QUESTION

Assessment task II – A report of your investment decision on a property

You will identify and collect data about an income-producing property, build a discounted cash flow model (DCF), conduct market/risk analysis and make an investment decision on a selected property, which can be a property from domain.com/realestate.com or the house/unit you are live in. You will describe the selected property, analyze market condition where your property located. You will explain collected data and how do you derive the data. Assumptions such as number of years of investment, the terms of interest, leverage level, etc. are required.

You will build a DFC model using the collected data and assess the risks using sensitivity and scenario analysis method. Your report is to be presented in the following format:

 All pages of your report must be identified with:

 Your name & student ID No.

 The Subject and assignment number: E.g. 16236 Assignment II 2012.

 Consecutive page numbers.

 Note the academic requirement for referencing of all information using the correct system. Refer to the Program Handbook for further information. Referencing must be strictly observed and students will be marked down if the referencing and format guidelines are not met.

 Appendices, where required, are to be scanned and attached at the back of the report.

SOLUTION

Introduction to Property Market in Australia

The property prices have been increasing in Australia especially the housing property. Thus major section of the country is being deprived of the investments by purchasing the housing property and thus is relying on renting property for accommodation (Rahman, 2008). This has a huge impact on this sector. It can be explained as that the buyers are reducing the appreciation and depreciation in the market will be affected there by the demand in the market will be affected and thus will result in ‘Wealth Effect’. This will affect the future demand and thus will result in instability.

Another important aspect is the effect on the security of people if the same is viewed from societal point of view. Thus as a result of people going away and showing disinterest will not develop the sector as well as will affect the security concerns of the Australian residents

If we go by the past, the Australian housing market has shown significant growth with as many as around 70% people having their own houses. A downward trend has thus occurred in the sector (Lee, 2009).  It has also been examined that out of the 70% having their own house around half of them have taken up loans for the purchase made by them. It clearly shows that housing property has been a key driver of the Australian economy.

However over the last few it has been observed that the prices in the big cities in Australia have been doubled since the start of the century till 2005. This can be said to be at a rate of around 15% per annum

A relation between the consumer price index which is a measure of inflation rate and the housing price index has been shown below as obtained from the Year Book Australia 2008:

It clearly shows that the increase in house price is more than the inflation rate prevailing in the country. This increase in price of housing price has been impacted by a large number of factors. These have been discussed in the coming sections.

Factors Effecting Price in the Market & Market Trends

A purchase of the housing property can be motivated majorly by two factors. Firstly a housing property is driven as a consumer market wherein the consumer identify the needs and look for property satisfying there requirement. This factor is majorly impacted by the social conditions prevailing in the economy.

Second is the consideration of the housing property market as an opportunity to make investments. Herein the investors identify this sector as a growing market and thus resulting in huge profits.

These two factors together as well as individually impact the prices of the housing property.

The demand of accommodation which is the term given for the demand of housing property can be determined by two factors, these are, price of owning a property and the price of rental. Thus there is relative relation between these two factors (Rahman, 2008). As the price of purchasing a housing property increases it has a positive impact on the rental prices which tend to increase. Inversely if the price of housing property decrease there is fall in price for renting a property.

Following are the determinants for the price of housing property:

1. Population of country
2. Standard of Living
3. Development of financial markets
4. Interest rates for Loan
5. Availability of loans

Thus the demand of housing property is governed by the price of the property as well as the interest rates for those making payment by taking loans. Other factors that impact are the income level and the returns on the property. This is very important and though the purpose for the purchase may be is to live in there; the return is still an important concern.

A major factor that has been influential is the variation in interest rates. The interest rates that are applicable is variable. This is to say that prevailing interest rates will apply. This has tremendously affected the demand wherein the insecurity related to the variation in the price has made the consumers in the market reluctant and thus affected the demand.

The loans for the housing property should have fixed interest charges. This will enable the boost that is required for the market as the apprehension will be reduced related to the increased costs that may be associated if the interest rates increase, that will certainly happen looking at the global financial markets.(Fama,1977) This will however impact the financial institutions but they will be benefited by increased income due to increased in loans for housing property. Thus the fixed interest regime will be helpful for the sector as well as the economy.

Property Evaluation & Market Conditions

The property considered in this example is a housing property in the region around Sydney, Australia. This is a one bed apartment with all the modern fittings including furniture, granite flooring, kitchen with all the fittings and exquisite bathroom with laundry also available. The area of the apartment is 80 square meters. It has been observed that a property has been giving an average return on investment of around 9.7% over a period of 25 years in the cities like Sydney, Adelaide and Canberra. Also the mean price of the property in the last one year has been considered at it has been seen that the mean price in November 2011 was $530,000 and that in March 2012 was $ 720,000 and also there has been huge variation in the price depicting that the market has been witnessing the higher change in prices due to appreciation in this sector owing to the reduced growth in the other sectors. These all parameters and the market conditions have been considered while doing the DCF analysis. The other factor that is associated with the property that has been considered is the facilities that have been made available like the apartment is fully furnished including the accessories in the bathroom with complete fittings. The fully furnished small garden in the front and at the back and the other factors like accessibility to the transport facilities also add to the cost of the property. Lastly the apartment is jut one storey and no other construction is there in the apartment. These in short give the essence of the facilities in and around the apartment, the housing property considered in the valuation done in the subsequent section. The income of the people staying in this area has been considered in planning the debt repayment in the DCF analysis and the owner share at the start of the purchase of the property considered.(Pietro et al,2005)

DCF Analysis

For the purpose of DCF Analysis an internet survey was done and the real estate websites were referred for determining the market prices. It has been observed that a property has been giving an average return on investment of around 9.7% over a period of 25 years in the cities like Sydney, Adelaide and Canberra. Thus for the purpose of discounted cash flow analysis the price of the property as on 2005 has been determined and to obtain the current price the per annum returns have been used as given in the Year book Australia. This is done so as to obtain the return over a life of the property which is considered as 25 years. This is because the conditions prevailing in the economy will be difficult to be forecasted as well as the property market generally having a shift in about 25 years time which will include the demographic effect.

The interest rates on loan have been taken as fixed as although variable interest rates are prevailing in the market the steps have been taken by the government to introduce the fixed interest rates and this has also been implemented by the market (Lee, 2009). Thus the fixed interest rates taken by the major banks in Australia have been considered and averages of these have been taken. For example HDFC have an option wherein they charge around 6.5% per annum interest rates.  Thus the interests that have been assumed is 8%. The discount rate is taken as 5% as the current return rate of most of the banks for individual account is in this range.

The return on the property has been taken on the conservative side and it has been assumed that 250% increase in the value of property at the end of 25 years.  This has been said to be conservative as already the sector has witness about the same increase over the past 5 years. Thus a return of 10% per annum is considered. The inflation rate has to be adjusted to get the real rate of return. This is obtained by adjusting the discount rate or the nominal rate with the expected inflation rate. For calculating the real rate of return the inflation of 7% is considered, taking an average of last 50 years. Thus the real rate of return comes out to be 3% as shown in the DCF model. Thus this DCF model considers all the factors related to the valuation of a property including the interest rates of the bank, the return on the property and the inflation rate which is actually based on the various parameters in the market including the GDP growth, income level of the people and the subsidies and tax rate by the government etc. (Abelson,2005)

Another factor that has been considered is that 70% loan has been taken for the purpose of these calculations which have to be paid in a period of 15 years. These assumptions have been made in order to estimate the impact of the variability in the market. However the same model would be used for doing the cash flow analysis by making it interactive. The below table DCF Analysis of the housing property.

Conclusion

The above table clearly shows that the Net Cash Flow for the property will be positive over the period of 25 years assuming that the price of the property will be appreciated to 5 times its current value. Such situation if prevail will be having good investment opportunity and the opportunity as housing property.(McGibany,2004)

Also the sensitivity analysis has been shown below wherein the discount rate has been increased/ decreased by one percent and the interest rate has been increased/ decreased by one percent

The above table shows the variation in net cash flow with the change in interest rate and the discount rate. The above table shows the variation in net cash flow with percent change which include increase/ decrease  in the interest rate and the discount rate.

References:

Rahman M. M.. (2008). Australian Housing Market:Causes and Effects of Rising Price. Available: http://eprints.usq.edu.au/4614/2/Rahman_2008.pdf. Last accessed 05th May 2012

Lee C.L.. (2009). Housing Price Volatility and its Determinants. Available: http://www.prres.net/papers/Lee_Housing_Price_Volatility_And_Its_Determinants.pdf. Last accessed 05th May 2012

ABS. (2007e): ‘Household income and income distribution 2005-06’, 6523.0, August 2.

ABS. (2008). Year Book Australia, Australian Bureau of Statistics.

Budget (2007-08). ‘Decision for our future – Fact sheet’, Western Australian Budget 2007-08.

Catte, Pietro. et al. (2004). ‘Housing markets, wealth and the business cycle’, OECD Economics Department Working Papers, No. 394, OECD publishing. Doi: 10.1787/534328100627.

McGibany, J. M. & Nourzad, F. (2004) Do Lower Mortgage Rates Mean Higher Housing Prices? Applied Economics, 36 (4), 305-313.

Fama, E. F. & Schwert, G. W. (1977) Asset Returns and Inflation. Journal of Financial Economics, 5 (2), 115-146.

Abelson, P., Joyeux, R., Milunovich, G. & Chung, D. (2005) Explaining House Prices in Australia: 1970–2003. The Economic Record, 81 (S1), S96-S103.

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