In this article you will find out more about:
How to Assess Fair Price for Real Estate
You found an interesting real estate project but do not know if the price is reasonable?
Don't worry, there is no need for complex calculations with multiple input factors. For a first quick check, you can apply a very simple but powerful method with help of your smartphone: the "yearly estimated rent times 20 to 25" or price/rent rule. What is it about?
What is the Price/Rent Rule
The underlying idea is that your real estate should generate a return on the invested amount of at least 4-5% per year. Why 4-5% p.a.?
Because this yield you could easily generate even after taxes with other long-term investments (e.g., globally diversified securities portfolio based on ETF replicating MSCI World Index: annualised 8% gross since 1987 - as of end of Nov 2022) with higher liquidity (by simply pushing the sell-button), flexibility (e.g., adjustable monthly saving rate) and significant less effort.
But step by step - let's run together through the few steps to be taken to find out the "fair value" for your real estate target.
How to Apply Price/Rent Rule for Your Real Estate Property
After you have identified a property you would like to own, search for rental prices for similar apartments in the same area, calculate the yearly rent and divide that by the apartment price - including all buying costs. If the result is below 4%, hands off - price seems too high. You probably might face losses in the future when selling your property again or at least need to be willing to park your money for less than 4% long-term. Considering also inflation, 4% p.a. gross is really poor!
Price/Rent Rule - Example
Let's do a quick example:
Investment | | | Expected Return from renting out | |
Apartment price + buying costs (e.g., notary fees, real estate agent, ...) | 190,000 EUR 9,500 EUR | | Monthly rent for similar (size, location, age, features as balcony), before taxes, maintenance cost etc. | 500 EUR |
Total Investment | 199,500 EUR | | Yearly expected Rental Income | 6,000 EUR |
Return on investment: 6,000 / 199,500 = 0,03 ==> 3% p.a.
What Is the Fair Price for Real Estate
In above example the expected yearly return on your investment would be (poor) 3%. Would you be satisfied for such a long-term investment?
But what would be a fair price for your real estate dream considering a 4% hurdle rate for long-term investments?
For that simply multiply the yearly rent of 6,000 EUR from our example above by 25 and you end up with the cap for your total investment amount:
6,000 EUR x 25 = 150,000 EUR
According to your quick analysis, you should not pay more than 150,000 EUR (incl. buying costs) for the apartment.
If you set a bit more ambitious targeted return for your real estate investment, for example 5%, the calculation would look as follows:
6,000 EUR x 20 = 120,000 EUR
Now it became obvious, why it is called the "yearly estimated rent times 20 to 25" rule. It simply describes, how many years of renting out it would take in order to earn the total investment amount.
Applying this rule of thumb, you soon might become frustrated as none of the current offers on the market jump over the hurdle rate of 4% yield. It could be a sign that the real estate market went a bit too hot. But if you really want to accept a lower than 4% yield on your investments in the long run or you consider holding your own piece of real estate as a mandatory milestone in life - go ahead and buy it.
PS: For indications of how much return you could expect from real estate investment in different countries, just check out the Global Property Guide. Before becoming too enthusiastic about the rates, make sure you have read the underlying assumptions and conditions (e.g., not valid for newly-built real estate).
Disclaimer: The scenarios or investment products presented above should not be construed as investment advice. All investments involve some level of risk, and past performance is never a guarantee of future returns. As always, do your own research in order to validate and better understand the underlying risks.
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