How To Calculate The Cost Of Buying A House
For the past two summers, I’ve been captivated by small Danish islands.
I was on vacation, the sun was shining, the island was lovely, and I walked around with my phone looking like those people who played ‘Pokémon Go’ a few years ago.
I didn’t see cars or other pedestrians. I stopped very suddenly because I had found something on the screen that matched the outside reality.
People around me were very startled when I looked up from the phone and shouted with wild enthusiasm:
“This is also for sale.”
I followed a map on an app, which showed me when I passed a house that was for sale.
The previous year I had fallen in love with Ærø, and my life would never be the same again if I did not get to put a pin on the world map right by Ærø. This year it was Dueodde on Bornholm.
Maybe you’ve tried it too? Maybe while on vacation abroad you’ve dreamed of a house that belonged to you?
Maybe you thought of the job that you had to return to after the holidays, so you could only use the house once in a while.
Then you started thinking of renting out your dream home and wondered if it was a good investment or not.
You do not have to wonder anymore. Here is the answer.
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Warren Buffett bought a famous building in Manhattan
In 1993, Warren Buffett received a call from an acquaintance who told him about a large property for sale right next to New York University in Manhattan.
It is a very attractive place in Manhattan, right around where the characters from the TV show Friends lived.
To this day, there is still some talk about how Warren Buffett quickly calculated a few things in his head and bought it without seeing the inside of the building.
There is not a lot of magic in the method: we know exactly what it is he is using to calculate and you can do it too.
He calculates what the revenue would be, subtracts expenses, and then multiplies it by 10.
That's his purchase price.
Owner earnings spent on properties
When I buy stocks, I figure out if it's a good deal. I find out what share price I have to buy the shares at in order for the money to theoretically be earned back in ten years.
The calculation is called owner earnings, and you may have come across it in my book Free Yourself or in one of my Facebook Lives.
That calculation actually comes from real estate investing.
In terms of stocks, you need to find the revenue and subtract the investments for the maintenance of the existing business.
This is exactly what you do when you do real estate calculations.
You find out how much you have in rental income from the house. From there, you deduct all current expenses and maintenance expenses. This means that you must deduct expenses for heating, electricity, water, gardening, property caretaking, cleaning, painting, replacement of home appliances and maintenance of the house. Then you multiply it by ten.
Why multiply by ten? Because you want the house to pay for itself in ten years with the rental income. In the 11th year, it starts to make a profit.
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What about the increase in value of the property?
Many people buy houses with the assumption that house prices will continue to rise.
They are making one of the biggest mistakes an investor could make: they assume that the trend that has existed so far will continue. One thing is certain. It will not.
There is a cycle in both stocks and real estate. It goes up, but it also sometimes goes down. Therefore, we can not just count on profiting from a value increase in the house.
With this calculation, the increase in value is free. If the house increases in value, you will just be getting a bonus gift.
So what should you buy your rental cottage for?
I saw houses on Ærø that were for sale for both DKK 500,000 and for DKK 2 million, and they were very different. The ones that were listed at DKK 500,000 were either small (50 sqm) or in need of some renovation. The ones going for DKK 2 million were palaces.
I found a really well maintained house for approx. DKK 1 million in the middle of Ærøskøbing.
If you have not been to Ærø, I should just explain that Ærøskøbing is the crown jewel of the island. A very beautiful town with cobbled streets and small colorful houses. It is difficult to find a house for rent in Ærøskøbing in the busy season. It is fully booked.
Such a house in Ærøskøbing can at least be rented out for approx. DKK 1,000 per night or DKK 7,000 per week. Let's say you can rent it out for a little less than half a year (I do not assume that there are many who visit Ærø in November, but it is reasonable to assume that it can be rented out from May to September).
Let's say that DKK 2,000 is spent on cleaning and other current expenses every week.
I multiplied DKK 5,000 by 20 weeks and then multiplied it by 10. Then I obtained exactly one million DKK.
So the house on Ærø could very well become a good business.
Did I buy the house then?
No, I actually didn’t. I got tired of the idea of having to act as a landlord for a home that is 5 hours away from Copenhagen. I got tired of the thought of having to receive calls about clogged sinks or burst pipes.
If you invest to make money, there is no easier way to make money than with stocks. With stocks, you will not receive any calls about problems in the store.
Stock investments take care of themselves. There is a day-to-day management and a board of directors to receive urgent calls about problems. Your job is simply to follow up when there are quarterly reports, but otherwise you can sit back and live your life.
It manages itself while you are entertained and get wealthy.
But who knows. Maybe one day you will become a holiday home owner on Ærø or Bornholm. Maybe to use it yourself.
You can read more about owner earnings in my e-book Free Yourself. Here you can see how the method is applied to companies, so you know which stock price is a good price. You can download the book here.
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Published September 2020.