Price is what you pay for a property, the value is what you get
“Price is what you pay. Value is what you get.” One of my favourite quotes from Warren Buffett, widely accepted as the greatest value investor who ever lived. It’s also a great motto for the property investor. In this article, I’ll explain what it means – and what it is that investors are really paying for.
What is the value of an investment property?
When we think about the value of any asset, what we really mean is the return it might produce. That return is measured in both capital gain and rental income:
- The more rental income your property produces, the higher its value
- The higher the price is likely to rise, the higher its value
Now, when we compare price with value, and when we discuss negotiating a discount when you invest in property, everyone considers ‘market value’ as the benchmark. This is great if you really believe that markets work perfectly, but they don’t. If they did, the price that sellers asked would always be the same as the price that buyers are willing to pay.
As a property investor, what you want to negotiate is the maximum value for the minimum price. So it pays to know what the real value of an investment property is – and not simply the market value, which is simply a price point based on a property, and usually by reference to nearby property prices.
Price does not equal value
You must disconnect from the way that most people think – that price equals value. It doesn’t, especially where investment property is concerned. A single property could hold different values for different investors. For example, let’s consider a residential apartment block in central London, in which apartments are priced at £400,000. Might this represent good value for:
- The investor who is targeting young professionals who work in the City?
- The investor who is building a portfolio of out-of-town properties for young families?
- The investor who has a ‘buy, renovate, sell’ strategy?
Clearly, for investors a and b, this opportunity holds no value. But for investor a, it might do. What they must now consider is whether its price will allow that value to be extracted.
How do you measure value?
There are three elements of value in an investment property:
- Rental income
- Capital gain
- Lifestyle value
Figuring out what the rental value is can be difficult. The best way is to compare with what other similar properties in the area are being rented for. You will also need to make an adjustment to your property. For example, a new build, never-before-lived-in apartment with all mod-cons and new furniture is likely to command a higher rental price than a 20-year-old flat that has never had its kitchen or bathroom updated.
So, the first thing you need to figure out is the rental potential – how much income will you receive from the property. When you do this, don’t forget to allow for void periods. How many weeks of each year is your property likely to be untenanted? Again, look at the local area. Speak to local agents and get a feel for the type of tenant and the average length of tenancy. If it’s 11 months, allow for one month of no rental income in every 12.
Capital gain potential
The second way that property investors gain value from their property is through the capital gain it makes. Of course, this is only a gain on paper until you sell the property.
Again, assessing the potential for capital gain is tricky, but there are some clues. For example, if you invest in an up-and-coming area which is receiving a lot of investment, it’s likely that demand for homes there will increase in the coming years.
The stronger the property fundamentals – the existence of and/or spending on new shops, schools, transport links, major employers and major investment – the higher and faster property prices are likely to rise.
Calculating price, based on your valuation
Before I look at the final element of value (lifestyle), let’s look at putting rental income and capital gain potential together to produce a valuation.
Let’s say that you are considering a property investment opportunity that meets the criteria of your investment strategy (near to town, aimed at young professional commuters). Having undertaken research and assessed the area comprehensively, you have discovered that:
- Rental income should be £1,000 per month, with one void month per year
- Property prices here are likely to rise by 7% per year over the next five years
Now, ask yourself, what gross return are you happy with? 10%? 14%? Of course, you must be realistic with your aims; but, having considered this, you can decide how much you are willing to pay for the property:
- If you want a gross return of 10% in the first year, then you would value the property at £550,000 (your expected rental income would be £11,000 and expected capital gain £38,500).
- If you want a gross return of 14% in the first year, then you would value the property at £157,000 (your expected rental income would be £11,000 and expected capital gain £11,000).
Before you have even spoken to the selling agent about price, you have an idea of the price you are willing to pay, because of the monetary value you place on the property reflected by the return you wish to make.
But, of course, investing in property is a lifestyle investment. So you must also consider lifestyle when valuing a property investment opportunity.
The value of a property as a lifestyle investment
This really boils down to two questions:
- How hands-on do you want to be?
- When do you want to start profiting from your investment?
Some property investors want a second job. They want to actively manage their properties themselves, vetting tenants, collecting rent, and coordinating maintenance. Others want a quiet life. They want their property to sit in the background while they enjoy the passive income it produces. Personally, I’m in the quiet life camp, so I always have an investment property manager look after my properties while I get on with my life.
Next, think about when you want to start profiting from your investment. For most people, this is later on in life, perhaps as they move towards retirement. Others want to start reaping the rewards a little earlier. You’ll have to structure your deal and investment finances accordingly.
So, remember: price is what you pay for a property, and value is what you get.
To discuss what your value goals are, and how to achieve them with property investment, get in touch with Gladfish today on +44 207 923 6100. Benefit from a free strategy session, and you could join hundreds of other investors who we have helped to build successful property portfolios.
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