On this board we look behind the numbers of median price reporting, carve up other statistics reported in the media, and hinge our positions on ratios of median income to median home price. Why should we blindly take someone elses rule-of-thumb multiplier of 10 or 8 or 13.3?
Let’s look at what that multiplier or Scale Factor means.
AnnualRent * ScaleFactor = PropertyValue
or in notation AR*SF=PV.
Solving for SF
SF=PV/AR
If you want to consider the gross return on investment in the property you could compute
GR=AR/PV *100. So The percentage of return (gross) is the inverse of the ScaleFactor.
A ScaleFactor of 10 implies 10% gross return
A SF of 8 implies a 12.5% gross return
A SF of 20 implies a gross return of 4%
This is why you need to consider what investment return rates on alternative investments yield when making an estimate or expectation of property value and determining what scale factor to use. (You also need a crystal ball to predict where rates will be 1,3,5 and 10 years from now)
If a single family home falls to the point where the scale factor is 8, but bond yields are at 4%, guess what happens ?An investor in that property will collect collect 12.5% gross rent, which might be >10% net after expenses. In an 4% world that is not sustainable and would likely lead to a significant increase in the price of the asset.
As far as the direction of rents. I believe that over a five year period they will at least track the rate of income increases. If you think incomes will stagnate than you will be right.
