April 23, 2010

When the Beagle sailed into Sydney harbour in January 1836, Charles Darwin wrote: "The number of large houses and other buildings just finished was truly surprising; nevertheless, every one complained of the high rents and the difficulty in procuring a house."
Some things never change. Rents always feel high if you're paying them, as does mortgage interest, but they're both obviously limited to what people are earning.
Over time, though, you'd expect the earning power of property (the rent it can generate—or save you if you live there) to rise roughly in line with the growth in average wages.
Over the very long term it has to be this way - it's not possible for people to pay more than their income in rent. In its 2001 yearbook, the Australian Bureau of Statistics (ABS) published a book full of statistics regarding the previous century of federation.
Figure 1: A century of rent                    1901         2001
Average weekly earnings (2001 dollars):        
                                                            $217.50        $830
Average rent on a 3 bedroom home (2001 dollars)     
                                                                $65           $250
% of income spent on rent                     29.9%           30.1%
Source: ABS
The average weekly wage for an adult male grew from "$4.35 for a working week of almost 50 hours, which after inflation equates to $217.50", to "$830.00 for around 37 hours work, in far better conditions."
So salaries averaged annual growth of 1.35% over and above inflation.
When it comes to rent "the average weekly rent for a three bedroom house in 1901 was $1.30, equivalent to about $65.00 today. The actual value today varies depending on location, but the average of eight capital cities for a three bedroom house is about $250 a week."
At 1.36% per year, the average growth in real rent was almost identical to the growth in salaries. It seems a fair assumption that this relationship will be maintained.
This assumed growth rate of income (rent in this case) is a key factor in any genuine valuation of an asset. And I'd like to take you through a valuation I conducted in 2008 on my former rental residence, a townhouse in Sydney. 
Valuation case study
This analysis was based on the expected cash the property would produce (or save me in rent) over its life; not a finger-in-the-air, hope-based assumption of continued price appreciation forever and a day. Here's how I went about it.
The first important input into my valuation was my “discount rate”, this is the rate of return I demand from my investment. When dealing with shares, I aim for something close to 15%. But due to the psychological and emotional benefits of home ownership, I was prepared to accept a lower return on a property investment; 10%.
Next, I need to consider how much of that return is likely to come from future income growth. I was generous to my property valuation in assuming that, in the modern era, wages growth (and therefore rental growth) can average about 2 per cent above inflation.
With the RBA targeting inflation of 2–3 per cent, I took a long-term rental growth of 4–5 per cent; although that rate is some margin above the real long-term growth rate, an assumption which serves to flatter the valuation and push it higher.
Total return
So, having settled on a targeted annual return of 10 per cent per annum and estimating future rental growth at 5 per cent per year, some simple subtraction told me the initial rental yield I needed to buy the property on; 5 per cent.
If my yield was below that figure, I couldn't realistically hope to achieve my long-term aim of a 10 per cent return. At the time, the rent being asked when I moved out was $850 a week, or $44,200 a year.
Out of this, however, the owner must meet the property's costs. I estimated these at about $6,700 (including $4,000 strata fees, $2,000 for repairs and maintenance and $700 for water fees).
The figure for strata fees could easily be higher. And, if you already own a property, you probably know of a dozen different "one-off" expenses I haven't thought of.
Anyway, for the purpose of my valuation, I was left with a net rent of $37,500, and for that to provide a yield of 5 per cent, I'd reach a value of $750,000 (the rent of $37,500 divided by 0.05).
If I were going to use the property as an investment, then I should also factor in the costs of managing the property (or my own time costs). A typical real estate agent's management fee would be 7 per cent of gross rent, amounting to about $3,000 a year and taking the net rent in this case down to $34,500.
On top of this, I'd have to reckon on an average of maybe about a week a year (being optimistic) where the place would be between tenants and therefore not paying me anything.
This brought the annual rent down to $33,650 and my valuation down to $673,000. So my valuation would range between that figure (as a pure investment) and $750,000 as a family home with no management costs.
So how far was my valuation from the price at the time? Well, the virtually identical townhouse next door sold at the time for $1.175 million (down from an asking price of $1.4million).
On my figures, the purchaser was accepting an initial rental yield of just 3.2 per cent. Adding a generous 5 per cent annual growth rate for rent, and the overall return would be 8.2 per cent (or 7.9 per cent if you subtract management costs).
For me, this just didn't cut the mustard and I moved up the road to rent another property. But I'd be interested in hearing the calculations being conducted by anyone paying today's prices for property.
I've certainly been out of step with the market for many years, so I'm open to the possibility that my logic is faulty. Or perhaps my ambitions of a 10 per cent total return are too lofty.
This article contains general investment advice only (under AFSL 282288).
Greg Hoffman is research director of The Intelligent Investor. BusinessDay readers can enjoy a free trial offer at The Intelligent Investor website. For more Intelligent Investor articlesclick here.