Intrinsic Value – Part 2
Determining the intrinsic value of a potential home purchase is not overly different from determining the intrinsic value of an investment property.
When it comes to a home purchase the ‘expected net annual earnings’ are replaced by the ‘annual net rental savings’ you achieve by purchasing the home rather than renting it.
Even with a home purchase there must still be a ‘Required Rate of Return’ as there are still costs and risks associated with home ownership and you must be compensated for this. Risks include financing and opportunity costs, structural risk, market risk and government.
So let’s analyse. A house comes onto the market and you feel it would make a nice home. Three bedrooms, two bathrooms and a decent sized backyard for your children.
You are currently renting a similar property, of similar age, similar condition, in a similar location for $450 per week. You expect that this new property might be rented for a similar amount. However, as a homeowner you will be paying some larger annual expenses you would not be paying as a renter. These expenses include council rates, water rates and insurance. Let us assume $3,000pa total for all.
You know that the current standard home loan interest rate is 4%, so you apply this as the required rate of return.
What is the intrinsic value of your potential new home?
Let’s start by revisiting our Intrinsic Value formula.
Intrinsic Value = Expected net annual earnings / Required Rate of Return
Adjust the formula for a new home purchase calculation, as discussed previously.
Intrinsic Value of new home = Expected annual rental savings less major ongoing homeowner expenses / Current standard home loan rate
= (($450*52))-$3,000) / 4%
= $20,400 / 4%
The intrinsic value of the property is approximately $510,000 and this is the maximum you should pay, including all associated purchase costs.
Should borrowing costs fall, so too do the risks associated with asset ownership. Should borrowing costs rise, so too does the risk of property ownership. The discount rate applied should be adjusted to compensate you for the risks assumed. By simply applying the current standard home loan rate, your required rate of return will adjust automatically with market conditions.
Understand that you are taking on more risk buying an investment property than you are when buying a home. Afterall, you don’t need to find tenants to rent your home. So be sure to apply a higher discount rate to calculate the intrinsic value of a potential investment property. Whilst this does mean that the same property could have two intrinsic values, this is fine. Paying a little more to secure the home of your dreams is not necessarily a bad financial decision. Just be sure to get a discount on the investment property.
When all is said and done, if a seller is demanding more for your dream home than the intrinsic value, you are probably better off financially by continuing to rent and waiting for a pullback in general property prices.
Finally, when it comes to a home purchase it is likely to be one of the largest and most important financial decisions you ever make. Please be sure to thoroughly examine the property before signing up to buy it.
We will be back to examine intrinsic value soon, this time with respect to share purchases.