The typical value-to-rent for small multi-family properties these days is around 10x-12x here in SD, implying a 6%-7% cap rate using traditional financing. The comparable price-to-rent for similar condos is, as the chart above suggests, around 18x-20x, albeit falling slowly.
The main reason that multi-family properties will always trade at a discount to similar single-family dwellings from the standpoint of price-to-rent ratios is the tax advantage the latter has over the former, although the cheaper financing also plays a role. The buyer of multi-family properties gets to use depreciation and writes off the interest expense (that is, it’s a pre-tax expense), but s/he isn’t living in the property and getting that direct tax benefit that an occupied dwelling gives its owner. Consequently, someone who’s purchasing a condo to live in, for example, should be willing to pay more for that unit than someone that’s merely buying it for its cashflow. The tax benefits are more direct to the former. But, that difference isn’t enormous. Perhaps the combination of the tax benefits and cheaper financing justifies a 15%-20% premium, but not the 35%+ premium evidenced in today’s market.
Now, having said all that (and acknowledging that I’m bearish on RE), here’s why I think the price-to-rent ratio will NOT decline to the 8x-10x range during this cycle. While it’s true that “this time it’s different” are the four most expensive words in investing, the fact remains that each “this time” is in fact a little bit different from the previous “this time.” So, here are a few differences between today and the late-80s/early-90s:
1. SD, whether you like it or not, is now a “glamour city” (to use Robert Shiller’s term), much like LA, NYC, SF, Miami and Chicago. It wasn’t mentioned in the same breath as these cities back in the early-90s. Back then it was a sleepy tourist destination with great weather and a big military presence. Today, it’s a much larger city, with a more diversified employment base (too much real estate, I know) and a “real” downtown. Rancho Santa Fe and La Jolla are known internationally as enclaves for the rich and famous. Again, this wasn’t the case 15 years ago. SD is, rightly or wrongly, now considered in the big leagues of american cities. Its biggest “problem” is, of course, the cost of housing. That’s probably the only thing that keeps the population from doubling. Bottom line: A boatload of people want to live here, despite the traffic and other negative issues. As housing prices come down, the area will become more attractive relative to other areas that are also facing falling prices. So, this relatively new “glamour city” status means that there’s a premium that may stay in SD housing prices for quite some time. Manhattan was probably the first “glamour location” and the price-to-rent ratios there have simply continued to climb over time, with temporary minor blips in downturns. I’m not saying those prices won’t fall, but they’ll probably always seem “high” to us normal folks.
2. The employment base is better in SD today than it was back in the early-90s. Yeah I know – here come the shouts – SD has an over-reliance on real estate. No doubt about it. But even factoring that in, the employment base is far more stable than it was during the early-90s. Even if real estate industry employment mean reverts, the employment picture isn’t going to look like it did 15 years ago. Consequently, another small boost to long-term real estate premiums in SD.
3. Back in the dog days of the early-90s, interest rates were 200 bps higher than they are today. And if things really do slow down, mortgage rates are more likely to fall than rise from current levels. Consequently, values to some extent will have another plank of flooring beneath them relative to the early-90s.
That’s three pretty big issues. My guess is that we get back to 11x-13x price-to-rent ratios at some point during this cycle, but those waiting for 8x-10x are going to waiting a loooooooooong time.
Recall that for most of the period between 1930 and the late-1950s, the dividend yield on the Dow Jones Industrial Average was greater than the yield available on 10-year treasuries. Many investors thought this was a necessary risk-premium to require in order to induce them to invest in stocks. Those who followed this approach sold in the late-50s and haven’t seen comparable dividend yields since. Things were indeed different that time.
