hey everyone eric here in this video
we're going to look at a home purchase
price calculator that i built
and you can download below that will
help us estimate what is a fair price to
pay for a home
based on the rent it can generate the
surrounding market
as well as comparing it to other asset
classes like stocks and bonds
okay let's get started so in order to
create a first estimate of
what is sort of a reasonable range of
what we should be paying for a house
you need two pieces of information first
off
you know we assume that we're looking at
an individual property
you need to estimate what the annual
rent
would be for let's say this house so it
doesn't matter if you're going to live
in the house or you're going to use it
as an investment property
and rent it out you should always
evaluate the price
as an investment as if you're going to
rent it so
let's say we're looking at the market of
reno nevada and we know that houses with
a similar amount of bedrooms that are
similar size and the exact same street
are renting for 2150 a month
so first we need to put into our
calculator 2150
times 12 months and that gives us an
annual rent of twenty five
thousand eight hundred dollars you'll
see that i've increased the rent two
point five percent a year
and i've uh built this model all the way
out to be a 30 year model so you can see
thirty years out
the rent is like fifty three thousand
dollars
okay the second piece of information we
need which is publicly available
is the cap rate so here's what the cap
rate is
the cap rate is the rent of the property
minus the operating expenses things like
property management
insurance all this stuff and so that's
the income that you would make
as the owner of this property excluding
the mortgage just the
income that the property generates
divided by
the price so let's say the property
generates five thousand dollars and you
you know after all of its expenses and
you paid a hundred thousand
the cap rate would be five divided by
one hundred so that would be five
percent
so let's look at the reno nevada market
and see if we can find some publicly
available
cap rates so we can put that in and
figure out
what is a reasonable price for the house
okay so reno nevada
nevada cap rates
class A real estate
okay so we can see here
that um you know we're seeing okay class
A real estate
or class double a real estate is 5.15
percent cap rates
so you're obviously going to want to
confirm this data like do a lot of
research
ask realtors and figure out what houses
in the neighborhood have been selling
for in terms of cap rates
but this is going to help you to to
figure out what is sort of the
value of the house relative to similar
houses in the neighborhood
okay so we know that the cap rate is
5.15 percent so with these two pieces of
information you collect
about a property that you're looking at
you can figure out
an estimated value for the house so how
are we calculating this
we're taking the rent twenty five
thousand eight hundred dollars
and multiplying it by one minus
the operating expenses we put in
operating expenses as
40 percent of rent typically you're going to see
30 to 40 percent
probably 40 if you're using a property
manager so
60 percent of that rent will be left over as our
income then we're taking that sixty
percent
and we're dividing it by the cap rate
doing that calculation gives us a sort
of a maximum price or an implied value
of three hundred thousand
five hundred and eighty three dollars so
you can compare this to what the house
is listed for or you know figure out
what offer you want to make
and see okay is this house reasonably
priced
this is a great starting point if you
like this content
please like this video and subscribe to
my channel it would really help me out
and i'll keep making content like this
and again if you want
you can download this template for free
off my blog
in the description below and use it for
your own calculations
so i would encourage any person at this
step to compare real estate
as an investment to other asset classes
the main other asset classes that people
invest in
are stocks and bonds there's obviously
other ones but mainly real estate stocks
and bonds so
i prepared a little bit of information
so you can sort of compare the value
of different asset classes so we know
that reno nevada has a cap rate for the
type of real estate that we're buying
of 5.2 percent so that's like the yield
on our investment is 5.2 percent
in stocks the typical valuation metric
is a price
to earnings ratio it's the price of the
stock
divided by the net earnings of the
company
so right now in the stock market we're
in the middle of a pandemic so it's
sort of hard to even know what the price
earnings ratio
is because companies are reporting price
to earnings you know they’re
reporting earnings all over the place
but some of the estimates that we're
seeing are about
30 times so every one dollar of earnings
a company makes people are paying
30 to 30 times that dollar of earnings
to own the company
and then bonds like high quality
corporate bonds reliable companies that
you lend money to and then they pay you
back and they pay you a yield
they're yielding about 1.5 percent
and this is a really low number relative
to historical standards
so how do we compare 5.2 30
and 1.5 well this is actually really
really interesting
we can convert each of these into a
similar metric
to compare it so we're going to convert
them all into price to earnings ratios
so this is very simple you just take one
and you divide it by the cap rate which
is the same as the yield
and you get 19 so for every
one dollar of earnings that the property
makes for for the owner
um the typical person is paying 19 dollars
uh 19 times earnings to own real estate
with stocks
it's just 30 times earnings and with
bonds if we do the same calculation one
divided by 1.5
people are paying 67 times the yield
to own a bond and the fascinating thing
about these three ratios
is that if you look over long periods of
time
they um the average has typically been
around 17
for all three of these asset classes so
if
you see that these asset classes are
very mispriced
sort of relative to each other that's an
opportunity
so bonds are absurdly expensive relative
to historical levels
stocks are very expensive relative to
historical levels
and real estate is priced a little
higher than historical levels
but relative to stocks and bonds real
estate is by far
the cheapest in this situation so
depending on the moment when you watch
this video and do your own analysis
it could be that stocks are the cheapest
or bonds are the cheapest but you want
to look at these three
to figure out like you know where should
i be hunting for deals
is real estate a good space to do it and
in this
situation if you need to deploy some
capital i would say real estate is a
good place to be hunting
okay so we have this three hundred
thousand dollars
but for as an estimated maximum price of
the property
but now um we should dive in and
calculate the
real cost and income of the property we
have an estimated rent
but you could go and reach out to
companies and figure out what would be
the actual property management fee
what actually would be the property
taxes in this neighborhood
insurance you know home upgrades et
cetera and you should crunch those
numbers for yourself
and i'm just going to show some example
numbers here of averages
that i'm just estimating that are sort
of averages across the u.s
so in the u.s if you pay a property
management company they generally take
10 percent
of your rent property taxes
an average could be like one percent of
the home value this can be
much higher and much lower depending on
the city and the state but
one percent for this example is fine
insurance
um half a percent of the value of the
property is
a reasonable estimate and home
improvements which is capex as
0.4 percent of the property next we want
to put something in for vacancy just to
make sure that you know as rent
as tenants change over time we're
covered in five percent
is is typically a pretty reasonable
estimate
and of course we're going to be buying
this property with
a loan so i've done some calculations
here
um anything in blue in this model you
can change
and it's a calculator so it'll just
basically update itself
so i've estimated we putting 20 down you
could put
10 and it would update but i'm saying 20 percent
because that's a very typical number and
that calculates for us
the amount of equity the down payment
and the amount of debt
based on our price that we calculated
above
i also put in an interest rate of 3.5
percent which is right now in 2020 kind
of what we're seeing
um in the market and the term of 30
years which is typical
and so here down below i use the payment
formula
so um this is an excel formula that will
calculate your monthly
mortgage payment basically or like an
amortized loan
and so it's looking at the term which is
30 years
it's looking at the monthly interest
rate which is just 3.5 divided by 12
and also the amount of the mortgage and
it spits out
the monthly mortgage payment for us
which would be one thousand seventy two
dollars
and annualized it is twelve thousand
eight hundred
and sixty nine dollars so
now down below we are going to calculate
what is the
actual operating income that we would
make off this property
as the owner because with that
information we can get an even more
exact
price that that we feel comfortable
about if we're going to try to buy this
property
so we know the baseline rent from up
above is twenty five thousand
eight hundred dollars vacancy we're assuming is 5 percent
of rent so again this the model
calculates
all this information for us you can see
the
the rent times the five percent then you
see property management which is the 10
percent times the rent
property taxes again this is pulling in
the the the property value from up above
and multiplying it by one percent
same with insurance same with capex so
we're estimating
total expenses of nine thousand five
hundred eighty one dollars
again you wanna collect the real
information on your property
but for this is for this example you
know this is this is perfect
and this would leave us with the rent
minus the expenses of sixteen
thousand two hundred and nineteen
dollars
so this leaves us at a sixty three
percent
operating margin so our income and
remember above we said 40 percent of
rent would go to expenses
so in this case it's 37 percent so it's a little
better than our initial estimates so
but it just shows that our initial
estimates were were very close and they
were reasonable
so given that we now have a good
estimate for our
income on the property we can
get an even more exact value by just
taking this income
and dividing it by the cap rate this
gives us sort of
you know that 19 times income that we
calculated on the asset class comparison
page
well we're doing that same thing we're
dividing the income by the 5.15 percent
and here you can see 314
or 315 000 which is pretty close to our
initial estimate of 300 000
so we know this is sort of a good range
to be in
now this from this 16 000
we need to pay our mortgage assuming
that we um purchase
basically 80 percent of the property with debt
so
when we do that we take the 16 000 we
subtract
13 000 and the cash flow of the property
is
3,350 dollars a month so
sorry a year so per month it's only like
what 200 bucks 300 bucks a month
but if we look at our cash on cash
returns it's a really typical metric
in real estate you say okay how much
cash did i actually make
3350 dollars and
how much actual cash did i put in i put
in
60 grand of cash so the return is 5.6
percent
cash on cash returns and over time the
cash flow should increase
as we increase rents you know gradually
and there's also an increase in value
over time
so here i'm sort of calculating you know
what we estimate the value to be
increasing by
over time and you can see that um
the the cumulative over time between the
the cash
flow and the value increase we expect to
be making
you know over long periods of time you
know
larger increases in in value and cash
here's an interesting point i just want
to highlight if you bought the property
with 100 percent cash
meaning like no mortgage um and you just
said okay
you know this property produced three
thousand seven hundred fifty five
dollars of cash flow and it increased
eight thousand in value
you see that the returns are actually
really really low
three four percent but this is
only if you bought the property 100 percent cash
when you have the ability to take out a
mortgage
it um increases the returns massively so
the key to real estate
is debt which is much different than
other asset classes like stocks and
bonds
which you typically do not buy with debt
you would just be buying with cash
okay so finally at the bottom we look at
our sort of overall cash on cash returns
i look at the increases in value and
sort of
the cash flow over time and this is
really interesting if we go out 30 years
you see that we put in 60 000 and we
actually end up making
655 000 so we
make uh
eleven times our money and you might be
thinking
wow this is incredible the only thing we
should be investing in is real estate
well that's actually not the case so
let's compare it with stocks
so if i put in sixty thousand dollars
into the stock market
and i made an eight percent return for
30 years
um let's just calculate what how much
money i would make
so 60 000 times one plus the eight percent
return
to the value of thirty years and eight
percent is like a
you know a return that is pretty common
in the stock market you actually also
make ten times your money
but you don't have to manage the
property it's completely hands-off if
you put it in an
index fund and you still make the same
amount of money so i bring this up
to say that you know you always should
compare asset classes
think about what is this asset class
going to do for me how is my money going
to work for me
and you know how should i be investing
in over time conscious of the overall
panorama of the investing environment
okay so um in the last piece is of this
655 000
um don't forget about taxes if you ever
sell this you're going to have to
pay a bunch of this gain in taxes and
also the time value of money
you know one dollar 30 years from now is
worth a lot less or it will be worth a
lot less than one dollar today
so we need to think about that in terms
of the net present value
so now you should have an understanding
of how to think about and calculate
what is a fair value to pay for a
property again
feel free to download this template
below if you want to play around with it
and i've also linked to some of my other
finance focused videos as well
if you found this content valuable
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thanks for watching and i'll see you in
the next video