By Gerald Tay (guest contributor)
Many investors have NO idea how to get their yields right. An investor cannot evaluate any investment, whether it’s a stock, bond, rental property, or option, without first understanding how to calculate Return on Investment (ROI).
Recently, a seasoned investor (let’s call him Henry) asked if I could help evaluate his investment yield for a property he just purchased. He calculated a Net Rental Yield (NRY) of 8%. My calculation came to 1.5%.
Who’s right, who’s wrong?
One BIG mistake investors make is failing to understand how to get their yields right. Henry is among many investors who lost money for this reason, not because he bought a ‘dodo’ investment. For example, NRY is the most basic form of yield every investor should know to evaluate.
Surprisingly, in every real estate class I teach, none of the participants (seasoned investors included) have ever gotten it right! To prove my point – Solve NRY by yourself below (answers can be found at the bottom of the article). Calculate the Effective Net Rental Yield for the following property:
Purchase Price: $1,300,000
Down payment: $260,000
Annual Mortgage Payments: $27,700
Annual Interest Payments: $15,600
Stamp Duties: $33,600
Monthly Gross Rent: $4,000
Rental Agent Fees (1 year lease): $2,000
Annual Property Expenses: $8,660
The second big mistake investors make
Does Net Rental Yield (NRY) equal the Final ROI or Return on Investment?
NRY must be used mutually with other yield ratios to accurately assess the performance (or Value) of one’s property and ROI (I’ll explain more in future posts).
Consider the six toughest buying-decisions considered by investors and home buyers:
1. If I buy when prices are falling, am I catching a ‘falling knife’?
2. If I buy when prices are rising, am I overpaying?
3. When is a good time to buy, sell or rent?
4. How do I know if I will achieve my desired ROI?
5. How do I gauge asking prices from sellers?
6. How do I know a good deal from a bad one?
Almost everyone would agree that novice investors do not know how to do fundamental analysis or read financial statements. They trade off the headline news and price momentum. They speculate very frequently, and lose a lot of money trying to flip property.
At the other extreme are successful investors who use fundamental analysis for property valuation. They buy, hold for long periods and generate fine returns.
Guessing games played in the Investment Guru land
Here are some ways the Investment Gurus try to gauge the “value” of a property:
1. Indicative Bank Valuations
2. Monitor average prices of new launches within the same or different regions
3. Gauge asking prices on price-per-square-foot for properties within the same or different regions
4. Developer’s Cost Based Approach:
Total Cost = Cost of Land + Construction + Financing + Taxes
Therefore, Selling Price = Total Cost + Seller’s Profit
5. Cost of Land Approach
6. Rely on ‘Expert’ Forecasters
When you walk into the “Investment Guru Land”, you’ll find that the investment guru who eats his own cooking is the exception, not the rule.
Sadly, the above ‘Try to beat the casino’ valuation methods are sold as ‘investment wisdom’ to retail investors and home buyers.
Take, for example, the Developer’s Cost-Based Approach. The major flaw in this approach – buyers suffer the seller’s chase for profits. In the case of a property developer, if his cost rises, he simply transfers these costs to buyers. This is an untenable position, especially for the average buyer.
Another evident example – Indicative Bank Valuations. Different banks can come up with very different valuations for the same property, which is baffling for many. Unfortunately, most people require a bank loan, such that the bank’s valuation is the final word.
If we are buying or selling a property, the bank’s valuation is a major determinant of the loan quantum. And herein lies another problem: SENTIMENT drives property prices.
Here’s evident proof of the flaws in relying on Indicative Valuations:
MS YVONNE LEE LEK SIEW LING: Recently, I received two valuations from the same bank for the same property which differed by $200,000 or 15% of the asking price. (Reported in the Straits Times Forum Page on 18 Jan 2011)
In response to the letter above,
“Indicative valuation should not be interpreted as the proper valuation of a property….. While Ms. Fischer finds that ‘indicative valuations’ are useful, they must not be relied upon for one’s property investment decision. …..it is not a subscribed valuation practice.”
Evelyn Chang (Ms.), Executive Director, Singapore Institute of Surveyors and Valuers, Feb 12, 2011 (The Straits Times Forum)
In response to a letter from another disgruntled buyer,
“We caution against relying on such indications, and urge buyers or sellers to obtain proper valuation reports from licensed appraisers if they need to ascertain the market values of their properties.”
Evelyn Chang (Ms.), Executive Director, Singapore Institute of Surveyors and Valuers, Jan 18, 2011
As you can see, the above valuation methods involve plenty of guesswork and exuberant assumptions. They may work in a bull market, but fail miserably in a bear market.
I Just Want the Truth!
So how do we value property as close to its true value as possible – even after taking into consideration all subjective elements like emotions, hopes… and sentiments?
How do you ‘value’ your property objectively and within reason – either as an Investor, Home Owner or Seller?
TIP: If you can get your ROI right, all other parameters, including price and location would have fallen into place.
Simple – start with the basics.
This is the thrust of the educational series of posts I will be writing on Property Valuation.
Exclude property cooling measures for simplicity. Answers are at the bottom of the page.
All you need is a pen, paper, financial calculator and a few minutes, and you will be able to derive your property valuation. I’ll explain my answers in future posts.
These questions are NOT purposefully designed to be confusing or to give you a big headache. I’m sure you’ll find that these questions reflect many similarities on actual grounds for making critical buying and selling decisions.
It’s okay if you fail to derive any answers – we learn from our failures. For those of you who did or came close, great job! You’re on your way to being financially wealthy.
I’m kind enough to provide many crucial numbers for you to work on. In reality, these numbers are NOT present and you have to find them by yourself! And this is the part where many investors fail….
Let the test begin…
1. A property is priced at $1.4 million and is expected to generate a yearly net cash flow of $41,200. Assuming no leverage, would an investor with a Desired Rate of Return of 8% be wise to invest at the current price and sell in five years?
2. Refer to the table below: Which investment has a higher Rate of Return, A or B?
3. I’m 35 years old today and estimate that I’ll need $1,000,000 to retire comfortably at 65 years old. If I’ve $100,000 to invest today, what annual Required Rate of Return would I need to reach my goal of $1,000,000?
4. Your investment’s Desired Rate of Return is 8% per annum. If a property has a 5% Effective Net Rental Yield, should you purchase it assuming all other parameters, including price and location, fall into place? Why?
Question at beginning of the article: Effective NRY = 2.7%
1. No, the Net Present Value (NPV) is -$292,212. Even though NRY is 2.9%, it is a wealth-decreasing project.
2. Investment B’s Internal Rate of Return (IRR): 25%. Investment A’s IRR: 20%
3. Required Rate of Return for retirement: 8% p.a.
4. Yes, 5% NRY is a stable yield investment and with leverage, the Total Return will be much higher than 8%.
By guest contributor Gerald Tay, who is the founder and coach at CREI Academy Group Pte Ltd, an organization dedicated to empowering retail property investors with smarter investing philosophy and strategies. He is a full-time investor with over 13 years of solid experience in building his wealth through Property Investment and is financially wealthy today.