Find Real-Estate Value Using This Litmus Test

Housing in the U.S. is still in a fragile state. Prices for the average home continue to fall, although they have leveled off in some areas. Investors are wary, though. Buying a house in certain areas is like trying to catch a falling knife.

I want to show you a simple method that can help prevent any major wounds. At the very least, it can help ensure that you can cover your investment expenses.

Where Are Home Prices Now?

Measuring home values with any accuracy is next to impossible, but there are indexes that try. Eleven years ago, Case-Shiller created a home-price index that measures percentage changes in the average home prices of 20 cities across the country.

In January 2000, the index was set at 100. It peaked at 206.52 in July of 2006. Now that index is back down to 139, meaning that the average home value in America is only 39% greater than it was in January of 2000.

In much of the country, housing values have plummeted below April 2003 levels, which was the last time the index was at 139.

There are arguments from both sides. Some say that we are seeing signs of stabilization, and even growth, in the real-estate market. Others think that home prices still have room to fall.

While pundits and indexes like Case-Shiller can offer us general insight into the health of the housing sector, they can’t tell us what is going on in our own backyards.

Get Specific

Don’t get caught up in the hype, but take a look around your neighborhood for opportunities.

If you have lived in your area for at least five years, you probably have a good idea about what is going on with your local market. You most likely know the streets that are popular, what areas are selling and what sort of rents people are paying for houses and condos.

If you are not familiar, take some time to check out Realtor.com and take a look at local home values and, even more importantly, rent rates. You can also find this information on other sites like Zillow and Craigslist.

The reason I bring up rent rates is that rent rates can help you figure out if buying real estate makes sense or not (even if you aren’t going to rent it out).

Rent rates are a major part of my litmus test.

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Sara Nunnally simplify the stock market for you with our easy-to-understand investment articles.)

Find Value Using Logic

Real-estate value is EXTREMELY subjective and completely reliant on area demand. How else could a 600-square-foot studio rent for $3,000 in New York City and $400 in Dallas? In more densely populated urban areas, you can use rent rates as a comparison for value. This method won’t work so well in rural communities.

I have bought and sold about a dozen properties in Dallas over the past eight years and have used this method to help me ensure a good value. There are obviously no guarantees, but I will tell you from experience that rent rates can be more stable than home values in the long term. They can really help you justify (or pass on) a deal.

This method has helped me to profit in every real-estate investment I’ve been in.

I call this method my modified cap rate calculation. Let’s start with what the basic formula looks like:

A capitalization rate is how quickly you can make money on an investment. But I add a twist.

My calculation is slightly different.

I assume that an investor needs to borrow money to buy the property. I use typical investor rates with a 20% down payment to find out how much my costs are going to be each year.

Then I divide the average yearly rent in the area by my annual costs to find the modified cap rate. Here is what it looks like:

Say a condo costs $100,000. A 20% down payment means an $80,000 mortgage. A 30-year mortgage with a 6.75% rate will cost $6,226.56 a year. Then you have to factor in taxes ($1,500), condo fees ($1,200), and insurance ($300). When all is said and done, rent is $12,000 a year.

Now say your total annual costs are $9,226.56. That means you’re left with $2,773.44 in profits.

This is good. You want to make a profit. In your math, you should use the lower average of the rents in the area. This gives you a conservative estimate for your profits.

Then I take it a step further. I want the profit to be at least a 25% return on my total annual fixed costs.

In the above case $2,773.44 divided by $9,226.56 is 30%.

A 25% profit means the property could carry itself if I had to rent it out, and it also will help to account for repairs.

Don’t forget that there are tax advantages to owning real estate, and write-offs on mortgage interest. Make sure you speak to an accountant first.

Selling the Property

You don’t have to rent the property. Investors sometimes just want to try and make a profit from reselling the house. But they can use this simple calculation, too. It helps to be able to rationalize cost on the house. In times of high demand, buyers will generally pay more for homes and don’t care what it can rent for. They are betting that the value of the home will rise.

But using this formula tells you if you’re able to profitably rent the home while you wait for prices to appreciate. You can at least feel good knowing that if worse comes to worst and you had to sell, a buyer would be more attracted to a house that is returning at least 25% on its annual costs!

Editor’s Note: Velocity Trader’s Zach Scheidt has another way to make money in the housing when the market goes bust.

U.S. homebuilders have staged a remarkable recovery — propped up by government stimulus and a rising stock market. But these companies are about to take a major hit!

In this special report — yours absolutely free – Zach’ll show you how you could protect and grow your money when it happens! Get all the details from Taipan’s Velocity Trader.

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