How do we know if the property we are going to buy is a good investment?
According to Bankinter, with a formula we can calculate an approximation of what the price of a home should be. To find out how much your flat (or the house you are interested in buying/renting) is worth and to spot bargains on the market we have to use this formula:
The key is called: PER (Price to earning ratio).
Sales and rental prices always have relationships that vary over time but can be calculated:
- a) Gross rental yield
This is the percentage resulting from dividing the annual income obtained from a rented property by its sale price.
Thus, for example, a property rented for 12,000 euros per year (1,000 euros/month) and worth 240,000 euros will offer a gross yield of 5% according to this formula:
(12.000/240.000) x 100 = 5%
It should be noted that we talk about gross return and not net return, because this is the ratio used for this calculation according to the Bank of Spain. If someone wants to calculate the net profitability, he/she should subtract the expenses from the income.
- b) The PER
If we do the inverse operation of dividing the sale price by the rental price, we will obtain what is usually called the PER (Price Earnings Ratio). This figure is equivalent to the number of times the rental price is contained in the sale price or the number of years it would take to pay the property if rented under the current price. It is a universally accepted ratio for valuing assets such as companies, houses, stocks etc.
The PER of the previous house would be 20 times and the calculation would be:
(240.000 / 12.000) = 20 times
Table of equivalence between rental and sale price
Based on the above data, as we have the two of the three figures above (sale price, rental price or PER), we can calculate the third. As we have the gross rental yield data for the whole of Spain provided by the Bank of Spain (BdE) updated quarterly, we only need to know a reliable rental or sales data to be able to calculate an approximation of the other variable.
Thus, according to the latest report from the Bank of Spain (BdE), the gross profitability of renting a property in Spain is around 4 – 5%. This is equivalent to saying that the PER is 27 years or 325 months.
To sum up, if we are certain that a property identical or very similar to the one we are interested in and we know that it is rented for a certain price, we have to multiply the monthly rental price to 325 months to obtain an appropriate approximate sale price.
For example, if it is rented for 1,500 euros per month and we multiply this monthly rental price by 325 months, we know that the sale price should be around 487,500 euros under current conditions.
In the same way, if we have a property that is sold for 270,000 euros, it would be enough to divide by 325 to know that its rental price should be around 830 euros per month.
To sum up, the lower the PER of a property compared to the Spanish average (25 times), the more convenient would be to buy it, while the higher it is, the better it is to rent it.
ADJUSTMENTS FOR EACH PROPERTY
The above method serves as an approximation of sale and rental prices, however, it is useful to fine-tune it later because not all markets and not all properties are the same. As a general rule of thumb, the PER can vary according to:
Provinces with more demand tend to have a higher PER than those with less demand. Thus, it differs that in Spain the PER of San Sebastian is 24 years, while that of Santa Cruz de Tenerife is 13 years, according to data from idealista.com.
2) Again, Location
Within the same city or town, the PER also varies. Thus, for example, areas with greater demand and considered to be more consolidated, tend to have a higher PER.
In this sense, the sale price per m2 at the close of the third quarter of 2018 in the Chamberí district (Madrid) is 5,243 euros, while the rental price is 18.2 euros m2/month (218.4 euros m2/year), according to data from idealista.com. Dividing the purchasing price against the annual rent gives a PER of 24 times. For Villa de Vallecas, with a purchasing price of 2,341 euros/m2 and a rental price of 11.0 euros m2/month (132 euros m2/year), the PER drops to 18 years.
3) The best houses tend to have a higher PER.
In line with the above, for the best houses or those in the best condition, a higher price is usually paid for the security of investing in them. Properties considered worse tend to have a lower PER.