What's a Home Really Worth These Days?

This is a vexing question for millions of Americans. There was a time when most people had a reasonably good idea of what they could sell a property for. There were enough purchases and sales to create comps. Not any longer. Homes that have been foreclosed on come to the market at distressed prices. This is happening in every neighborhood across the country. When one property sells at a distressed price it influences all the properties around it.

So what is residential real estate worth today? The answer to that question is, “About 15 times the annual rent”.

RE professionals are going to write me and say that this simple calculation is wrong. They will say that the number is lower. Possibly as low as 12 times rent. They might be right. However in areas of the country that I watch the 15 times rent number is a pretty good indication of value.

Based on this calculation the following rent/price guidelines can be determined:

It is still difficult for a homeowner to make a reasonable estimate on what the rental value of a property will be. But I have found that most people have a better handle on this number than they do on what their home can be successfully marketed for. Though there are regional considerations for rental values, by and large this formula works well for metro versus rural properties as a valuation tool.

This analysis creates a tremendous problem. There are very few homes for sale at 15 times rent. The only ones that come up for sale in that price range are those that are in foreclosure and are being sold by bank lenders. We know that there is demand for properties when those conditions are met. That has been proven in just about every area of the country.

In my view the bulk of unsold homes on the market today are trying to get sold at a multiple of rent that is at least 20 times. That is why these homes are not selling. The implication is that on balance RE is still 25% overvalued. The bad news is that rental values are dropping across the country as homeowners are forced to rent properties that can’t be sold.

I would be interested to get comments on this. I would like to hear from people around the country if they thought this pricing mechanism was in the ballpark for their area. I would be particularly interested to get comments from folks who live outside the US to get a look on how that stacks up as well.

If my sense of this is correct we are in for a very rude awakening. Those with $1MM+ homes will be particularly depressed by this calculation. My sense is that high end RE is in the process of a massive correction. The sheet rock palaces that were built with cheap money from 2002 to 2006 are worth half of what was paid for them. We just haven’t figured that out yet. The impact on consumption will be very significant when that reality sets in.

A back of the envelope analysis of the rental values of American homes produces a capitalized value of $9 trillion at 15 times rent. The mortgages on these same homes is equal to $12 trillion. We are missing $3 trillion in value based on this. That might be a decent estimate on how much the RE mess is going to cost us.

Comments

[Mark in San...:]

I had always heard 100 x monthly rent was a better indicator. . .when I bought rental condos in the early 1990's downturn here in CA, I bought a place for 110K, and rented it for $950 a month, so I was nearly at the 100 times rent.
Here in San Diego, there were press stories about investors buying foreclosed homes for 150-200K, and renting them for $1600 a month. . .clearly these were in the sweet spot. Since that time (March/April) there has been a feeding frenzy on these cheap homes, and prices at the bottom has pushed back up to the 250K to 300K range.

As for the top end of the market, that is where implosion has been taking place. . .all those million plus homes and condos can't find buyers because they are over the conforming loan limit. That means only a few have been selling to cash buyers, and that market is limited. Should be an interesting Fall with McMansions flooding the market.

Sep 12 04:42 PM

[Nick36:]

Perhaps the real worth of a home relative to rent depends on the unemployment rate and the job security people have.

Because when the unemployment rate is high and many people are afraid of loosing their jobs. Then renting rather than buying a house makes more sense to them, even when house prices are attractive. Because in such a situation people must be prepared to move to another location in search of employment, if they loose their jobs. And moving when you rent is a lot easier, quicker, and cheaper than when you own your home.

When the economy is doing well. Then 15 times the rent number might be a good price to pay for a home. But when the unemployment rate is high and there is a lot of job insecurity. Then 10 times the rent number might be a more reasonable price for people to pay.

Because it costs a lot of money and aggravation to move when you own your home. And that consideration goes into the price people are willing to pay for the home they buy.

Sep 12 05:16 PM

[Jiang Nan:]

15 times! Here in Shanghai one would be lucky to get 25 times.

I have a few properties that I rented out for about 35 times, and that was up about 20% (from already high 28 - 30 times) since beginning of this year after the massive credit expansion.

I kept telling my since early this year, at RMB 60,000 per m2 ( US$ 8700 per m2) or RMB 5500 per ft2 (US$ 800 per ft2), the luxury condo in Shanghai is more expansive than most places in US. But prices kept defying my prediction of looms.

Even the average apartment downtown at 1/3 the price (about RMB 2.5 million for a 2 bed rooms 1100 ft2) works out to more than 10 times white collar family annual income.

Who knows, USA might become competitive again in a few more years.

Sep 12 06:33 PM

[evegas:]

In las vegas,depending on neighborhood it is anywhere from 9 to 14 times rent.And no shortage of homes to pick from.

Sep 13 12:27 AM

[RatWatcher:]

My rental is just about right on 12 mon rent = 15x sale value. Not however a coincidence, its a factor how I set rent. During the boom (2005 ish) I got more $$ per month but LESS than 15x theoretical sale price....now reverting to normal. Can't go lower because rent needs to cover mortgage expense. Irony, if sales price continues dropping, the ratio INCREASES with no one actually involved doing anything at all....

Sep 13 02:05 AM

[OptimizedPrime:]

Price-to-rent ratio is based, among other things, on expected appreciation. In the boom times of California real estate, the actual cost of homes (factoring in appreciation) was virtually free, so houses could literally sit empty without any rent at all and still make money.

I've played with a spreadsheet on this (not very hard to make one) and if you expect 1% appreciation per year, then your ratio is 18:1 for break-even (no profit that is). At 0% appreciation per year, it's about 15:1. At 4% appreciation your ratio can be 40:1. And so on.

Nobody in their right mind is expecting prices to go UP in the next ten years. As such, the author is right to say that the proper "fundamental" ratio is about 15:1.

The same thing happen to stocks in the .bomb era: they returned to fundamentals (profits, growth, risk). Anybody who ignores this is an idiot.


OP

Sep 13 03:55 AM

[evegas:]

I don't think some things were taken into consideration.My rental in NV Has a TOTAL carry cost of $300 ONLY per month and rents for $1350.When I was on the east coast my expenses were TRIPLE that number because of taxes but did not rent for too much more.

Taxes,insurance,assoc fees,and all carry costs should be considered before coming up with a "real" ratio.

Sep 13 12:40 PM

[Gregman2:]

Historically, commercial was valued using cap rates. Is this methodology now the fall back?;-)

Sep 13 05:03 PM

[jseed:]

You can't simply put a single multiple on rent and expect to get a fair value on housing any more than you can apply a PE multiple (or dividend yield or Price-to-book multiple for that matter) to judge the value of the stock market, let alone an individual stock. As OptimizedPrime points out, growth rate assumptions matter but so do costs of funds. For housing, the primary variable in cost of funds is the mortgage rate. Thanks to the Fed, currently the mortgage rate are at historical lows. The ETF DMM tells us the housing market is actually likely to increase over the next 5 years (although modestly).

Of course, as the commentator from Shanghai notes, even if we could agree to the cost of funds (which goes beyond mortgage payments) and growth rates, other factors creep into play like price elasticity of the supply of housing stock. Homes in Shanghai, like San Francisco, will likely always trade at a premium to rents. If you plan on living in either location long-term, it's a lot less risky buying now then finding yourself on the sidelines if the market shoots back up under the pressure of even modest gains in demand.

You may ask what about those poor suckers who bought into housing in places like SF two years ago based on that logic? At the time, the market was also giving you a free put in the form of 100LTV loans, or better yet, Pay Option Arm loans that could accrue principal to 125LTV. It was a cheap option than many took out and are now excersizing. Of course, being long the underlying and long a put is equivalent to owning a call and the first batch of buyers made out like princes. Now that you have to put 20% down, your resulting lower strike price is leading to much more prudent buying and at lower underlying prices.

Where does that lead us? I'm long DMM, but with mortgage rates at historical lows, I won't be surprised if I'm wrong and house prices creep back up regardless of today's rent multiple, especially in cities like San Francisco.

Sep 13 05:06 PM

[Bruce Krasting:]

Thank you for the comments. From this and other sites a summary of the results:

-The 15X number is in the ball park across the country.

-California reports 25X is their reality. This implies their RE is still over priced.

-Miami and Vegas sound cheap by this analysis.

-DC looks good Metro NY not so good. Possibly the impact of big government?

-Outside of USA RE is much more expensive. 25X to 35X is normal. This means that the USA looks cheap. Does purchasing power parity have anything to do with currency rates? Nah..

Jiang Nan: Thank you for your most interesting comments. I re-posted your thoughts here:

www.zerohedge.com/arti...

Sep 13 05:43 PM

[OptimizedPrime:]

@Jseed: you make a common mistake (I think) in Price-to-Rent ratio analysis: you assume "nice" areas should have a better ratio. This is false. Nice areas have higher rents (which reflect actual "real" demand for the asset's utility) and they have higher prices. The RATIO is inescapable though, whether it's a shack in Detroit or penthouse on Park Avenue.

Higher P/Rs indicate a higher expectation of appreciation. Same as P/E ratios for companies.


OP

Sep 14 02:24 AM

[Troyhector:]

"Experts say this is a bad omen for residential real-estate prices and homeowners trying to sell or refinance, because the fire sales, many to cover soured subprime loans, put downward pressure on the value of nearby homes. All of this undermines federal efforts to stabilize the housing market and revive the broader economy.

"While the banks are trying frantically to get loans off their books, they face the problem of large shadow inventories of housing being dumped on the market, which would depress prices further," said Anthony Sanders, real-estate finance professor at George Mason University in Fairfax, Va."

Read More: www.housingnewslive.co...

Sep 14 02:26 PM

[jseed:]

OptimizedPrime: I agree "niceness" shouldn't enter the equation. But I do think areas where building restrictions (both physical and via ordinance) are heavy, supply can't keep up with demand and price swings are more common. If your a long term resident in that area, one method of ironing out those swings is by buying, even when it's more expensive to rent. Pure theory with only antidotal support, so I'll concede there may be a better explanation why high multiples seem to persist.


On Sep 14 02:24 AM OptimizedPrime wrote:

> @Jseed: you make a common mistake (I think) in Price-to-Rent ratio
> analysis: you assume "nice" areas should have a better ratio. This
> is false. Nice areas have higher rents (which reflect actual "real"
> demand for the asset's utility) and they have higher prices. The
> RATIO is inescapable though, whether it's a shack in Detroit or penthouse
> on Park Avenue.
>
> Higher P/Rs indicate a higher expectation of appreciation. Same as
> P/E ratios for companies.
>
>
> OP

Sep 14 09:41 PM

[Russ Wetherill:]

The 15 times multiple seems to be a good estimate of valuation for the homes I'm looking at in Southern Cal. Here are my rent-vs-buy calculations for a 3/2 1500 sf home:

Purchase Price: $550k
20% Down: $110k
Closing Costs: $20k
1.0 Points: $5.5k
Total out-of-pocket: $135.5k
Financed amount (5.5% 30yr FRM): $440k
Monthly Mortgage Payment: $2,498
Taxes and Insurance (1.5% of PP): $688/mo
Total Payment: $3,186
Interest Portion: $2,017
Paid to Principal: $482
Interest Tax Deduction: $570/mo
Lost earnings on out-of-pocket (CD @ 2% interest): $226/mo.
Home maintenance (1% of PP / yr): $458/mo.
Net Owning cost: $2,819/mo.
Rent for 3/2 1500sf (craigslist): $2,300
Owning Loss vs Rent: - $519/mo.
Current Rent Multiple ($550k/(12*$2,300/mo.)): 19.93
Purchase price for no owning loss (15.82 multiple): $437k
House price based on 15 times rent: $414k

So the correct valuation for this property in the current market is somewhere between $414k and $437k, which is about 20% less than current asking price.

If this property were actively managed as a rental unit, then a 10% management fee would need to be deducted from the rental income, reducing the rent to $2070/mo. This results in a break even price of: $386k. The asking price of $550k is now 30% too high. These numbers become a little more attractive when you add in depreciation for a rental property.

There is also the uncertainty of whether the property increases or decreases in value in the future. Historically, the value of the property increases over time so that a break-even position might be beneficial over time. In the current depreciating market, however, buying at 20% below break-even might be the minimum conservative amount. This results in a purchase price of 0.8*$437k = $350k for primary residence; or 0.8*$386k = $309k for a rental property. Based on these assumptions, the asking price is too high by 36% and 44% for a primary residence and rental property respectively.

Some people might say that rental property could be purchased at higher valuations than the above analysis might indicate because of appreciation of the value of the property and tax deductable depreciation of the asset. I prefer to look more at cash flow because the tax deduction can not be written off against ordinary income above a certain income level and is therefore not realized until sale of the property. Likewise, the house price appreciation cannot be realized until sale.

The rental property really needs to either: 1) show positive cash flow, or 2) at least not require monthly cash infusions from other investments. There really has to be some benefit to justify getting involved with a property - the sooner that benefit is realized the better.

Sep 15 02:18 PM

[jstratt:]

Having watched the residential RE market closely a 3/2 home in a good location doesnt have much downside. Even a 3/1 doesnt have much downside although it also doesnt have as much upside.

The mansions never made sense in the best of times. After heating, cooling, maintaining and paying taxes on huge homes little is left. Much like in the 80s the huge homes will likely lose 40% of their value. They may lose more!

Sep 15 07:35 PM