Why should rental values matter to homeowners? Because when the proverbial tide goes out, the rent someone will pay can the stronger indicator of value. People need to live somewhere and the alternative to owning is renting.
In real estate, a properties value is derived from its cash flow divided by the investors required yield. This yield factor is known as the Cap (Capitalization) Rate, which is also cash on cash yield used to derive a properties value. For example, if the required yield for a property is 7% and it nets $14,000 per year (after taxes, insurance, maintenance, and management) the property’s value is $200,000. Cap rates are highly depended on borrowing rates and other fixed income returns. Thus, when borrowing rates go lower and stay lower, as they have been, property values will go up.
Rational investors will want a yield that is higher than their borrowing rate. Using the above example, if you can borrow 80% of the purchase price for of less than 7%, you have positive leverage. Positive leverage means your cash will earn more than 7% by borrowing. With positive leverage, the more you borrow, the greater your cash return. Obviously, positive leverage is greatly influenced by rate, amortization period, and the amount being lent relative to value.
If cap rates are driven down below the positive leverage, then negative leverage occurs. In this environment, buyers are now more focused on price appreciation. A market becomes speculative if buyers’ expectations are purely focused on appreciation without considering improving fundamentals, such as interest rates or incomes. In 2005, we saw this in its extreme when people where lining up to buy condos with the expectations of flipping them before even closing.
In reality, competitive forces will drive cap rates down to near the average borrowing rate and so some degree of price appreciation is baked into every market and every investment. Investors will participate in this market if they expect higher rents from improving fundamentals, value added appreciation from improvements, and better management.
Using the above logic, a market is more rationale when rent equivalent yields are less than the average borrowing rate and more speculative if the yields are lower. But what cap rate should be used for comparison? The average 30-year mortgage rate seems best for this purpose, because it is the longest fixed rate option for most buyers and therefore best to see what “positive” leverage exist in the market. As of this writing the FHA 30 year rate is 4.25%.
In making any value comparisons, we also need to consider the monetary advantages of homeownership: tax savings on interest and taxes, appreciation in value, amortization of the loan, the opportunity cost of the down payment… and the intangible of doing what you want to the house. The cost of renting also needs to include some assumptions of rent increases, renters insurance etc. (Note that Trulia has a pretty sophisticated calculator that uses a true net income approach by metro area (www.trulia.com/rent_vs_buy/). Trulia’s calculator produces a percent advantage or disadvantage of owning vs. renting. )
For data we used Zillow Data (www:zillow.com/research/data). This site provided data for the average three bedroom rent rate and sales price. Tax information is from each municipality and home insurance was based on state averages. For all other inputs, we used the same rules of thumb as Trulia’s rent vs buy calculator.
The following are the results: Note that this should only be used as a guide, since the rent rates and unit values are only based on Zillow’s pool.
Metro areas such as San Francisco, DC, San Diego and Seattle are in the more “speculative” range, as expected. Some surprises are Detroit with a low yield. This might be due to the high city taxes. New York is another outlier, showing high net yield. Here, the relative low taxes in the city might help but note higher taxed areas like Westchester and New Jersey would show different results. Overall, the results show that there is still a lot of positive leverage in the market place and that rate can rise much farther before prices need to adjust.