Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 35

Residential investment property fails simple valuation test

The Herengracht Canal in Amsterdam has been a favoured strip of real estate in the city since the 1620s. The Herengracht House Index, constructed by finance professor Piet Eichholz of Maastricht University, tracks house prices in the area over a 380 year period – commencing with the Dutch ‘Golden Age’. Over that time, real (i.e. inflation adjusted) house prices have only doubled, which corresponds to an annual average price increase of something like 0.1%. This would indicate that despite short-term rises and falls, prices roughly follow inflation.

Valuing like other financial assets

What could this mean for investors in the Australian residential property market? It may have looked like an attractive option recently. Auction clearance rates have been healthy, but rising prices have prompted media commentary on a possible housing ‘bubble’. What do we find if we apply value-investing principles?

We’ll start by assuming that residential property, at least the investment kind, derives its value in the same way as other financial assets - by producing cash flows - and obeys the same fundamental financial laws.

Since property income is fairly predictable, the valuation exercise should be straightforward. We just need three numbers:

• discount rate, or rate of return required by an investor

• net rental income generated

• long-term rental growth rate

We can plug these values into a simple formula that will calculate the present value of the cashflows into perpetuity, following the same principles used to value a business.

A discount rate reflects the rate of return an investor needs to compensate them for the risk of investing in a particular asset. A good way to estimate it might be to start with the 10-year government bond rate (a proxy for the rate that applies when there is no risk, currently around 4% p.a.), and add a risk premium.

In the case of equities, the risk premium is commonly thought to be around 5-6%. I think a case can be made for a lower risk premium for property, given that it has a more stable profile, but we should also consider that property is a much less liquid asset than equities, and investors should demand some compensation for this. For the sake of argument, let’s choose a risk premium of 4%. This gives us a required rate of return of around 8%.

Net rental yield is the next piece of information we need. The chart below, published by RP Data, shows a current gross rental yield for Australian capital cities of around 4.3% p.a.

RM rental yields

RM rental yields

To calculate a net rental yield, subtract all the expenses that an investor must incur in generating the gross rent, including property management fees, maintenance, insurance etc. A reasonable estimate may be around 1.0%, which gets us to a net rental yield of 4.3% - 1.0% = 3.3%.

The final number required is the long term growth rate in rents. As shown in the chart above, a figure just above 3% p.a. may be a reasonable estimate. Let’s assume 3.2%.

Combining these numbers into a valuation can be done as follows: divide the annual rent earned on a property by a divisor, which is calculated by subtracting the long term growth rate from the discount rate, as set out below.

Value = Net Rent p.a. /(Discount Rate – Growth Rate)

This is the formula for calculating the present value of a stream of cash flow that grows at a fixed rate in perpetuity. If a property generates $20,000 per year of net rent, we would calculate its value as $20,000/(8% - 3.2%) or $20,000/4.8%, equal to around $416,667.

If that property can be bought today at a net yield of 3.3%, it would imply that the market price of the property today is $20,000/3.3% = $606,061. This is significantly higher than our valuation of $416,667. On the basis of the discount rate and long term growth rate we assumed, buying property on a net rental yield of 3.3% appears hard to justify.

Continuing assumption of capital growth

Over the past three decades, there has been a fourfold increase in Australia’s indebtedness as a percentage of annual disposable income, to 150%, as well as massive growth in property prices. Together with the above analysis, these facts indicate that the same level of growth is not sustainable. If this is correct, it may pay to be cautious about buying on the basis of a continuation of assumed capital growth.

Of course, the conclusions you reach with this approach depend on the assumptions you put into it, and the purpose here is not to argue that property is overpriced. Rather, it is to set out a framework that allows some basic assumptions to be converted into a fundamental value. By doing this, you can decide for yourself whether there is long term value to be gained.

Roger Montgomery is the Chief Investment Officer at The Montgomery Fund, and author of the bestseller, ‘'. 

May 26, 2014

A very good article. We have the incipient problem in Australia that many country towns, especially mining communities, are destined to become unviable as their population is replaced by automatic, remote-control operations, falling commodity prices (meaning that many mines will continue to operate only to service existing contracts) poor health and education choices (no specialists, long distances to travel for medical and hospital treatment) diminishing community spirit as workers leave in droves on weekends of at completion of fly-in, fly-out arrangements. Many people ave evaluating these choices as against living in expensive cities, even if they have expensive public transport. However, with the escalating cost of fuel, there will be no choice for many but to move to cities. This may appear to be a cause of higher prices in the capital cities, especially Sydney, Melbourne and Brisbane but it is apparent that country property has been declining at an astonishingly fast rate, with banks in general virtually not financing property in country towns unless the purchasers can almost afford to pay cash.

May 24, 2014

Hi Roger,

For some reason I think demand supply dynamics have been missed in your calculations. That's true in equities as well. If there is less free float of a stock then buyers who are interested in those assets must pay a higher price to obtain them. They may also have huge premiums to underlying value. Now how does one calculate what premium can be given to a property is based on ones needs and affordability. By your argument a 2bedroom in north shore should be similar to 2bedroom in western Sydney since cost of actual construction is similar except for council rates etc. which would be a small percentage to the actual cost of property.

I think there is a supply side issue in property markets especially in Sydney. Negative gearing has made it worthwhile for owning properties with low rental yields and till that does not stop property will continue to be the investment choice for Australians.

October 30, 2013

Dear Roger, Thank you for the article, I very much agree with your 'cash flow' approach, but wondered if the inclusion of a long term interest rate and an assumed level of long term financial gearing would reduce the cost of capital and bridge the valuation gap between intrinsic value and prevailing markets prices?

Roger Montgomery
October 30, 2013

Yes Steve, it might but the objective of a valuation is not to explain or arrive at the current price. We already know what the price is.

We look at valuations as a reference point below which we would be willing buyers.


Leave a Comment:



'FOMO' is driving residential property prices, not yields

Lending policies can spoil good SMSF strategies

A better approach to post-retirement planning


Most viewed in recent weeks

After 30 years of investing, I prefer to skip this party

Eventually, prices become so extreme they bear no relationship to reality, and a bubble forms. I believe we are there today, not for all stocks but for many in the technology space.

Australian house prices: Part 2, the bigger picture

There is good reason to believe the negatives will continue to outweigh the positives over the next 12 to 18 months. There is more concern about house prices than the short-term indicators suggest.

How to handle the riskiest company results in history

It is better to miss a results bounce and buy after the company has delivered than it is to step on a landmine. With such uncertainty, avoid FOMO by following these result season investing tips.

Australian house prices: Part 1, how worried should we be?

Three key indicators are useful for predicting the short-term outlook for house prices, although tighter lockdowns make the outlook gloomier. There is enough doubt to create cause for concern.

Welcome to Firstlinks Edition 369

Imagine you had perfect foresight about COVID-19 at the start of the year. You correctly foresaw that the global pandemic would kill over 700,000 among 20 million infections by August. In Australia, borders would close, cities would be locked down, most mortgagors would be on income support and companies would be allowed to trade while insolvent. You then had to guess how much the stock market would fall. Would you say about 10%?

  • 6 August 2020

The rise of Afterpay and emergence of a new business model

Sometimes the simplest ideas are the best. The founders of Afterpay stumbled on the attraction for consumers of paying by instalments, and now retailers must offer the facility or lose business.

Latest Updates


The 'Heady Hundred' case for unglamorous growth

Checking global stocks with higher prices than the FANGAM stocks but weaker margins and growth identified almost 100 companies. Astonishingly, the ‘Heady Hundred’ are valued at over US$3 trillion.


Share Purchase Plans brickbats and bouquets

Many Share Purchase Plans leave large gains on the table for institutions, but some companies are handling them more equitably. As a shareholder, check if your company receives a pass or a fail.


Three new lessons about listed companies during COVID-19

Many companies have strengthened their balance sheets but their soundness can be directly correlated to the duration of the pandemic. What lessons has 2020 revealed coming into reporting season?

Investment strategies

What does the 'fear gauge' VIX really mean?

The VIX as a measure of risk has a place in equity markets in interpreting market sentiment, but it is overly simplistic to think it can represent volatility in equities as a whole. Just what is it?


Where we see growth opportunities in software stocks

Financial software companies have favourable attributes and industry tailwinds that may see investors rewarded, especially with super funds driving for greater efficiencies and better member experiences.


Five ways to use the family home for retirement income

The family home is the bedrock on which many retirement plans sit, with special tax and social security benefits. Many products generate an income stream from the home to make retirement more comfortable.



© 2020 Morningstar, Inc. All rights reserved.

The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use.
Any general advice or class service prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, has been prepared by without reference to your objectives, financial situation or needs. Refer to our Financial Services Guide (FSG) for more information. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.