How do you measure if a property market is overvalued?

There is a headline today suggesting that the Sydney property market is overvalued by 40% which is obviously designed to grab the attention of readers. You can look in the property news each and every day and you will see similar headlines about other property markets, but how do you measure if property market is overvalued? Is there a foolproof way to see whether you are overpaying for a property?

A property is worth what somebody is willing to pay

We can wrap up the property market in an array of different ways, slice and dice the variations and arrive at different opinions, but the fact is a property is only worth what somebody is willing to pay for it. On this basis, is any property market really overvalued? Is any property market really undervalued? The price is the price on that day – perhaps we are confusing the current value with potential long-term value when deeming property to be overvalued? Confused?

Traditional valuation methods

There are two main traditional valuation methods which are the multiple of income (otherwise known as the affordability factor) which varies from area to area and country to country. Historically in the UK three times a combined income was seen as the norm but in some areas of London for example people are today buying houses on seven, eight or even nine times combined income. In many ways this traditional valuation method has gone out of the window.

When investing in the buy to let market, as another example, the most popular method of valuing a property is on rental income/rental yield. During the heights of the London property market we saw some investors buying properties with rental yields of less than 2% while in other parts of the UK there are double digits rental yield possibilities. So, while many focus on rental yields it has to be a balancing act between the rental yield and potential long-term capital growth.

Supply and demand

The most basic element of any investment market is supply and demand whether you are buying shares or buying property. If there are more buyers than sellers the price will be squeezed higher and if there are more sellers than buyers the price will fall. Simple…..

On occasion there will be short-term supply/demand issues which can impact prices but on the whole the majority of markets around the world deemed “overvalued” have relatively high demand but relatively low supply. Some investors will walk away from these “overvalued markets” but at the end of the day it is the flow of investment money which dictates the direction of markets in the short, medium and longer term. Governments and regulatory bodies can do their best to manipulate the markets but investment flow will always win in the end.

Conclusion

Article headlines suggesting that the Sydney property market is 40% overvalued is written purely to grab the attention of readers. Do those writing these articles actually expect the Sydney property market to fall by 40% to a “fair value” which would in itself bring about major problems for the area both in terms of economic growth and employment?

The fact is a property is worth what somebody is willing to pay, this may be deemed too much in the eyes of some people, too little in the eyes of others. At the end of the day what is a property market but an information exchange were different opinions and different valuations are considered with the market arriving at a general consensus.