One of the most pervasive challenges facing the residential real estate market is determining property values. When it comes to residential property, most end-use buyers think in the same terms as renters: Monthly housing expenditure.
In other words the purchase price is most evaluated in terms of monthly payments for principle-interest-taxes-insurance (PITI), home owners’ association (HOA) dues, upkeep, etc. This is especially true when lending standards are lax and required down payments are low.
With this in mind, it seems almost obvious that given a particular mortgage interest rate, housing prices should closely track their respective rental market–and until the housing bubble starting in 2001, they did.
The U.S. Federal Reserve lowered the federal funds rate eleven times, from 6.5% to 1.75% over the course of 2001. [United States Federal Reserve System. Federal Reserve Bank of New York. Historical Changes of the Target Federal Funds and Discount Rates. New York, NY. Print.]
By 2002 home prices were appreciating at an annual rate of 10% or more in California, Florida, and most Northeastern states.
Low interest rates compounded by poor underwriting and a gross expansion of the securitization chain lead to housing prices increasing exponentially in relation to commensurate rents.
So the question remains: What ratio between value and rent represents stability in the residential housing market?
Going back to 1982 when the U.S. Bureau of Labor Statistics (BLS) began tracking rental data and ending at 2001 when the great housing bubble began, annual gross rents increased steadily and in sync with property values averaging a 20 to 1 ratio, respectively.
In other words, a property should be expected to yield 5% per year of its true market value in gross rents in a stable market.
Going back to 1960, however, the chart below indicates a steady decline in annual gross rental income as a percentage of value oscillating about a linear trend.
[Davis, Morris A., Lehnert, Andreas, and Robert F. Martin, 2008, “The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing,” Review of Income and Wealth, vol. 54 (2), p. 279-284; data located at Land and Property Values in the U.S., Lincoln Institute of Land Policy]
That being said, based on national averages, an owner-occupant should strive to pay no more than 20 times the projected annual gross rent for the target property to mitigate the risk of overpaying in a the trap of a real estate bubble.
It’s important to note that local market conditions can vary drastically from national averages. When evaluating a particular property, consider historical value to rent ratios for that property’s local market when applying this valuation method.
From an investor’s perspective as with that of an owner-occupant, it’s important to value a property based on its rental income rather than potential appreciation.
While a given house will appreciate over time (barring real estate bubbles) most–if not all of that appreciation will be offset by inflation. So betting on appreciation is a highly speculative proposition that incurs disproportionately high risk relative to potential real return.
When you look at a residential property from a rental income perspective, valuing it based upon its net operating income (NOI) or net rent is much more meaningful than its gross counterpart.
Net rents are analogous to corporate earnings, except that in the residential market, rents experience relatively little volatility (i.e. risk).
Continuing the analogy between residential real estate and stocks, historically a price to earnings ratio of approximately 15 or better is a good buy in the S&P 500. That ratio applied to residential real estate yields a cap rate (NOI / Price) of 6.67% or better.
Given cost of ownership, a residential property purchased at market value and leased at market rent will most often create a negative cash flow after accounting for insurance (approximately 1% of value per annum), taxes (3%), maintenance (roughly 1%), property management (10% of gross rental income) and vacancy, especially if a mortgage is involved (which is not a component of cap rate calculations).
In most markets, investors must find substantial discounts to market value to generate the target cap rate of 6.67%. Residential properties available at a significant discount are few in number and difficult to find.
Most markets are saturated with local investors who are solely dedicated to sourcing such opportunities. This problem is compounded by the pressures associated with the downward trend in average gross rent to price ratio.
The challenge of finding competitive (as compared to other investment options) risk-adjusted returns in real estate is what leads to the need for a “creative” approach to investing.
Given this challenge, serious investors should work backwards from a target risk-adjusted rate of return in developing their strategy.
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