Tips To Avoid Housing Bubble

[Jason Parks]

Buying a a property is like buying a business. Nobody wants to pay too much for a business that generates only so much profits. Similarly, we need to think rationally about a property from an income approach, just like how the bankers think about a business.

You may ask: what if I'm buying one for my own use? The answer is: you should treat the home you're buying like an investment property equally. The key idea here is you want to find out the fundamental value of a home. And history tells us that all properties and assets go back to its fundamental value sooner or later. That means, relying only on speculative values set forth by people in real estate market can cost you big discount of your net worth later when property values really adjusts. Unless you have couple million dollars sitting in your bank account, the chances are, you care about your net worth. The bottomline is you don't want to pay too much for what a property is really worth fundamentally.

Owning a property gets you a series of rental income. So the income approach actually makes you think backward: For the rental income that you're getting regularly, how much would you want to pay for it? Savvy investors and bankers know that we can employ the so-called Discounted Cash Flow (DCF) method. We're not going to take 10 pages to discuss it. But the key point here is, you want to compare the fundamental value (we call it Rent-Implied Home Value) with the selling price out there to determine if it's a bargain or not.

If your property value deviates largely from your Rent-Implied Home Value, beware! This is a strong evidence that your home value has large bubble content.

Some of the tips to avoid getting caught by bubble are:
1. Check how much is needed to maintain the gross rental income
People who are familiar with Rent-Implied Home Value concept may try to inflate it by hidding the ongoing costs needed to maintain the grosss rental income. Two properties may get you the same rental income, but one of them may cost you whole lot more to maintain.

2. Check how reliable the rental income is.
Yes, we acknowledge that there is vacancy risk. The vacancy rate actually tells you the fair probability that you can get your property rented. Be sure to find out the long term one.

3. Be sure to check if the rent yield is larger than Treasury bill's rate
This may sound technical. But it's important! Rent yield tells you how much return you're getting from your property. If it's less than T-Bill rate, why would you want to invest in this risky property in the first place when you can get more return risk-free?

4. Collect the most accurate rental and costs information
Accuracy depends on your dilligence. Garbage in, garbage out. Simple as that.

Fortunately, you don't need to crunch all that numbers by yourself. [LINK REMOVED] does most of the work for you, free of charge.

Next time you buy a property, remember, check your Rent-Implied Home Value.