Real Estate Values and Rental Income

[YoungFT]

Watching this real estate game as a mildly active investor I'm always amazed at how disconnected real estate values can get from the income they can generate.

Today's Wall Street Journal (Jan 3, 08) has a great article on this issue.

Home Prices Must Fall Far
To Be In Sync With Rents

[FONT=times new roman,times,serif][FONT=times new roman,times,serif]By GREG IP
January 3, 2008; Page A2[/FONT]
[/FONT]
U.S. house prices "likely would have to fall considerably" to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists.


The study, which doesn't necessarily reflect the views of Fed policy makers, suggests prices would have to fall 15% over five years, assuming rents rose 4% a year. House prices would have to fall further if the adjustment took place more quickly.

The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6,600 a year) and the average home price was about $134,000.


But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%.


That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade.

The U.S. study is by Morris Davis, an economist at the University of Wisconsin-Madison and until 2006 a staff economist at the Fed; and Andreas Lehnert and Robert F. Martin, staff economists at the Fed.

In an interview, Mr. Davis said lower long-term interest rates can explain only a small part of the drop in the ratio. "To justify current price levels, you need rapid growth in rents." But it's hard to imagine the scenario that would justify such rapid growth in rents, he added. Indeed, it's possible rents will grow more slowly than 4%, reflecting the overhang of unsold homes that might be rented out.


Mr. Davis said the authors postulated a five-year horizon for the rent/price ratio to return to normal by looking at previous downturns. "When a downturn begins, it will last for a while."



[end of article]

 

[JoshMclean]

I think the inventory of homes plays more of a factor in this area. It doesn't make sense that an $800,000 beach house rents for the same as a $350,000 house in Nashville for example. It's more about the amount of rental properties on the market in my opinion.

 

[seaside2]

Rental income is a mystery to me. Lil Seaside lived in LaJolla, CA. Paid $1600/month in a townhouse for sale at $1.6 Million. This seemed to be typical of the area. I think that the owners are just trying to cover the interest and let the capital gains be the real deal.

'Course that was a couiple of years ago and since the bomb hit, who knows

 

[egrp]

i have been saying this from the start...rental income is way too out of line with home prices...thats why i'm 30 and still rent. honestly its frustrating to me cause it forces me to throw money away by renting.

i think vacation areas will always be even more out of whack due to their "high" values and seasonal rental income...but even in places where you would expect it to be more in line such as atl, dallas, dc, its not.

housing has further to fall...although i do think rents will rise some as well...cause the rental deals you can get on nice apts/condos/homes in the best areas of cities are very cheap.

 

[Rather B Paddlin]

Hmmm. Based on the annual rents being 5% of the home value it would seem there are some appropriately priced homes in our market. There are homes in the area that are for sale for less than $1 million that gross over $50,000 in rental income. Additionally, there are homes in the area that gross over $100,000 a year in rental income that could be had for less than $2 miilion.

 

[Smiling JOe]

egrp, I hear people talk about throwing money away on rent quite often. I think you are looking at it wrong. First, let me state the obvious, if you don't own, there isn't any upside potential. However, there isn't any downside potential either. No matter if you rent or own, there is a cost associated with living in a dwelling. For some, it is rent, and for others, it is interest. Since the average homeowner lives in a house for no more than 7 years, the majority of each months check to the lender consists of interest. You don't see a shift of that majority to principle until you are on year number 15 of your 30 year loan. You say that you are throwing your money away by renting, but in reality, you would be throwing it away in the form of interest paid, if you owned. So you must shift your paradigm. You must also remember that when you are renting, you have no obligation to the property other than that which is stated in the contract with your landlord. Get transferred by work to another location? Need access to cash to buy a car, or pay for some unforeseen medical expense? Not much of a problem if you are renting. However, if you own, you might have to sell your home in order to free the cash, and we know how tough it can be to sell a home right now. Have a plumbing problem? Call your landlord. There are sacrifices made by renters, but you cannot have your cake and eat it too. Again, as a renter, you miss out on any upswing, but you are not throwing your money away. Rent, as is interest on your loan, is an expense of living.

 

[destinsm]

egrp, I hear people talk about throwing money away on rent quite often. I think you are looking at it wrong. First, let me state the obvious, if you don't own, there isn't any upside potential. However, there isn't any downside potential either. No matter if you rent or own, there is a cost associated with living in a dwelling. For some, it is rent, and for others, it is interest. Since the average homeowner lives in a house for no more than 7 years, the majority of each months check to the lender consists of interest. You don't see a shift of that majority to principle until you are on year number 15 of your 30 year loan. You say that you are throwing your money away by renting, but in reality, you would be throwing it away in the form of interest paid, if you owned. So you must shift your paradigm. You must also remember that when you are renting, you have no obligation to the property other than that which is stated in the contract with your landlord. Get transferred by work to another location? Need access to cash to buy a car, or pay for some unforeseen medical expense? Not much of a problem if you are renting. However, if you own, you might have to sell your home in order to free the cash, and we know how tough it can be to sell a home right now. Have a plumbing problem? Call your landlord. There are sacrifices made by renters, but you cannot have your cake and eat it too. Again, as a renter, you miss out on any upswing, but you are not throwing your money away. Rent, as is interest on your loan, is an expense of living.

Smiling Joe,

Great post... kinda suprised me coming from a Realtor though... maybe you do rentals as well?

 

[Mermaid]

Smiling Joe,

Great post... kinda suprised me coming from a Realtor though...

It has more to do with SJ being able to see both sides of an issue and look them squarely in the face.

 

[SHELLY]

i have been saying this from the start...rental income is way too out of line with home prices...thats why i'm 30 and still rent. honestly its frustrating to me cause it forces me to throw money away by renting.

SJ is right on target with remarks about present-market renting vs. buying. Financially speaking, it currently makes sense to rent and save, and wait for the prices to come down/income to rise to a comfortable level of affordability.

The notion of "throwing money away" is Realtor-talk to fluff clueless clients for the sale. Knowledgeable, rational renters have already crunched the numbers and know whether or not they can afford a home AND support a lifestyle of their choosing.

Here is an example of one such person who believes with all his heart that renting is "throwing cash in the trash:"

MORTGAGE MELTDOWN
Johnnie Pitts

Beaming with pride and talking a mile a minute, Johnnie Pitts stacked up piles of legal documents on his living room floor the Wednesday before Christmas. The San Francisco Muni driver had just returned from having his signature notarized on agreements that permanently modify his once-exorbitant mortgage to a reasonable interest rate, allowing him to keep the three-bedroom bungalow on Oakland's MacArthur Boulevard.

"It says right here what I have to pay for the life of the loan," he said. "Now I know exactly what I have to work with. Not like that adjustable-mortgage nonsense."

Pitts started off financially unsophisticated, but he now shows a shrewd grasp of how the system works.

"If you think your house is all yours, just miss a payment or property tax bill, and you'll find out who it really belongs to," he said. "We're not homeowners; we're renting from the banks and investors."

Earlier this year when he realized his mortgage was slated to reset to well over $4,000 a month - the same as his take-home pay - Pitts started speed-dialing his loan servicer, banking giant Chase, asking for a loan modification. "I called over and over," he said. "I was a pain in their rump roast. I was a wild hair up their gluteus maximus."

At the same time, he boosted his income by racking up overtime - an extra 10-hour day every week - to catch up on some missed mortgage payments and property taxes. "It's not like I was trying to shirk my responsibility and run," he said. "My family and co-workers said, 'Why don't you just do a short sale?' but this is my house. This is the major purchase of my life."

When Pitts bought the run-down house for $429,950 with 100 percent financing in 2005, his interest rate on the larger of his two loans from Chase was fixed at 7.2 percent for two years and then could reset to as high as 10.026 percent. New increases could come every six months. Now Chase has agreed to lock the rate at 6.75 percent for the 28 years remaining on the loan and has made similar modifications to the second mortgage.

Pitts skipped his October, November and December payments while negotiating with Chase; it agreed to roll those past-due amounts into the overall loan.

The package is a great deal for a subprime borrower, considering that the going mortgage rate for prime borrowers with good credit is 6.25 percent plus a half a point (0.5 percent of the mortgage total) up front.

It's also a better deal than the "teaser freezer" program touted by President Bush. That plan, which applies only to borrowers who meet a narrow set of criteria, freezes the initial interest rate for five years, not the life of the loan.

"We have been working with (Pitts) for many months and have adjusted the rate on his loan to make it more affordable," said Chase spokesman Tom Kelly. "If it's an owner-occupied house and the owner has been making payments and has been in contact with us, we will do all we can to work with them and come up with solutions."

Pitts' monthly mortgage will now be just shy of $2,800. Property taxes and insurance add another $700 a month. The $3,500 monthly total is still quite steep for a man whose base income is about $4,000 a month, although he can earn another $1,000 or so through overtime.

The new payments are fairly similar to those Pitts had for the first two years of the loan - which he struggled to make. Chase's Kelly said the bank only does loan modifications that make economic sense for the borrower. "We look at what the total payment is going to be and say, 'Can he afford it or not?' " he said. "Ultimately, if the borrower cannot afford whatever modification we do, then they cannot keep the house. Doing a patchwork thing might keep them in the house for three more months, but what good will that do?"

Does Pitt really want to continue working six days a week to keep a house that is now valued at about $330,000 - $100,000 less than he paid for it? He insists that he does.

"When it comes to renting, it's just cash in the trash," he said. "You can't win no way when you're renting, especially if you're single and in the 35 percent tax bracket. Owning a house is the best thing you can do for yourself. It's worth it to have some stability."

Now that the word "modify" has entered his vocabulary, Pitts frequently invokes it. "I'm going to modify my lifestyle," he said. "I shop at the dollar store; I buy in bulk and on sale. If push comes to shove, I may have to get a roommate."

His self-improvement mania extends to his health. He's lost 45 pounds in recent months by bicycling 5 miles a day.

Pitts said he took some ribbing from co-workers for being gullible when they read about his mortgage situation in The Chronicle. "Everyone knew my business, that I got taken to the cleaners," he said. "They said, 'You're so naive.' I said, 'No I'm not, I'm trusting.' "

Pitts seems to have boundless optimism about his home's prospects. He's loves doing fix-up projects, and there are plenty to tackle. "I want to bring the house up to code and standards so I can one day refinance," he said. "If I'm ever fortunate enough to have a family, the house is here for them."

Pitts is a New Year's baby, born at 12:02 a.m. on Jan. 1, 1965, the first newborn of that year in his Bustrop, La., parish.

How will he celebrate his birthday this year?

"I'll be working, the same as on Christmas," he said. "It's time and a half on the holidays. I'll take the money. Renters have a different mentality; they can party."

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[ame="http://www.youtube.com/watch?v=TxylHPnoloI"]YouTube - Real financial heros part 3 of 3[/ame]



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[Smiling JOe]

Smiling Joe,

Great post... kinda suprised me coming from a Realtor though... maybe you do rentals as well?

:funn: No, I don't have rentals in my business plan, but I try to keep my eyes and ears to the ground to assist people in finding rentals as needed. My business is real estate sales. Isn't it a sad statement that my comments about rentals would surprise anyone? I am in the business to help connect buyers and sellers. One side aspect is providing pertinent information to people regarding real estate in general. Not everyone wants or needs to purchase, and I don't know why anyone would try to shove a square peg into a round hole.

Don't get me wrong, there are benefits to home ownership, too, but owning is often just a lifestyle choice. There are times when owning may be less expensive than renting. It was true in SoWal, not too many years ago. Currently, it is less expensive to rent. Again, there is no upside potential if you are renting.