[quote author="IrvineRenter" date=1222835149]
You seem well versed in the efficient markets theory of asset pricing. Unfortunately, this theory fails to explain extremes of volatility as witnessed during a financial bubble. People bought houses because prices were going up. They had no idea why, they just saw prices rising and assumed they always would. The short-term past history of price increases creates an unrealistic expectation for future price increases. There is no concept of value.</blockquote>
I agree with you on this point. For real estate, it would be difficult to call it an efficient market since it is difficult to get in and out (illiquid) and there are very high transaction costs (broker fees, mortgage expenses, resetting of tax basis, etc). Due to those in efficiencies, and due to a lack of focus on fundamentals the prices increased to much to fast in the previous five years. Therefore, let's try to validate comparable sales not use them to validate the value.
[quote author="IrvineRenter" date=1222835149]
To be more accurate, equating price/rent ratio to the real value of houses is akin to the price/earnings ratio of stocks. There is a fundamental difference between the two however. Earnings growth in stocks can justify very high price/earnings ratios whereas rents and rent growth in houses do not. Rents cannot increase faster than wage growth because people earn the money they spend on rent. The growth of rent is fairly constant. You cannot have a tremendous growth rate in the rent/price ratio of houses. This makes the fundamental value of houses consistent and predictable. It is only when people believe in unrealistic rates of appreciation that higher prices can be justified. The fact that incomes have not kept up with house prices is one of the primary reasons prices are falling right now. Prices always fall back to affordability levels when bubbles burst.</blockquote>
This is where I begin to disagree ... but you touched on an interesting point ... one that warrants further discussion. Here is what I originally said:
[quote author="columbussquare.com" date=1222780448]
To accept your theory rent rates equals ?real values? would be like saying that book value is the ?real value? for stocks.</blockquote>
I like your assessment that:
earnings = rental income
The thing that is missing from this conversation is the real estate equivalent to a P/E and that is the <a href="http://en.wikipedia.org/wiki/Cap_rate"><strong>Cap Rate</strong> (see detailed explanation here)</a>.
Let's add:
p/e = cap rate
If you want to disregard comparable sales then lets apply to SFR homes the approach that is used by professionals in commercial real estate and apartments. The cap rate is equal to a rate of return or more simply: <em>how long it would take for the building to pay for itself if you exclude financing and taxation</em>. For the purposes of these discussions let's consider the decision making process the same for both "owner occupied" and "non-owner occupied". The only difference is that in "owner occupied" you are both the tenant and the landlord. The use of a cap rate allows a good reality check to see if the price matches the value.
The higher your cap rate the greater your expected return on investment (because you expect to recoup faster). The Wikipedia said, "In May 2008, the cap rates 5.98% for the offices and 6.28% for the apartments. By comparison, 10-year treasury yields have remained largely between 4% and 5%"
The formula for cap rate is:
<em>annual net operating / cost (or value) = Capitalization Rate</em>
Using simple algebra you can apply this formula as:
<em>proposed purchase price * cap rate = annual net rental income</em>
to compare it to monthly rents:
<em>annual net rental income / 12 = monthly net rent</em>
to "gross it up" to include operational costs:
<em>monthly net rent * 1.05 = monthly gross rent</em>
Let's try it with some real numbers:
proposed purchase price = $413,000
cap rate = 6.0%
$413,000 * 0.060 = $24,780 / 12 = $2,065 * 1.05 = $2168
With market rates for this property in the neighborhood of $2200/mo this scenario would indicate that the price matches the value.
However, if you went your the "rent rate = purchasing power" theory then you wouldn't be able to value the property any higher than $293,000 ($2200/mo divided by a combined cost of all expenses of $750/mo per $100,000). This would be 29.06% below cap rate valuation.
How you handle down payments? Are they just "prepaid rents"? If you allowed for 20% down you the value would only increase to $366,250. This would be 11.32% below cap rate valuation.
[quote author="IrvineRenter" date=1222835149]
There are no qualifying assumptions on whether or not rental value is a good indicator of a houses pricing. All of the qualifiers you mentioned would already be represented in the rental rates. People can only afford rent based on their incomes. Rents are tied to incomes, and houses are valued by rents.</blockquote>
As explained above, I'm ok with tying value to rental rates. In fact, I would say that this is a much more accurate method than comparable sales. But to do so you have to use a multiplier that was designed for the cash flow valuation. That is the purpose of cap rate.
[quote author="IrvineRenter" date=1222835149]
Using recent comps to value house prices is the epitome of irrational exuberance. If a fool overpays for real estate, the transaction itself is not a validation of value. In fact, comparative sales comps used in our financing system is what enables irrational exuberance. We had a series of greater fools overpaying for real estate for several years. If comparative sales were a good measure of value, why have prices dropped? Why are houses valued so much less today than they were two years ago? It is because they were never "worth" that much to begin with. There was merely a series of fools each justified by the previous one and enabled by loose lending standards. Take away the unstable financing, and you end up with a steep drop in house prices.</blockquote>
Agreed, the value was too high in 2006. If you use <strong>cap rate</strong> then the drop that has already occurred brings prices in some markets to their true value. Because times are tough it might mean that better prices can be gained in the next 6-12 months but that is not guaranteed. If you're in escrow right now, or considering making an offer, do the appropriate analysis and verify that the purchase price matches the value using a reasonable cap rate.
[quote author="IrvineRenter" date=1222835149]
I wrote a long post on the real <a href="http://www.irvinehousingblog.com/blog/comments/investment-value-of-residential-real-estate/">investment value of residential real estate</a>. The whole idea of an ownership premium is a concoction of irrational exuberance only believed by bubble market participants. In every other market in the country (at least before this latest bubble), there is a premium for rental. Ownership is supposed to represent a savings over renting. Renters have unlimited freedom and no liability for maintenance and repairs. Owners have taxes, insurance, maintenance, liability, etc. The savings of ownership is to compensate them for the burdens of ownership and the lack of freedom to move when they want to. It is only the artificial ownership premium generated by a false believe in rapid appreciation that causes people to overpay. As you noted, prices were about 50% of the peak market sales prices. This is also why prices are going to drop nearly 50% from the peak.</blockquote>
Using cap rate you're ignoring any type of ownership premium since the math is the same no matter if you're the tenant or someone else is. If we say the peak was 2006, then rental rates have increased 2-4% since then. With the current level of rental income I expect that prices in most markets will not drop more than 30% from the peak (i.e. right about now). If the market over corrects, which it has been known to do, then any purchase after it crosses the "true value" line would mean that buyers would be under-paying for an asset.
[quote author="IrvineRenter" date=1222835149]
I would advise people to start looking when prices got to within 10% of rental parity. I would not pay any more than that because there is no return on investment if you pay more. Given how dire the financing and economic picture is, we will most likely overshoot rental parity and have many properties sell at prices lower than the cost of an equivalent rental.</blockquote>
With a 6% cap rate it will pay for itself within 17 years. In some markets that you can start looking. In others we need a further decline or an increase in rental income.
