“Price is what you pay, Value is what you get.”- Warren Buffett
So you own a house. Or you are planning to buy one. Maybe now. Maybe sometime in the future. You are probably earning a handsome $50,000 or north of it, every year. As a responsible American, you pay your taxes and contribute to your retirement accounts. But buying a house is, unfortunately, a little less straightforward.
To put things in perspective, buying a bag of potato chips is easy. You try them out one by one from your favorite retailer and make a mental note of which ones you like and which ones you don’t. They don’t cost much anyway. Whereas buying a house is far from this. Your home-buying decision can decide the age you retire, the school your children go and much more. When should you buy a house? Where should you buy a house? Should you even buy one? These are some of the hotly debated questions in the world of personal finance.
You can answer these questions only if you know what you are dealing with, in the first place. Even if you already own a house, chances are that it would account for a significant chunk of your personal net worth. Estimating the value of your house gives you a picture of your financial health. So without any further ado let’s dive in.
No discussion about valuation is complete without talking about the distinction between price and value. The price that a home or piece of real estate sells for is not necessarily its intrinsic value. More on intrinsic value later. The market price (or simply, price) can be affected by factors such as short-term supply and demand, investor sentiment, and government policies. The intrinsic value, on the other hand, is a measure of the utility of an asset. Market conditions have nothing to do with it.
The most common method of real estate valuation is the Comparison method. Basically, you make an estimation based on the recent price of a comparable property that is similar in the location, size, and age of your property. As you might have already guessed, it is not independent of the market conditions. It will backfire on you if the economy is in a bubble. That’s where the discounted cash flow (DCF) method comes into the picture.
First things first. There’s no way you can value a house without making some assumptions. Primarily you have to assume the price at which the house is sold at some point in time down the line.
DCF method defines the value of an asset as the present value of all the future benefits that it will generate. Actually, Aesop had summarized the whole idea a thousand years back. “A rabbit in hand is worth two in the bush.” The method involves estimating the future cash flows that the property will generate, such as rent payments, and then discounting those cash flows back to the present using an appropriate discount rate. The resulting present value is the estimated intrinsic value of the property. DCF makes assumptions about future economic conditions, market demand, and the asset’s operating performance. It’s time for an example. Get ready to crunch some numbers.
Let’s assume that the annual rental income of a house is $25,000
Let the annual expenses (property taxes, maintenance, insurance, etc.) be $6,000
And the remaining useful life of the house be 40 years
Future cash flow in every year = rental income – expenses
= $19,000
Now we have to calculate the amount if invested at the discount rate, will compound into this $19k every year in the future. All we have to do is reverse the compound interest formula. But we can just plug the numbers into the present value function in google sheets and get the work done even more easily. Just copy the below line and paste it on an empty cell.
=PV(rate, nper, pmt, [fv])
‘rate’ is the discounting rate, Here, 0.07
‘nper’ is the number of years held. Here, 40
‘pmt’ is the payment. Since we are getting paid here, it is -19,000
‘[fv]’ is the future value. Here, 200,000
Our magical number here is $253,301. This means that, at around a quarter million dollars, your home purchase becomes a financially sound decision for the above data.
But the DCF method is not a silver bullet for valuing homes and real estate. There are too many uncertain variables that involve forecasting future cash flows. However, it is better to use a flawed method consistently than to use a more subjective method that is not based on sound financial principles. It is also important to consider the market conditions when valuing homes and real estate. In a hot market, where prices are rising rapidly, it may be necessary to use a higher discount rate to reflect the risk of overpaying for the property. Conversely, in a cold market, where prices are declining, it may be necessary to use a lower discount rate to reflect the potential for a bargain. Also, be realistic about assuming future cash flows.
Now that you know how to value a house, you can think about buying your house with a lot more clarity. Or, know what you actually got under your roof. But keep in mind that the value of a home or piece of real estate is ultimately determined by the market. However, the DCF method can be used to estimate the intrinsic value of a property, which can be helpful in making informed decisions. When it comes to making your purchase decision, it should be noted that value is also subjective. Even if the price is above the intrinsic value of the asset, it would make sense to buy the property if you have the cash with you and you don’t have anything better to do with it.
Charlie Munger is not as much a household name as Warren Buffett is. He is Buffett’s partner in Berkshire Hathaway. The largest shareholder of Apple and Coca-Cola. Munger is known for his obsession with rationality. In finance and life. But Munger famously got a yacht built for him just out of curiosity about how one is built. If you have a solid reason and solid cash, nothing should prevent you from buying your dream house. Just that, it shouldn’t be out of ignorance.
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