The value of any financial asset comes down to the cash you expect it to deliver to you in future. With shares you get dividends, with bank accounts it’s interest and from property you get rent.

So you can value property in much the same way you would a share. All you need to know is how much cash the asset will deliver, net of expenses, and when that cash will arrive.

The first step is to deduct the costs of owning and managing your property from the rent you expect to receive. This gives you the cash figure. Then you need to discount that figure to convert that future income into today’s money.

It’s much less complicated than it sounds. The way the sums work is that your current net rental yield on a property, plus the long-term average annual rental growth, will equal the long-term annual return you can expect to make.

If you buy a house that provides an initial rental return of 6 per cent and the net rent grows at 4 per cent per year over a long period of time, then your total return will work out at 10 per cent. So if you know you want a return of 10 per cent, then you need to pay a price that equates to a rental yield of 6 per cent.

We’re going to assume you want a return of 10 per cent from your property investment because that’s a reasonable target rate of return for real assets like property and shares.

The last assumption we’ll make concerns rental growth. With the RBA targeting inflation of 2-3 per cent, we’d guess at long-term rental growth of about 5 per cent a year.

Now imagine that you’re thinking about investing in a townhouse in Bellevue Hill in Sydney’s eastern suburbs. You think you can rent it out for $850 a week, or $44,200 a year.

From this you expect to pay $4000 in strata fees, $2000 for repairs and maintenance and $700 for water. That leaves net rent of $37,500.

For this proposed investment to provide a yield of 5 per cent – what you’d need to get your total return up to 10 per cent – you’d need to pay no more than $750,000 ($37,500 divided by 0.05). Sounds OK, right?

But hang on, what if you don’t want the hassle of managing the property yourself?

A typical agent’s fee would be 7 per cent of gross rent, amounting to about $3000 a year, taking your net rent down to $34,500.

Then you’d have to reckon on an average of a week a year where you’re between tenants, bringing net annual rent to $33,650. That means you should pay no more than $673,000.

So to deliver your required return, you’d need to pay somewhere between $673,000 and $750,000. How much would you pay?

Well, on April 13 this year, someone paid $810,000 for a three-bedroom apartment in Cranbrook Road, Bellevue Hill. In March, a townhouse in the same suburb sold for $1.265m. That price offers a net rental yield of around 3 per cent. There are bank accounts that offer better returns than this.

Ah yes, you say, but you can’t negatively gear a bank account.

True. But you’re only paying less tax because you’re losing more money. Negative gearing works best in times of high inflation, where the losses you make are offset by rises in a property’s value. If prices don’t rise, negative gearing is money down the drain.

But Bellevue Hill isn’t a typical suburb, you say, it’s where all the rich people live.

Actually, even after a few years of stagnant or falling property prices, a rental yield of 3 per cent isn’t anything out of the ordinary. According to RP Data, the average gross rental yield in Melbourne last quarter was just 3.6 per cent. In Sydney it was 4.2 per cent. And these are gross figures.

Now consider this: if property prices halved, average net rental yields around the country would double to between 5 per cent and 6 per cent.

This would do huge damage to the economy and the national psyche. But would it represent the financial opportunity of a lifetime?

Hardly. Add in the 5 per cent expected growth and you’d still be looking at a return of around 10-11 per cent.

Falls of this magnitude may not happen but they’re certainly possible. Too many investors buy property not on the cash flow their investment will generate, but in anticipation of continual property price rises.

No doubt that’s a consequence of the extraordinary rises over the past two decades, but it doesn’t mean the next 20 years will be just as good as the past 20; and it may mean the opposite.

This article contains general investment advice only (under AFSL 282288).

Posted by Nathan Bell – Money Manager (Fairfax Digital) on 7th May, 2013