As Charlie munger says, it is useful to invert a problem and think through. So let me try that and please bear with me on the mental acrobatics.

If like me you believe the basic definition that the intrinsic worth of an asset is the sum total of all the cash flows one would receive out of an asset from now onwards, then real estate could be analysed using the same approach as stocks or bonds.

Using that logic, we can say that there are two components to the cash flow
1. Rent which is equivalent of dividends
2. Final sale price of the asset (real estate) which is the same as the sale price one would get from a stock or bond

Like stocks, it is easy to get the value of rent (or dividend), but difficult to get the final selling price. In case of real estate the final selling price would depend on the state of real estate market, interest rate, economic activity of that area and location of the real estate. This is similar to stocks where the final selling price depends on a large number of factors, most of which cannot be predicted.

Using the same analogy, if it is possible to value a stock roughly, if not with precision, then one should be able to get some idea whether the real estate asset is under valued, over valued or fairly priced.

I recently read an article in fortune on real estate valuation, current pricing and likely future of the same in the US
Real estate : Buy hold or Sell

I have included a few paras from the article which are very relevant for valuing real estate

Many factors determine the value of a house. A family would consider the quality of local schools, the number of bedrooms, the size of the yard. Economists assessing a region look at interest rates, employment, and population growth. But over time the most reliable guide to home values is rents.

In most markets people won’t lay out much more in monthly costs to own a house or condo than they would to rent a similar property unless they expect a huge profit when they sell. Indeed, speculators chasing quick profits did a lot to inflate the recent bubble.

But once the fervor fades, prices must fall to restore their normal, long-term relationship with rents. Rents exercise a kind of inevitable gravitational pull on prices. The ratio of prices to rents “behaves much like price/earnings ratios for stocks,” says Yale economist Robert Shiller. “Like P/Es, price-to-rent ratios are mean-reverting.” In other words, while prices soar from time to time, sending the ratio to exceptional heights, sooner or later the relationship is bound to return to its historical average.

The last para above is very important. Kaushik in his blog has posted several times on the rent for several properties in places like bangalore. Although this is anecdotal evidence, I would not discount it completely.

So based on this evidence if the rent is say 20000 per month, we are talking a valuation of 48 lacs for a 3 bedroom apartment ( 1 lac = 100000)
Rent = 20000/ month = 2.4 lacs p.a. For P/R ( price to rent like PE ratio) of 20, the valuation is 48 lacs.

The only variable in the above equation which can be debated is the P/R ratio. I will discuss about this in more detail in the next post, but think of it this way – the inverse of P/R is the yield on the real estate. For P/R of 20, the yield is around 5%. Globally, most investors demand a yield of 5-7% on an average. So a P/R ratio of 20 is around the average and may not be too low.

Net post : Looking real estate valuation using the ‘invert the problem’ approach.