Valuing Property - Discounted Cash Flow Method

I have been following a few forums recently pertaining to Singapore's property market and I am quite surprised that the market is pretty resilent in certain areas.  One of the areas selling well is Spottiswoode 18 whereby the news reported very good sales on 18 Jan 2011, despite the cooling measures.  In the same article, it was stated that other mass market condos were not doing as well with only 20% sold.

I gathered that investment in property yields profit in two areas, capital appreciation and rental income.  Since I strongly believe that capital appreciation is unlikely to be strong enough to attract investors after the recent cooling measures (as can be seen from only 20% sales of mass market condos stated in the news article), I wonder whether condo investment is still attractive from the rental perspective.  Afterall, Robert Kiyosaki's (although some claim that he made his fortune selling books than from property investment) Rich Dad, Poor Dad did talk a lot about buying property for rental.

My next question then is how to price property.  My best bet is the discounted cash flow model.  For those who are not familar with this, I have quoted from Wikipedia...

In finance, discounted cash flow (DCF) analysis is a method of valuing an asset using the concepts of the time value of money. All future cash flows are estimated and discounted to give their present values (PVs) – the sum of all future cash flows, both incoming and outgoing, is the net present value (NPV), which is taken as the value or price of the cash flows in question.

Using DCF analysis to compute the NPV takes as input cash flows and a discount rate and gives as output a price; the opposite process – taking cash flows and a price and inferring a discount rate, is called the yield.

Discounted cash flow analysis is widely used in investment finance, real estate development, and corporate financial management.

My next question is how do we use the DCF for property.  After giving it some thought, I believe that I have worked out a simple way to value the property.  I must state that this model is very simplified and I could have worked much further to make it more accurate by really considering all cash flow (e.g. loan taken, loan paid, interest paid, stamp duties, etc).  However, I feel that this model suffice to explain why some still think that property investment is worthwhile.  A very complex model will put a lot of people off.  Let's look at the table.

Assumptions

1. Property price of $700,000 (mickey mouse condo) over a span of 10, 20 and 30 years
2. Discount rate of 1% to 15% 
3. Flat rental of $2.5k (good location)
4. Capital appreciation (net of inflation) is 4% per year, e.g. capital appreciation 6% - inflation 2%

 Limitations of Model

1. Does not take into account loans and interest payment (I can do it but it's not ideal to illustrate a complicated model). This means that the calculated PV is lower if we consider the loan interest.
2. Did not consider increase in rental (meaning that the PV is higher if I were to price increase in rental).  Did not do it as I did not see significant increase in rental over the past 10 years.
3. Assume that the unit can always be rented out and the cost involved in renting out the apartment.
4. Capital appreciation does not take into crisis which is likely to result in negative growth. 

 

No. of Years	10	20	30
Rental income	$2,500	$2,500	$2,500
Cost	$700,000	$700,000	$700,000
Appreciation	4%	4%	4%
Sales Proceed	$1,036,171	$1,533,786	$2,270,378
Discount Rate	1%	1%	1%
Discount Rate	3%	3%	3%
Discount Rate	6%	6%	6%
Discount Rate	8%	8%	8%
Discount Rate	15%	15%	15%
PV at 1%	$1,222,171.22	$1,798,372.59	$2,458,676.91
PV at 3%	$1,026,914.62	$1,295,544.48	$1,523,379.02
PV at 6%	$799,395.09	$822,339.42	$808,240.79
PV at 8%	$681,250.10	$623,615.50	$563,357.64
PV at 15%	$406,688.68	$281,494.71	$231,269.04

Based on the table above, it is not difficult to understand why Spottiswoode 18 is a sell out.  At the current low interest environment, most individuals compares this investment with what they can get in savings or fixed deposit, i.e. 1%.  At 1%, the present value of the property ranges from $1.2m (sell at 10years) to $2.4m (sell at 30 years), assuming no downturn. 

However, when alternate investments with higher rates of returns appear (which is very likely as interest rates raise over a timeframe of 10-30years, not a question of if but a question of why), the present value drops.  It appears that if we assume 4% capital appreciation net of inflation, property will still remain attractive as long as mass market investments do not provide returns of more than 6%. To simply what this means, it simply means that the moment savings accounts or fixed deposits go to 6% or if investors become more complex over the areas and are better able to gather returns of more than 6%.  Once this happens, property losses the charm.

For more astute investors with annual returns of 8-15% or more, buying a property for rental yield now is simply not worth it as the present value of the property is much lower than what a person will fork out.  For example, the present value is only $406k (10years) and $231k (30years).  Some may ask what if he rents out for 99 years.  At 15%, the present value for holding 99 years is only $200k.  Surprising? Not to me.  As my investment returns falls into this range, there is no way I will buy a mickey mouse apartment at the current price of $700k.