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To Rent or Buy? Determining the Real Value of Real Estate
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This information does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may view this information. Statements, opinions and forecasts made represent a particular observation and assessment of the market environment at a specific point in time and are not intended to be a forecast of future events or a guarantee of future results. Investors should seek financial advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended. Statements regarding future prospects may not be realized and may differ materially from actual events or results. Past performance is not indicative of future performance

Buying home is one of the biggest investments you’ll ever make, but how can you determine the value of real estate? Price is in plain sight, but value is nebulous. To find the best real estate deals, there are two metrics that can help estimate the true value of a property: the price-to-rent and price-to-income ratios.

Even eight years later, the 2008 U.S. housing market collapse remains fresh in our minds. I have been asked countless times, “how did it happen?” There is no simple answer; there were many contributing factors. One of those was that people often do not know how to value a home (much less a second or third rental property) and so are challenged to make good housing purchase decisions.

People often like investing in real estate for emotional reasons. They find comfort in owning something tangible—a “real” asset. Yet, a real estate investment is subject to all the same inputs as any other investment. After all, a building is no more or less tangible than an operating company or its stock. It is affected by interest rates, supply, demand, leverage, the economy, etc. Nothing is an inherently better investment; it’s always about the ratio between price and value. Recall one of Warren Buffett’s famous quotes: “Price is what you pay, value is what you get.”

The tricky part with any investment is that while price is plainly in sight, value is nebulous. The value of something is always an estimate. In real estate, there are a few potentially toxic trains of thought, such as It is always a good idea to get a sense of the “deal” you’re landing relative to other available properties, but this data point is insufficient to tell you if you’re really getting a good deal on an absolute basis. If the entire neighborhood is expensive, getting a 5% better deal than your neighbor could be the equivalent of winning the battle but losing the war. Think of all the people who bought what they thought were cheap houses in 2006—only to see their entire neighborhood’s property prices plummet by 30% to 40%.

Important Metrics in Valuing Real Estate

Using comparables is not a sound way to estimate value, but there are two metrics that can help estimate a property’s true value: the price-to-rent and price-to-income ratios.

Price-to-Rent

An asset’s value is: the cash flow it will generate in the future discounted back into today’s dollars. What are the cash flows for real estate? Rents, of course! Thus, a key metric is the price you’re paying relative to the underlying potential rents of the property. You might think that if you’re going to be living in the home you’re buying, then rents don’t matter. Nothing could be further from the truth. As Buffett has said “sooner or later valuations matter,” and this applies to housing every bit as much as the stock or bond market.

The reason the price-to-rent ratio works well is that there is no speculative element to rents. In housing, like what happened in the housing bubble, some people pay an expensive price for a house, only to find a “greater fool” and sell that house at an even higher price. What rents do is anchor cash flow to something that has no speculative element. Nobody rents an apartment to then sub-lease it to someone else to make a profit. People who are renting do so to live in the property, not to find a greater fool.

There can be a multitude of traits that make real estate go up in a city. Taxes, job growth, geography, and weather are just a few that make a place more or less desirable. Remember, however, that all those traits also affect rents, which is why rents are a nice anchor to the non-speculative worth of your house.

To calculate this, you take the annual rent, subtract landlord costs (like taxes, maintenance and other expenses) and derive the net cash flow you would enjoy if you owned and rented the property. The very general rule of thumb is: you buy at 10-times net rents, 15-times net rents is roughly fair, and you sell at 20-times net rents. Of course, real estate is idiosyncratic, so you need to adjust this ratio for where you live.

The Economist has a free website where you can see the price-to-rent ratio for the country and major cities. This website uses gross rents (before landlord expenses), so the multiples will be lower than my rules of thumb, but as you can see from the national prices, you can get a quick feeling for where the country or city is relative to its history over the last few decades. Obviously, the ratios around 2006 are a great example of “very overvalued.”

The point here is to look at the valuation of your city over time to get a sense of fair valuations. Then ask your realtor to find 3 to 5 places for rent similar to what you are looking to buy and develop a specific price-to-rent ratio for the home you’re considering. If the price-to-rent ratio has been rising rapidly for a while, don’t assume prices will go up forever. Trees don’t grow to the sky. Like the violent price increases we saw in the early- to mid-2000s, this can be symptomatic of a bubble.

Price-to-Income

The price-to-income ratio is another handy valuation metric to get a feel for price sustainability. The logic is that the income of your community is what pays the residents’ mortgages, so if a price-to-income ratio gets too high, it becomes unsustainable. The chart below shows that the U.S. housing market topped out at a little over four-times price to median income. When San Francisco peaked at more than 10-times incomes in the mid-2000s, that was a clear warning signal. Now, if you’re in the market for a $1 million house, it will never be cheap compared to your community’s income. Unlike price-to-rents, this metric is not useful for a single home, but it does give you a sense of how expensive your city is.

Remember the rule often given to an individual when asked how much home they can afford is “three times your income.” This is often too aggressive depending on the situation, but if your city’s price-to-median income is greater than 3.5 times, for example, it means your entire community (on average) is being very aggressive relative to their income. A mortgage is a 15-to-30 year commitment, and a business cycle is 5 to 8 years. This means people who bought a home on the high end of what their incomes afford are left unable to make mortgage payments if they are laid off during the next recession.

Other Factors Impacting Value

In addition to price-to-rent and price-to-income ratios, consider these dynamics when estimating value.

Valuations are generally inversely related to interest rates: Affordability has a lot to do with housing valuations. When interest rates are low (as they are now), mortgage payments are smaller and people reach for a larger home. When this happens en mass, valuations increase. The rub is that once interest rates normalize, the purchasers will have to deal with higher rates on their mortgage, and you could see your home’s value decline. There is no easy answer to this dilemma other than waiting for valuations to come back to earth by renting. Anecdotally, I heard the story of a famous investor being mocked because he was “wasting” his money renting a big house in California in the mid-2000s. He had the last laugh when he was able to buy the house he was renting a few years later for a 50% discount.

Leverage cuts both ways: Most people use a mortgage when buying a house, which means they are using leverage. The effect of this is important on returns and risk. Let’s say you buy a $100,000 home with 20% down. The following year, your home appreciates by 10% and is worth $110,000. You made 50% on the money you put down (i.e., you put $20,000 down and now have $30,000 of equity in your home.) Wonderful right? The problem is that leverage is a double-edged blade. If your property fell by 10%, your equity just fell by 50%. This is why a home, over the long term, usually works out so well for people; real estate prices over a 10-plus-year period hardly ever fall. Over the short-term, however, where prices can fall and not recover, owning a home with a mortgage can be risky, as many people found out in 2008.

Buying a home is one of the biggest investments you’ll ever make. Buying aggressively in an expensive market can wipe out a decade or more of your savings. It’s worth some work and education to ensure you are making a wise investment.

Accompanying this paper is a spreadsheet I created to help you in your decision making (Download Spreadsheet).  If you fill out all of the assumptions (the yellow boxes), the spreadsheet will reveal when the crossover point is to buying rather than renting. Play with the assumptions, and then work with your financial advisor to determine the best avenue for your family.

Sources:

    1. The Economist, "American House Prices: Realty Check, November. 2015"
    2. The Economist, Zillow "Ratio of House Prices to Annual Rent"
    3. The Economist, Zillow "Ratio of House Prices to Median Household Income"
    4. Warren Buffet, “American Business Magnate, Investor and Philanthropist”