There are a number of ways to value a property. The first and most obvious is market value; this is what most people talk about when they refer to value. Market value, very simply defined, is the price an informed buyer is willing to pay and an informed seller is willing to accept at any given time, where neither party is forced into the deal.
If houses were bought and sold thousands of times a day like shares on a stock exchange, this value would fluctuate dramatically. Because they’re not, however, we don’t see this variability, but it does exist. Market value can change quickly due to changes in the availability of credit, government policy changes and most of all, changes in market confidence. We can see this if we look at recent history. In Sydney, for example the price of housing has fallen 9.5% in the last year, despite there being very little change in the nature of housing there. We’ve also seen a nationwide lending crackdown, which in the past 6 months has substantially reduced the number of potential buyers and the amount they can borrow, which has reduced demand and led to falling prices. But unless this is the new normal, then credit will loosen and market values will rebound.
The upshot is this: I can accurately assess a property’s market value now, but this is only useful now, not into the future. If in a year’s time the market value has reduced by 10%, it doesn’t matter if I assessed it correctly to begin with - I’ve still lost 10% of the value of my asset.
So we need to find a way to value property that is more useful as a long-term property investor. This is where intrinsic value comes into play.
WHAT IS INTRINSIC VALUE?
In simple terms, the intrinsic value of a property is its replacement cost. Intrinsic value can be estimated by determining the cost of building an equivalent structure on an equivalent block of land. Unlike shares, houses and blocks of land are not identical, but you can generally find ones that are sufficiently similar to allow for comparison, particularly at the lower end of the market.
The Intrinsic value of a house will look something like this:
Land Value: $200,000
Improved Value: $200,000
Total Value: $400,000
The same can be done for apartments and townhouses, by dividing the total land value of the complex, by the entitlement of that particular townhouse or apartment (i.e 1 of 10 in a complex of 10).
HOW DO YOU DETERMINE A PROPERTY’S INTRINSIC VALUE?
You can most easily work out intrinsic value by determining what a similar vacant block of land has sold for, and what it would cost to construct improvements of similar size and spec. At Aquila Property Investment, we use Queensland land valuations to determine land value, and our unique value calculator to determine the value of improvements, based on their size, quality and age.
You’re never going to be perfectly accurate in working out a property’s intrinsic value. There are factors in the cost of replacement in particular that are difficult to measure, such as the value of good design, or in the case of townhouses or apartments, the cost of getting a project approved (which will be divided across all of the units). Nonetheless, it should give you a good baseline of what a similar property would cost to construct.
HOW CAN WE USE INTRINSIC VALUE
The main use for intrinsic value is to compare it against market value, to see if we are achieving good value or not. Intrinsic value’s primary strength is that it is far less subjective than market value. Market value can rise or fall rapidly based on how people feel about the property market. Intrinsic value relies on harder numbers: the value of vacant land and the cost of construction. This is helped by the fact we use land valuations, which are only conducted every 1-2 years - this gives the land value we use greater stability than the market value.
Intrinsic value’s greater objectivity gives us a useful anchor to test market value against. If, for example, the market value of a new house is $500,000, but if equivalent blocks were selling for $200,000 and I could build an equivalent house for $250,000, then the market value for this new house is too high. Even if I don’t build that house myself, someone else likely will and this will reduce the market value of the first property.
Let’s say we decide to build this new property for $450,000. This is the property’s intrinsic value, because that’s what it costs to produce, so paying $450,000 to do so is neither good or bad value. But how does it compare to similar established properties in the area? Let’s say we find an equivalent property that is 5 years of age, and we calculate that its intrinsic value is $400,000, based on the fact that the improvements are less valuable because of age. If the market price is $425,000, then building the house for $450,000 is good value compared to this. But if the market price is $350,000, then we would be foolish to build - as our new house is likely to be worth less in market value after it has been constructed. The established property, however, represents great value - as the market price is $50,000 below its intrinsic value.
This is the same process for units, if a little more complicated. We see a new unit that we want to buy, in a complex of 100 units. It’s for sale for $600,000. We work out the intrinsic value - the cost of land was $10,000,000 (or $100,000 per unit) and the cost of construction for that unit based on its size and spec is $300,000. If we allow for marketing costs and a fair 20% profit for the developer, then the intrinsic value of the unit is $500,000 - $100,000 short of the market value, and a difference that would take many years to recoup. The fact is, another developer can buy another equivalent site for $10,000,000, and build another 100 apartments for $300,000 per apartment, sell them at $500,000 and still make a profit of 20%. The next developer will also try and achieve the higher market value of $600,000 if they can, but while there are still profits to be made at a lower sales price, developers will keep piling in and building until an acceptable profit margin is no longer there.
Understanding a property’s intrinsic value can help us avoid major mistakes, and gives us the opportunity to profit from mismatches between market value and intrinsic value. It is not, however, a long-term predictive tool. If we want to maximise our future profits, we’ll first need to select the right kinds of property in the right locations.