For the capital growth investor one of the best ways to insure capital Growth (Appreciation) is to buy in an undervalued market. Buying in a market that is undervalued assures the investor you can indeed look for sustainability in your investment as the market place can afford to pay more for housing than the current housing prices.
When buying overvalued, the market is overheated and the sustainability of cash flow or capital growth is extremely limited or perhaps ready to crash all together. This is paramount to know as when people buy property not knowing this and ultimately buy in a market that is overvalued they may believe they made a great purchase only to learn they do not have any sustainable returns. This happened to many people just before the market crash in 2006 and 2007. For starters let’s look at what is a balanced market.
Median income divided by 3, equals an affordable house payment.
Undervalued markets are similar to the affordability index. When a person (owner occupied buyer) goes to buy and finance a property, the lender typically requires that the person’s total housing cost do not exceed roughly 1/3 of is gross income. So if a person makes $33,000 a year the lender wants to see his total housing payments (PITI) principal, interest, property taxes, and insurance to not exceed 1/3 or say $11,000 a year. ($33,000/3=$11,000) In this case $11,000 annual payments would be divided by the 12 months and a total of his monthly housing payments would be $916 per month. (11,000/12=916) So for this scenario this as considered an affordable home.
Next: How much home can you buy for 1/3 of your income, this will equal an affordable home price:
I want to keep this principle simple without complex calculations but in short, this answer will change based on current interest rates, taxes and insurance. A simple call to the local lender or realtor can give investors this information or you can Google it and easily find this info and it will continue to change as these fees and rates change.
Sticking with the scenario at play let’s say the $916 PITI will buy investors a home valued at $125,000. So now that you determined that a $33,000 annual income will buy a house for $125,000 we know that a $125,000 home is an affordable home to you. Next we want to determine the entire market place to do this let’s look at:
The median income versus the median home price:
What you are looking to establish is how much is your marketplace median income and the markets median home price. This is simple. Investors can read this in the newspapers or find it on line or by calling your local realtor as well. Keeping with this example let’s use the $33,000 per year as the median income and the $125,000 home price as the median home price. This is considered a balanced market. Now with an understanding of a balanced market you want to look for the undervalued market.
For example if you find a market with a $33,000 median income and a median home price of $100,000 you instantly know that this market is undervalued. To pay for a home worth $100,000 requires less income which tells you this market has room to grow. The flip side of course would be a market that has a $33,000 median income with a median home price of $150,000. This market is overvalued.
As simple as this seems most investors fail to look at this simple formula and later find their investment returns are not sustainable.
Now you can be a purposeful investor and find the markets (remember real estate is all about location) that can give you better odds of capital growth sustainable returns.