Tuesday, March 27, 2012

Residential Housing as a Fixed Income Alternative

The alternative decision that many home owners have is: if one does not want to enjoy the intangible benefits of living in their dream home, renting is an option.

Trying to think about a home as an investment-alternative, let us try to apply the Dividend Discount Model (DDM) as a tool to appraise a “fair value” for a given property. Using the following assumptions:
1.      Monthly rental payments are qualified as a “dividend” 
2.      The long-term annual rent and property inflation factor of 3%
3.      No time horizon needed because this is an income-evaluator
4.      Required rate of return depends on the judgment, the demands of the investor
Studying the following examples with three different return requirements:
Notice that the same income-producing property (at $2,000/mo or $24,000/yr) can have three separate “fair value” prices, depending on return preferences. A 10% ROIC translates into paying no more than $343,000 for the estate, if 5% then $1.2 million is justifiable. We won’t get into specifics of what the implied risks are, which have to be priced into the required return. If the wide range confuses you, that’s a good thing - that reflects the limitation of applying models to reality. The point of this whole exercise is to help you as a Buyer or Seller to appraise the value of a home given your alternative option—renting to generate income.

If this peeks your interest, please, let me know. We can apply some examples!