How can you be sure you won’t lose money on your house?
In this article I’m going to teach you how to buy a house in peak housing market cycle and not overpay.
I have been able to find, flip, and rent a diamond in the rough house in a hot market without overpaying using this method which I am going to share with you.
Check out the video post for this article on Youtube.com/notwaitingtolive:
The real estate market has hit peak cycle across the country. If you’re buying this year there’s only one way to be sure you won’t lose money.
There are three ways to price a house:
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Market Value – which is a function of material and location attributes of a house as well as a market’s short term and long term debt cycle
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Replacement Cost Value – which is the cost to match the existing building specifications (primarily used to determine value of property loss insurance claims)
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Capitalized Value – which is the amount invested in a property relative to the amount of income the property generates
Most homebuyers only consider market value. This is the most volatile of the three methods to price a home.
As we learned in the 2008 housing market crash, your house can lose 10% of its value seemingly over-night. If you or your family can’t absorb selling your house for tens or hundreds of thousands of dollars less than you paid for it, you need to closely consider purchasing a home based on its capitalized value rather than market value.
The graph below provided by the Federal Housing Finance Agency shows the last 7 years of significant home appreciation was preceded by several years of significant depreciation that forced many home owners to sell for a loss.
In the context of the last 30 years you can see in the graph below that the housing market may be on the cusp of turning down again:
To calculate the capitalized value of a home you need to make two critical assumptions:
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Fair Rental Value – which is the competitive rate a property will rent for
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Capitalization Rate (Cap Rate)– which is the desired rate of return for the investment
Step 1: Determine Fair Rental Value
There are three easy ways to determine Fair Rental Value:
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Use a site like Zillow to compare what nearby properties have rented for recently
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Check out the fair market rents for your area on the Housing and Urban Development website
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Use rentometer.com to find the most reliable current market rate for rents in your area
Step 2: Determine Net Operating Income (NOI)
Once you have selected a realistic rental value for the home you’re looking for, you need to estimate the Net Operating Income for the property.
Net Operating Income, per year = Rental Income, per year – Operating Expenses, per year
Operating Expenses include all expenses to operate and maintain the property in rental condition. This includes property tax, future repairs, maintenance, vacancy, and listing expenses. This does not include the cost of a mortgage. Typically, Operating Expenses can be assumed to range between 40-60% and a good starting point is 50% if you have no other information at all.
As an example, let’s assume the rental income is $1,000/month. If the operating expenses are assumed to be 50% of the rental income, each month the Net Operating Income will be $500/month. For the year the NOI is assumed to be $6,000/year.
Step 3: Pick Your Capitalization Rate
Investors compare use of their capital against all other opportunities in all other industries (health care, automotive, you name it) at the same time. For this reason, the Capitalization Rate in which investors are willing to invest in real estate goes through short term and long term cycles.
The Capitalization Rate for real-estate typically ranges between 4-15% and is a function of opportunity cost in any market. Most stable competitive markets and investment have lower Capitalization Rates for real estate that range between 4-8%. Professional investors seek realistic opportunities with Cap Rates ranging 8-12% and therefore scour the less competitive and less stable markets to invest.
The Capitalization Rate you pick has a significant effect on the price what you will consider “over-paying”.
As a starting point you can pick a Cap Rate that is equal to the trending mortgage rates of the next couple years. Over the last decade the Federal Reserve have kept rates near 0% in an unprecedented measure, so you can expect the mortgage rates to increase over the next few years.
Cap Rates between 8-12% are much safer investments from the buyers perspective as they lower Capitalized Value in the Capitalized Value Equation below:
Capitalized Value = Net Operating Income, per year / Capitalization Rate
Step 4: Find Peace in Your Capitalized Value
Capitalized Value is the total investment required to bring a house to rental condition and any fees associated with acquiring the property.
For the example of $1,000/month in rent, the Net Operating Income was $6,000/year. If you assume a Capitalization Rate of 10%, which is a common investing benchmark these days, the Capitalized Value would be $60,000.
Alternatively if the Capitalization Rate is lowered to 4% to be comparable with the rate of today’s mortgages, the same house at the same rent has a Cap Value of $150,000.
If you live in Southern California you may have just had a mini-heart attack because you can’t find anything for less than 3x that number.
If you choose to value your home for less than a 4% cap rate right now, you’re valuing your home for less than your mortgage. Mortgage rates will only go up from here. Make peace with the fact that you’re playing housing market poker where even strong hands can lose.
Losing 10% on a $500,000 house is $50,000. Families living paycheck to paycheck cannot absorb that loss when they need to move or can’t afford to continue paying the mortgage.
This article is not a lesson on how to buy any house and not overpay. Right now houses are grossly overpriced across the country. To find a house that’s priced right will be 1 in 100, but they are definitely out there.
Over-paying is a relative term. You need to be aware of what that number is for you by knowing the capitalized value.
Renting is a strong option to ride out peak cycle housing markets and should be leveraged as a tool for those who need to be resourceful with their monthly budget.