Wednesday, August 08, 2007

Valuing my house

In a recent post Dr. Housing Bubble presented three ways to value a property. For a stock market investor, these valuation methods seem pretty basic. "The Cost Approach" is pretty much book value, "The Sales Comparison Approach v2.0" is a relative valuation close to P/B ratio, and "The Income Capitalization Approach" is a stable value DCF model. I'd like to take the third and try to get a value for the little guest house my family rents.

First, we pay $1,200 a month or $14,400 a year to rent our 2 bedroom/1 bath house. It's about 900 square feet on what would be a relatively small lot, if it were separate from the main house. Our landlord hasn't raised rent in 5 years and is willing to pay for normal repairs. I don't know what his expenses are, but I would imagine it would be no more than the 45% of his rental income. So his cash flow is something like $7,920 a year.

In a traditional DCF model, you'd divide that number by the discount rate minus the expected stable growth rate. In the real estate model, those rates are combined to create a standard "cap rate". Nearly every home will have a stable rental growth rate that matches inflation or 2-3%. The discount rate would depend on what return you might expect to make by investing in a different property in the area or making some other equivalent investment. Stock market returns are similarly risky and will probably return 10% or so. That makes 7% a fairly reasonable cap rate. So if it were possible to buy our house on its own, $113,143 would be the fair value.

According to Rentometer, the median in our area is $1,700. That works out to a fair value of just $160,286, which I would gladly pay.

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