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We have all seen various countries’ property markets go through a bubble before crashing. And we all know that in a bubble buyers are likely to pay more for a property than they really should. However there are a number of criteria that buyers can use to judge whether a property has been over-valued and avoid the problem of finding that once the property bubble has burst, that the property has a vastly reduced valuation should they want to sell.

Avoiding a Property Bubble – Price to rental yield

Evaluating a property’s value requires emotional detachment: don’t look at it form the perspective of it being a home, but rather as a money-making asset. The first yardstick to use in your assessment is a property’s price to rent ratio, even if you aren’t planning to rent out the property. For example, if the price/rent ratio is 50, which gives a gross rental yield of 2% then the property is very overvalued. What you are looking for is a price/rent ratio of between 14 and 16, which gives a rental yield of between 6 – 7%, then it is fairly priced. Higher rental yields indicate that a property is undervalued.

This comparison between price and rental yield in the market you are buying may seem odd, but it is a valuable way of assessing what is happening in a market. For example, if rental yield levels are high, this usually means that the cost of buying a house is low, compared to the cost of renting a house. Therefore, it costs potential buyers less to borrow from the bank than it does to rent. It is also a scenario that works well for investors looking to buy property to rent out.

The opposite is true when rental yields are low. This means buying property is more costly than renting. Buying-to-rent won’t make an investor any money and a significant number of buyers wills have trouble getting mortgages.

If you look at price trends, what you want to see are higher price/rent yields –11% is an ideal yield — because that represents a good buying opportunity.

High valuations and affordability

Also watch out for very high valuations per square metre. If there is an economic crisis, house prices will fall to a more realistic level. General affordability also suggests a bubble. For example, if property is priced so high that few can afford it, then values will naturally have to come down or there will be a lot of unsold homes. How will you know if prices are too high? Look at the country’s GDP/capita. In a country where the ratio of house prices to GDP/capita is high, it’s a fair bet that houses are overvalued.

Prices vs construction costs

One last one is the relationship between homes and the cost of building them. When prices are much higher than the cost of construction, developers are motivated to build plenty of properties. Eventually, too many new properties pushes the price of the properties down. The one region where this rule doesn’t apply is Europe and this is due to the numerous regulations covering new buildings, which have an effect of limiting the supply of new homes, therefore house prices are always above the cost of construction. But, outside Europe, or other regions with high levels of building regulations, this ratio is one to keep an eye on. because prices above building costs signal a property bubble.

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