15 May P/E Ratio for Property
APPLYING EARNINGS MULTIPLES TO PROPERTY AS AN ASSET CLASS
This week, I would like to demonstrate how one can use the concept of the PE ratio to value other asset classes, like immovable property.
Just to recap from past articles, our gross yield (or gross return on an investment) is calculated as follows:
Gross yield = Gross annual rental
Price paid for the property
Let us assume that our investor is considering purchasing a sectional title unit that can be let out for R3 500 per month. The seller’s asking price is R600 000. The gross yield from the purchaser’s perspective is:
Gross yield = (R3 500 x 12)
If we invert this percentage, we obtain an earnings multiple of 14.3. In other words, the purchaser is prepared to pay 14.3 times the gross annual income that the property yields in order to purchase this property.
Bear in mind that this is a gross return, before our investor has deducted any expenses. There is also the possibility that the tenant may move and this means that the property will not generate any income for a month or two.
Investors who invest in the equities market would probably think twice about investing in a share that is trading on a PE ratio of 14.3 times and would consider that such shares are becoming quite expensive. However, investors in the property market are generally quite happy to purchase property on these multiples or higher. As with any market, people need to avoid being caught up in the euphoria of a rising market. We have short memories and seem to have forgotten when interest rates were 17% and more. There is an oversupply of rental stock in certain areas and this means that tenants have significant bargaining power regarding rentals that they are prepared to pay. Declining rentals translates into lower yields.
The message should be very clear. Investors must purchase those assets or investments that will earn a reasonable yield and that are therefore trading on sustainable multiples. Do your research correctly and only buy once you are satisfied that the earnings multiple that you will pay is acceptable. You will more than likely regret overpaying for that asset or investment as it will not earn the income that you anticipate and the market value does not increase as expected or does so at a decreasing rate.
Graeme Jay – Managing Director of The College of Property Management and Development (CPMD)