There are keys to finding an investment property that will at least track the market. One tool, developed by Edward Leamer at UCLA, is a creative gauge that can help you evaluate different properties for their appreciation potential.
Leamer’s concept is a variation on how stocks are evaluated. When analysts look at stocks, they often focus on the price-earnings ratio as a measure of whether the stock is overvalued or undervalued.
The higher the number (especially relative to either the market as a whole or to historical averages), the more likely the stock is to decline in price over time. For example, when technology stocks were the place to be in the 1990s, most of them not only had high price-earnings ratios relative to more traditional stocks, but also were trading at extraordinarily high price-earnings ratios.
Consequently, the tech wreck really came as no surprise.
What Leamer proposed was to view real estate in a similar light. In this case, though, the ratio is the price of the investment property to the annual proceeds of the rent. This calculation will give you a standard by which you can judge the relative potential for appreciation of different properties in different neighborhoods and even in different cities. In other words, it helps to make sound investment decisions by giving you a tool to measure alternative investments against each other.
Here’s how it works.
* Plan A. Suppose you’re looking at a $255,000 property that will rent for $1,500 per month, or $18,000 per year. (We can assume there is no vacancy period, but you can figure in whatever you deem to be a reasonable.) You are also looking at a $120,000 property that will rent for $850 per month, or $10,200 per year. The price-earning ratio for the first property is approximately 14 (255 divided by 18), and the second is approximately 12 (120 divided by 10.2). The second property appears to be a better candidate for appreciation since it has the lower price-earnings ratio.
* Plan B. For a truly effective comparison of the two properties, you need to make a second calculation. You need to look at the price-earning ratio average for both properties relative to those properties in the same neighborhood. If the ratio for the neighborhood of the first house is 20 while the ratio for the second house is 10, then the first property might be the better buy. It is underpriced relative to its surroundings, while the second property is overpriced.
Although all this might appear complex, it’s really quite simple. After all, you already know the prices being asked for the properties you are evaluating, and you should know what rent you can charge once you own them. All that’s needed is to find out the averages for prices and rents in the immediate neighborhood, and you’re done.
Any local real estate agent or property manager should be able to help you out with these two numbers.
Here is a helpful process to go through if you want to choose a property that will propel you to financial success.
Ask the professionals. The people who best understand the housing market are those who are in it every day and who depend on it for their livelihood. If you are interested in where prices will rise the most or where the best rental property buys are in your area, seek out real estate agents, developers, builders and city planners. They have a feel for the market and will be able to point you in the direction of the bargains.
Try this. Interview a number of the top people in each of these fields and ask them about the future of the community. Try to understand who is now living in the community and whom they think will be living in the community in the near future. Find out which neighborhoods they think are the best values and which neighborhoods will be boosted by the development going on in the community. From their answers, you should be able to form a clear picture of where the opportunities for investment are in your area.
Read the local brochures. Promotional material, news circulars and community associations have newsletters and bulletins that contain real estate information and potential projects that could affect the value of housing.
Visit the building department. Ask what major employment, transportation or development projects are on the drawing board? Is the municipality using federal money to place new facilities? When will these come on line and begin to change the location of jobs and residences?
Tom Kelly’s new book “Cashing In on a Second Home in Mexico: How to Buy, Sell and Profit from Property South of the Border” was written with Mitch Creekmore, senior vice president of Houston-based Stewart International. The book is available in retail stores, on Amazon.com and on tomkelly.com
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