How do you know how much you should pay for your next dream house?
Currently, I’m looking at houses in Portugal, where we live. I’ve found a house that I absolutely love. But is the price right? What is my house worth?
I have looked at many houses, apartments, townhouses, and villas in both Denmark and Portugal.
We actually live a cozy and comfortably life right now in a rented house, but our landlord has decided to increase our monthly rent from 3,000 euros to 5,000 euros, which has sparked a search for our own home.
Both the rent and real estate prices in Portugal have risen dramatically the last couple of years.
The house I rent was listed for 800,000 euros when we arrived here two years ago, but now identical houses are listed for 1.2 million euros.
In other words, there is quite a hot simmering housing market in Lisbon’s attractive suburb Cascais… possibly even a bursting housing bubble.
There are many flexible mortgage borrowers among the Portuguese, and they may not be able to keep up with interest rate increases in the long run. But we haven’t seen that yet – prices seem to be holding steady for now.
What Is My House Worth?
There are, of course, many ways to assess it.
I have fallen for an old house that is located inconveniently half an hour away from Cascais and the international school and an hour away from Lisbon. But what’s even worse… it needs a significant update.
The big plus of the house is that it is charming and has a fantastic view. How do you put a price on that view? How do you put a price on a cozy local community?
I’ve hired a consultant who uses the simple strategy of looking at similar houses in the area and making comparisons.
Well, that’s a very simple strategy. Maybe a bit too simple.
It’s like buying stocks with the assumption that the stock is worth what similar companies are trading at.
If you used this method on an internet-based startup during the dot-com bubble in 1999-2000, you would have overlooked the fact that the entire industry was in a bubble about to burst.
There’s another method that is much better.
Warren Buffett actually has a pretty simple calculation.
What Is My House Worth to a Value Investor Like Warren Buffett?
In 1993, Warren Buffett had the opportunity to buy a large property near Washington Square Park – the place where the characters from the TV show Friends were supposed to live. A very attractive location in Manhattan.
Warren Buffett calculated a few things in his head and quickly made the decision without even seeing the inside of the building. People marvel at how he can make big decisions by just thinking for a moment or scribbling a number on a napkin.
That’s because his calculations are simple and get to the heart of the matter.
He calculates the income, subtracts the expenses, and multiplies it by 10.
Voila.
That’s his purchase price.
Owner Earnings Used for Properties
When I buy stocks, I calculate whether it’s a good deal. I figure out at what price I need to buy the shares to (theoretically) earn back the money in ten years.
The calculation is called owner earnings, and you may have come across it in my book Free Yourself.
This calculation actually originated from real estate investment.
When it comes to stocks, you need to find the pretax income and subtract maintenance costs for running the existing business.
It’s exactly what you do when calculating a building’s value.
You figure out how much rental income you have from the house. From there, you subtract all ongoing expenses and maintenance costs. That means you need to subtract expenses for gardening, occasional repairs, roof replacement, cleaning, painting, administration, appliance replacement. Then you multiply it by ten.
Why multiply by ten? Well, you want the house to have paid for itself in ten years with the income from the rental. From the 11th year onwards, it starts generating profit.
With this calculation, the appreciation in value is a free ticket. If the house increases in value, it’s just an extra bonus.
So, What Price Should You Buy a House For?
I have seen houses in the Cascais area of Portugal ranging from 800,000 euros and up – it mostly depends on the location.
For the house I’m currently considering, I’ve made a bid of 820,000 euros.
It’s located an hour outside Lisbon and 30 minutes outside Cascais in an area that is becoming popular, especially among German and Scandinavian expats.
I estimate that the house could be rented out for 5,000 euros per month, mainly because of the view. That means I would ideally want to buy it for a maximum of 600,000 euros (not counting ongoing expenses).
Unfortunately, I’m not the only one interested in the house, so it’s not realistic to negotiate a lower price.
The House Requires Significant Renovations
I have had a building inspector and an architect go through the house.
The necessary renovations and improvements that I want would cost at least 400,000 euros.
It needs a new roof, new electrical wiring, new plumbing, a new water system, and some walls need to be demolished – but first, structural reinforcement needs to be done.
I want a pool and a lower garden and wall to better enjoy the view from the house.
I want to improve the insulation and install new windows. I want to move the kitchen and perhaps create an annex.
I want to convert the attic into an office and bedroom.
Sigh.
The list is long.
Let’s say the final price, including renovations, would be 1.2 million euros.
How much should I be able to rent it out for?
I would need a minimum of 10,000 euros per month (not counting ongoing expenses), and that is not going to happen.
What should I do then?
Well, I’m actually still thinking about that.
The house is located in a completely unique place with protected nature. How do you put a price on a view? How do you put a price on how happy it will make me every day? It’s difficult, and the calculation doesn’t take that into account.
If the house were already renovated, I would probably buy it – even at the 1.2-million-euro total cost with renovations.
The work the house requires makes me hesitate. It will take at least 6 months to plan with architects and 6 months to execute.
It’s a year-long wait.
But what about all the time I would spend on it? What is my time worth?
I would spend a lot of time planning and following up, having meetings with architects and craftsmen, and probably a lot of time waiting in the house when some of the people don’t show up.
If the renovation doesn’t go smoothly, I might lie awake at night.
All the time it would take and the headaches it can cause.
Can I put a price on that?
No, I can’t.
So, am I going to buy it?
Hmm… I have made a preliminary non-binding offer, but there has already been a new and higher bid from another buyer.
Now I have to consider whether I want to engage in a bidding war and contribute to further raising the price.
These are my thoughts on my possible future dream house.
What would you do?
You can read more about owner earnings in my e-book Free Yourself. You can learn how to apply the method to companies so you know when to invest. Download the e-book here.
