How to tell if a property is overvalued

In the wake of the incredible house price boom witnessed in most of the developed world over the past decade, a lot of ideas have sprung up as to how to value a house 'fairly'. The reason for this is that traditional methods, such as working out house prices as a multiple of salaries, or perhaps mortgage affordability as a percentage of income, seem to have 'stopped working' recently.

There can be no doubt that house prices are .. ahem! .. at the top end of their range compared to traditional valuation methods, but don't let anyone fool you that this is now the 'norm', or that a 'new paradigm' is in place. Such talk rightly marks the climax of an asset bubble, as witness the dotcom bust as the millenium rolled over. Many things can change as technology and societies develop, but basic human nature isn't one of them, and the twin drivers of any asset bubble, fear and greed, are rather depressingly evident in this bubble too.

So if you live in an area where houses are trading at, for example, twice the historical sustainable relationship to salary, how can you tell whether this is 'ok' or 'bad'? Easy. There is one relationship that has stood the test of time and wheathered all previous house price booms and busts - the relationship betwen the house as an asset, and the return on that asset.

What do we mean by this? Any asset has a 'return' - what you make for holding the asset. Houses traditonally 'return' in 2 ways - by capital appreciation (house price growth) and by rent (if you own a house, you could rent it out). As it can be difficult to create a simple equation that factors in both these elements indivdually, they are usually rolled together, to give an easy way of comparing the required sale price of a house against it's 'true' worth.

Is it complicated? No. It's simple. If the price of a house is 12 times or less the annual rental income you can achieve from that house, then it is a 'buy'. A good investment in other words. These levels were last seen in the UK almost 5 years ago, and in the US over 3 years ago. Conversely, if the price of a house is 20 times or more the annual rental income you can achieve on that house, then it is a definite 'sell'.

As an example, say you want to buy a house priced at $100,000. You know that the house currently rents for $10,000 a year. According to the calculation, the house will be a 'good buy' up to 12 x $10k, i.e. $120,000 , so in this case yes, it is worth buying now, as you are likely to both cover the mortgage costs with the rent, or even make a small profit on it, and also benefit from any coming capital growth.

Another example, you own a house that rents out at $20,000 a year in a swanky neighborhood. You notice that identical houses in the street are up for sale (and selling!) at over $500,000. Guess what - it's time to sell - the house is over 20 times more expensive than the annual rent! Chances of any more capital appreciation in this market are slim, and you can actually make a far better return by simply selling the house and putting the proceeds into an interest bearing bank account. Interestingly, most amateur investors tend to hold property rather past this point, and end up unable to sell as the market tips to the downside. If the figure of annual rent to price is already way past 20, you may be too late to sell easily.

Not as complicated as it seems, is it? Just remember the '12 - 20' rule, and you should be able to enter an exit the house market at the very best times.