset price goes much below its fundamental value due to panic selling. Arguments like ‘builder will not reduce the price due to increase in cost of production’ are unfounded and reflects nothing but herd mentality. Any asset bubble burst is characterised by huge loss to the stake holder. Stake holders get desperate to minimize loss or get liquidity resulting into panic selling. Bubble burst defies willingness or un-willingness of any stakeholder and the asset price tries to find its true economic value owing to economic forces (invisible hand). That’s why bubble burst causes economic distress. Example Asian crisis in 1997, US sub-prime crisis in 2007. In domestic share market there are plenty of similar examples.

Good news is that, unlike other countries Indian banking system is robust. Liquidity is primarily under the control of the banking system and shadow banking system is not that big to control liquidity. So a huge economic catastrophe due to property bubble burst is unlikely, though it would definitely cause economic damage.