John Paulson gave an interview on CNBC in which he described the “best investment for a retail investor”. To some it may come as a surprise that this wasn’t some stock or bond, it was to buy a home (or primary residence).

For many this will represent a large investment, possibly larger than the whole of their equity investments put together. So why is John Paulson saying it is a good idea?

Housing is an essential cost, if you don’t buy a house then the alternative is renting. Paying a mortgage lasts a finite time, renting lasts forever so in the long term (30+ years), buying is almost always cheaper. High leverage means outsized returns. If I put down a $10k deposit on a $100k house, and that house goes up to $110k in value, I have a return of 100% on my initial outlay. Interest rates are low – it has never been cheaper to borrow money.

I want to focus on the second point above, because ‘high leverage’ to any value investor brings one thing to mind – high risk. If that house instead falls to $90k in value, you have just lost $10k. If it falls to $80k in value you are now trapped in negative equity. Over a period of 20-30 years the chances of house prices being below where you bought are minimal due to inflation, but in the short term it can create financial pressure on you, especially if interest rates rise in combination (and house prices are correlated inversely to interest rates which makes this scenario realistic).

But more than that, us value investors can’t stand paying more for an asset than it’s worth. Even though we are long term focused and pretty much guaranteed to be better off buying in almost any scenario, we can’t help but want $1 for 50 cents and practically vomit at the idea of paying $2 for it.

So we can’t help but be curious, what is the intrinsic value and how do you assess your risk? There are always pundits saying house prices will crash, or interest rates will rocket. How do you know what a ‘fair’ value of a house is. In this article I’ll look at how you can assess this. I don’t disagree with John Paulson, buying a home is a great investment – but from an academic point of view valuing a house is very interesting.

Where to begin valuing a house?

Most people will be familiar with the huge industry in house valuation and selling. Agents use similar sold prices in the area to see what the market is willing to pay for a house and will advise you on it. But us value investors know better than to trust Mr Market to value our assets. If the market fails in such a highly competitive and liquid market like the Stock Exchange, then do we really believe it works for real estate when:

Real estate is highly illiquid with few transactions locally A lot of buyers and sellers have little investment knowledge, and could be thought of as simply ‘dumb money’

So where do we start? Well there is another market connected to real estate that is more liquid and more competitive. It also involves more sophisticated investors. This is the rental market.

Using the rental market

Most big cities will have a large rental market with apartments and houses competing with one another for tenants. This market is much more liquid – people can move around far more freely and will do so if their rent is beyond other rents near by.

Because of this liquidity, the rental market is more competitive and much better reflects supply and demand of housing in the area. If more people want to rent than there are houses available then landlords will charge higher rents. Conversely if few people want to live in an area landlords will have to compete harder on pricing to attract tenants.

Finding market rents is also relatively easy, simply browse a local agents website to find a list of advertised apartments and the rents requested.

But how do we use these rents to determine the value of a house?

Well we treat it as the same as any other investment, its value is the discounted sum of all future cash flows. But there is no need to put together a complex equation, all this says is that the ‘intrinsic value’ of a house is proportional to the rental income it achieves.

Rental yields

To calculate, Rental Yield = Annual Rent / House Price. If we assume that Annual Rent in the current market is fair, and we know a normal rental yield is then we can calculate intrinsic value as Annual Rent / Normal Rental Yield.

But what is a normal rental yield? Well this is the tricky part, there is no universal answer. For me living in London, the norm is for rental yields to be low because of the high demand for houses in the capital and void periods (when houses sit empty waiting for new tenants) are very short. If I was to live in a small town in central USA, a normal rental yield would be much higher. We need to review the historical rental yields in a specific area, and this isn’t easy. Data is scarce and can be difficult to locate.

Example: London

I am going to look at London as an example because house prices have risen around 50% in the last year in some areas. Many are calling it a bubble, others say it’s simply high demand from an increasing population. It’s also easy to get data on London. Here is a table with the current rental yields on London property in different areas.

Postcode 1 Bedroom 2 Bedrooms 3 Bedrooms EC1 City of London 4.5% 3.0% 4.6% W1 Central London 2.9% 2.7% 2.5% W8 Kensington 2.7% 2.3% 3.5% W9 Maida Vale 4.4% 3.7% 3.1% W11 Notting Hill 3.3% 2.8% W12 Shepherd’s Bush 3.9% 3.3% W14 West Kensington 3.5% 2.9% 2.4% NW1 Camden 3.9% 3.5% 4.3% SW8 South Lambeth 3.2% 4.2% SW10 West Brompton 3.4% 2.5% 3.1% SW11 Battersea 5.6% 4.5% 4.2% SW12 Balham 4.8% 4.1% SW15 Putney 5.7% 4.4% 3.7% SW17 Tooting 4.5% 3.8% 4.5% SW18 Wandsworth 4.8% 4.1% 2.9% SW19 Wimbledon 4.7% 3.8% 3.4% N1 Islington 4.5% 4.1% 3.8% E14 Poplar 5.8% 5.5% 4.9% E15 Stratford 6.4% 6.1% 5.4% SE10 Greenwich 5.4% 4.4%

Source: http://www.londonpropertywatch.co.uk/average_rental_yield.html

You can see how much they vary within even one area, depending on the size. Also some areas, like Central London, which has high cash-rich foreign investment, have far lower rental yields than less affluent areas in London like Putney:

The chart shows historical rental yields in Putney, though only for the last 10 years or so. These may look fairly flat to you, but don’t be deceived by the power of rental yield. For example a rise in yield from 4% to 6% may not seem like much, but at constant rental income represents a 33% fall in house value. This chart suggests a 1 bed flat in Putney may represent good value at the moment.

We don’t just need to look at history though, also think from the perspective of a landlord. What % return would you want from a particular house? It would depend on things like what interest the bank pays you. If it’s high at 5% you wouldn’t invest in a property yielding 4% in rent. Conversely, while it’s low now at sub 2% suddenly even a rental yield of 3% looks attractive.

Let’s take a look at Central London:

This shows a completely different and interesting picture. I would be wary of buying a property in Central London at the moment with rental yields so low. If a more normal 5% yield returns, house prices could halve in value. At the very least this suggests that house price inflation cannot continue at the rate it has been without becoming dangerously overvalued.

Conclusion

This analysis can be a good guide when purchasing a house but like I said early in the article, buying a home is almost always cheaper than renting in the long term. Even though rental yields in an area can be abnormally low, you don’t know how long they will remain so. For every year you wait, that is an extra year of paying rent. Unless you foresee some catalyst on the horizon for house price falls, then the sensible thing to do is buy a home that you can afford to make payments on (under higher interest rate scenarios too!)

Also, there is more to buying a home than from an investment standpoint. Having your own home where you can raise a family in stability has a lot of intangible value. On the whole I agree with John Paulson, buying a home is probably the best investment someone can make.