Following Part 1 from last week, this time I would like to discuss the best way of thinking about the approach to figuring the reasonable and fair price of a home. I am sure there will be different opinions and views on this matter, but I would like to comment on this from my point of view. Being the age I am now, I have experienced and lived through quite a few bubble bursts. My point of view is based on such trying experiences.
Basically, I look at the reasonable and fair price using two factors. The first one is the ratio of the average price of a home in a particular area to the average household income in that area. What I find to be reasonable and fair price would be where the Average Home Price is within a multiple of 3 ~ 5 times the Average Household Income. I have a range because you still need to consider the various elements of the subject home, such as level of security of that area, the age of the home, access to transportation, existence of good schools, and availability of daily life infrastructure, including supermarkets, medical facilities, etc., all of which make our lifestyle comfortable and safe.
The second factor that I look at is the relationship between the selling price of the home and the amount of rent that it will command if rented out; in other words, the property’s net return. In Japan, gross returns are oftentimes indicated for a property but please disregard it as it is nonsense. What one should focus on is the Net Return. Broadly-speaking, Net Return is arrived at by subtracting the property’s maintenance costs from the annual rental income actually received. This is called the NOI (Net Operating Income). You then divide this number by the listing price of the property to obtain the percentage return.
These days, because home prices have skyrocketed, it is not surprising to see net returns in the 1% ~ 2% range, especially in the more popular neighborhoods. Certainly, if you apply leverage by using home loans, particularly at the current low interest rate environment, one can attain an outwardly higher net return. I said “outwardly” because, after you consider the various risk premiums, the net return may not be that high.
In Part 3 next week, I would like to explain what risk premium is and discuss what kind of impact it might have on the net return.