When it comes to bidding, how much is too much?
Published 28/02/2016 | 02:30
One question homebuyers have is how much they should pay for a house. The relationship between house prices and rents - the yield - is a good measure of the health of the housing market as a whole. But on a day-to-day basis, how useful is this big picture connection between house prices and rents?
It turns out that this link between house prices and rents is actually really helpful for those who have decided to buy and are wondering how much to bid on a property.
When friends ask me "Is now a good time to buy?" I tell them it's not about the when, it's about how much. There's never a bad time to buy, if you look at a house over the right time horizon - 10 years plus - and are only willing to buy it for the right price. But how do you come up with the right price?
Take a family thinking about buying a home in today's market. Suppose they are going to bid on a three-bedroom semi-detached house in Meath, close to the coast. They check the latest Daft.ie House Price Report and find that the average price of a three-bedroom semi-d in Meath currently is €145,000. But the house that they are interested in, in Bettystown, is listed at €225,000.
Should they rule out buying this property because its list price is so high?
Not necessarily - remember that the figure given in the Daft.ie report is just a county-wide average. In a county like Meath, there can be a huge differences from area to area. Properties in Dunboyne, close to the city, or in Bettystown, close to the coast, are more expensive on a like-for-like basis than properties in Oldcastle, near Cavan. Indeed, the same is true across the country. Instead of a national housing market, what we have is really a collection of thousands of micro markets dotted around the country.
And this is where the yield, or relationship between rents and prices, comes in. When thinking about how much to bid, and especially your maximum bid, think about what multiple of the annual rental bill you'd be prepared to offer.
It helps to calculate the yield, the cost of rent for a year as a percentage of its current value for sale. A 10pc yield, for example, suggests you should bid no more than 10 times the annual rental income (100 divided by 10), while a 5pc yield suggests you should bid no more than 20 times the annual rental income (100 divided by 5).
Back to our house in Bettystown. The prospective purchasers know that a three-bed semi-d in the area rents for roughly €1,200 a month, or almost €15,000 a year. This annual figure should form the basis of any bids they make and in particular should help them figure out what their maximum bid is.
The latest edition of the Daft.ie Rental Report shows that the average yield for a three-bed semi-d in Meath is a little over 7pc. Seven goes into 100 just over 14 times, so what the market is saying is that, on average, three-bed homes in Meath are worth roughly 15 times their annual rent.
I've rounded a little bit. The annual rental bill is actually a little bit less than €14,500 and seven doesn't go into hundred exactly 15 times. This is because using the yield is not an exact science. It's a method to make sure that the value you are placing on the house is in the right ballpark. Here, 15 times the annual rent of €15,000 gives a figure of €225,000. In other words, in this case, the listed price is in line with what looks healthy across the rental and sales markets.
It's worth highlighting that if the house had been listed at €250,000, rather than €225,000, that shouldn't affect the maximum this family is willing to pay for living in that house. The property's worth is determined not by the seller but by the value of the service you get from the home - and we can measure that through the rental market.
Another thing to note is that this multiple of the annual rent will vary across different property types - the bigger the property, the bigger the multiple on average - and also vary by region (and also over time). Whereas for three-bed homes, the multiple is typically 15, for four- and five-bed homes the multiple is between 20 and 25. For one- and two-bed homes, the multiple is closer to 10 times the annual rent.
There is nothing to stop this family bidding more than €225,000, as long as they know that, if they do, they are driving down the yield of their own home. In more everyday language, they would be paying more for the property relative to the value they get out of it on a day-to-day basis as a home.
Taking on more risk should only be done if you've a good reason. Ultimately, if you buy a property, that means you value it more than anyone else on the planet - so know why!
Not understanding this logic of the value of a home is where the Irish housing market went wrong in the mid-2000s. Ten years ago, people were bidding 35, 40 and, in some cases, 50 times the annual rent to buy a house. If you bear in mind the logic of bidding multiples of the annual rent when buying a home, we can make sure that doesn't happen again.