There are generally three approaches to calculate the right price for any property; using historical data, using today’s data, and using future data. Most people use the first two approaches as they are more straightforward and easily understood, but in this post, I will focus more on the third approach – using future data.
Common approach – using historical and today’s data
Using historical transaction data – starting from launch price to the recent transacted prices, one will be able to calculate the average yearly capital appreciation and use that to estimate the reasonable price tag for a particular property at this point in time.
Using today’s data is only possible recently with the help of SRX’s live platform which provides real-time transaction information. However, this real-time information is not available for individual buyers or sellers who are not represented by an agent which put them in a less favourable spot when comes to getting the best deal.
By referencing to historical and present data, the common approach has a goal of validating if the current asking price is the right entry price to buy – entry strategy. In the next section, I will introduce an approach that is closer to an exit strategy.
Less used but powerful approach – using future data
This approach is not new to the financial world, but very under-utilized in the arena of real estate.
It is the discounted cash flow approach.
It looks at bringing the projected future income into today’s monetary equivalent so as to get a meaningful indication if the cost to purchase is worthy or not.
Step 1: List down all yearly income and expenses
- Multiply recurring monthly income and expenses by twelve to get the yearly amount
- Include all cost of buying and selling such as legal fee, agent’s fee and etc.
- Set aside some expenses for some minor repair work
Step 2: Discount net cash flow for each year to present value
- For each year, sum up all the income and minus all expenses to get the net cash flow for the year
- Calculate the present value for each year by using the formula in the diagram below
Step 3: Sum up all discounted present value
- Add up all discounted present value
- You will get the net present value of this property
- This is how much it should cost you to buy today
Should cost method is always wrong
Just like any estimate or projection, this should cost method will always be wrong. It can never be entirely correct.
Due to the assumption made on interest rate either constant for the entire time period or varies as per your subjective interpretation of the future and the inflation effects on future income and expenses, these uncertainty makes it only an estimate.
So why use this method?
Because we all have an interpretation of the future whenever we buy any investment product (consciously or subconsciously), and this method will allow you to quantify them into numbers.
Should cost method will allow you to quantify interpretation of the future into numbers.
Hence, by using these numbers will bring objectivity in when you are comparing a few properties based on the same assumptions.
This is how you should shortlist and find the right property to invest.
Are you already using this method?