Has Price-to-Annualized Rent Ever Been Normal in San Diego?

[admin]

[img_assist|nid=1831|title= San Diego Price-to-Annualized Rent, '88-'06|desc=|link=node|align=left|width=466|height=311]

Yes.

Using the following data:

1. Median price for a San Diego resale home as of year end '88-'05 and June '06 (source: DataQuick).

2. Rent index as of year end '88-'05 and June '06 (Source:  http://data.bls.gov/labjava/outside.jsp?survey=cu).  I used both "Rent of primary residence" and "Owners' equivalent rent of primary residence," the results were indistinguisable.

3.  Rent for a San Diego residence, 3 BR and 4 BR, averaged, as of August 31 '06 = $2,322 (ideally, I would have used June 30, '06 data, but don't have it) (Source:  http://sandiego.rentslicer.com/)

With 2 and 3, I calculated the annualized rent for '88-'05 and June '06, e.g., (rent index for year end '88/rent index for June '06) x rent for 3BR/4BR residence as of Aug. '06 x 12

Then, I divided the median price by the annualized rent for '88-'05 and June '06.

Results:

The price-to-annualized rent ratio reached its trough in 1995, at 9.7. As of June ’06, the ratio stands at 20.3.

So, for substantial periods of time (’88-’00) in recent history, San Diego’s price-to-annualized rent ratio has been reasonable (10-12). I expect prices to return to a reasonable/defensible multiple of rent (8-12X) during the upcoming recession/depression.

Sincerely,
Puritanical Bible Beater

[powayseller]

Good job! This proves that fundamental value is 10-12x rent in San Diego. Housing prices are higher here, but the ratio is still the same here as anywhere else. After all, if it were more, investors would never invest here. Makes total sense.

[lindismith]

JG, love your charts.

Just curious if the same holds true for 1 and 2-bedrooms?

[Bugs]

Appraisers normally use monthly rents and monthly factors when appraising SFRs, condos and 2-4s. The monthly factor is referred to as a “Gross Rent Multiplier”.

The use of annualized factors is generally reserved for apartment properties (5+ units) and non-residential properties like office and retail. The annualized factor is referred to as a “Gross Income Multiplier”, and we sometimes measure it as different points in the income stream, such as either before or after vacancy/collection losses, or after consideration of any rental concessions. For residential properties, appraisers just stick to the monthly rents.

A annualized gross income multiplier of 10.0 (sale price/ annual rent = 10.0) would equal a gross rent multiplier of 120 (sale price/monthly rent = 120).

The 1995 GIM average for houses of 9.7 would equal a GRM of 116.40, which would have actualy a little higher than what the apartment properties were selling with at the time.

The thing to remember about the 1995 prices is that they were undervalued relative to the long term trend, so I don’t think you should be using a GRM of 120 (= GIM of 10.0) as your baseline. It probably should be closer to 145 (GRM) or 12.0 (GIM), and vary off of that.

The GRMs we were seeing of 280-300 x monthly rents would equal an annualized GIM of about 24.0+, so you can see that off of the peak we would have had a long ways to go in order to get the rent/price ratios back down to the 145-165 (12-13) ranges.

Let’s give our bulls the benefit of the doubt and say that rents will continue to climb at a double digit pace. If we start from an average of $1,900/month for an existing 10+ year old 3bd/2ba home. How far up would the rents for that home have to go in order to meet a declining price structure (now at $550k) at the 150-165 GRM rate? Assuming the rents are increasing by 10% per year and the prices are decreasing by a similar amount, we can lay out the scenario.

Yr1: $550,000 Price / $1,900 Rent = 289.47 GRM (24.12 GIM)
yr2: $495,000 Price / $2,090 Rent = 236.84 GRM (19.73 GIM)
yr3: $445,500 Price / $2,299 Rent = 193.77 GRM (16.15 GIM)
yr4: $400,950 Price / $2,528 Rent = 158.60 GRM (13.21 GIM)

Under this scenario it would be 2009 before the rapidly decreasing price structure intersected with a rapidly increasing rental structure; assuming those opposing trends could occur simultaneously for any length of time.

The resulting $400k median price would represent a 27% decline in pricing, and the $2,528 rent would represent a 33% increase. Bear in mind, this what-if only corrects down close to long term trend line; it doesn’t overcorrect like every other downswing normally does – it would take at least 1 or 2 more years at these same rates to do that.

The other thing to remember is that the rental market for homes is not the only game in town for a rental tenant – houses compete for rental dollars with apartments and condos, so we’re not just talking about the one rental segment increasing by double digits during an RE downturn; we’re talking about all rentals increasing in varying degrees.

Speaking of which, am I the only person on this board who finds the idea of the rental market rapidly increasing during the same time frame the sales market is crashing to be…implausible?

[(former)FormerSanDiegan]

Excellent research ! At the absolute null in 1995, it was slightly below 10, staying there for less than two years.

At the end of ’95-early ’96 the 30-year rate was in the 8-8.5% range.

Let’s look at it from an investment standpoint.
Wwould buying a SFR as a rental at that time result in positive cash flow ?

Assume 8.25% loan
1.2% property tax
$50/month insurance
150K property

Using 9.5x rent implies a rent of 1315 per month

100% LTV:
PITI = 1127+150+50 = 1327
Negative cash flow of $12 per month before maintenance, etc
So, with No down, so there is no way to break even before tax considerations (I’ve also ignored PMI or increased rate due to 100% LTV).

90% LTV
PITI = 1014+150+50 = 1215
Postive cash flow of $100 per month before expenses and excluding tax considerations. Probably not break even after expenses, but positive after tax considerations.

80% LTV
PITI = 901 + 150 + 50 = 1101
Positive cash flow of $214 per month. Modest positive cash flow before tax considerations or considering opportunity cost of the down payment.

Conclusion : Previous low point in San Diego resulted in marginal (break even) cash flow from rental properties with 10-20% down.

[studenteconomist]

My experience (gained through second hand knowledge) is that properties will never cash flow, after all expenses, with just 0-10% down. Why would they ever? It has to do with the attractiveness of investment. If I could get a 100% loan and break even on a house the first year, I would make enormous profits over the next years as both rents increased and the equity increased. That kind of investment would blow away any other type (stocks, money markets, etc.) for total returns, especially considering the tax benefits of equity build-up. Equity would definitely increase in this environment because it is a function of rent increases, and they could go up at least the level of inflation. I, and everybody else who has a rational investment attitude, would continue buying houses until they were bid up to so that the total return on the property in the long run was no more attractive then alternative investments of similar risk. This is what happened in the 90s and early part of this decade. As the investment environment of stocks (dot com bust) and money markets (interest on T-bills, bonds) dropped to multi-decade lows, people bid up houses to the point their total returns matched those other investments. This was a rational process, and my mind it was until 2002-2003. But, as is usually the case, the bidding went way past the rational price and reached bubblemania where prices got way ahead of themselves, which was the situation the last 2 years.
Given the current interst rate environment and the other returns on attractive uses of capital, prices and rents will not reach the 12.0X gross rent multiplier, ever. The new rational level given interest rates at the moment is probably 14-16X times rent. I guaranttee you will never see an 8-12X ratio given our current investment opportunities and economy. The only way to see that level is to have interest rates climb back to where they work in 1995 (>8.0%) or have much higher unemployement (>7.0%). If these become the case we will be back to 1995, and it will repeat.

[powayseller]

What’s the difference between “owner equivalent rent” and “rent of primary residence”? The Fed in a recent report calculated the US price-rent ratio using the OFHEO existing homes sales index / BLS owner’s equivalent rent. Does anyone even use rent of primary residence? (The report concluded that the recent spike in the ratio would be normalized by a stagnating house price, and not by rising rents).

[barnaby33]

From the BLS website:
The expenditure weight in the CPI for rent is obtained by directly asking sampled renter households the following question:

What is the rental charge to your CU for this unit including any extra charges for garage & parking facilities? Do not include direct payments by local, state or federal agencies. What period of time does this cover?

However, the expenditure weight in the CPI for rental equivalence is obtained by directly asking sampled owner households the following question:

If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?

In English it means that, “rent of primary residence,” is just that rent paid by renters. “Owner equivalent rent,” is a more squishy figure derived from asking owners what their house would rent for.

Josh

[vegasrenter]

“This proves that fundamental value is 10-12x rent in San Diego.”

Kind of – it shows that 10-12X is fundamental value at troughs, not most of the time. I’d guesstimate normal/average as halfway in between, or about 15X, still a pretty hefty ownership premium, and unfortunately out of reach for potential buyers such as yours truly.

[pencilneck]

Great chart!

While I agree with most people here that that 94-96 was the trough of the last real estate market cycle, 88-89 was very close (if not exactly) the previous top. Thus I disagree with the statements that the chart is merely showing gains from the previous bottom, as it shows quite a bit of the previous top.

[(former)FormerSanDiegan]

studenteconomist –
I agree with you that the multiplier depends on the interest rate. I’ve made this same point in other posts.

Look towards the bottom of the following …

http://piggington.com/sell_or_hold_if_mortage_is_roughly_equal_to_rent

In an 8-9% 30 yr fixed rate environment a multiplier of 10x-12x made sense.

My point was to underscore that these data show that at the worst point things broke even with 10-20% down. Some people thought it was a better cash flow environment than that to purchase at the bottom. This is why I am expecting about a 20% decline in nominal prices over 5 years, assuming 3-4% wage growth and interest rates in the same range as today.
sale of my primary residence to

[Bugs]

I would never say never to either increases of mortgage interest rates to 8.5% and/or the return of a 10x rent multiplier for housing. Just as this high entered previously uncharted territory, I think this backlash also has the potential to go where no backlash has gone before.

Depending on the losses suffered in the secondary market, I cannot rule out a standard 10% mortgage interest rate and 20% downpayment requirements at some point in the next few years.

[powayseller]

So owner equivalent rent is a homeowner’s knowledge of the rental market? Seems like a crazy way to measure something, but the two measurements are similar. They are up 60% and 66% in the last 10 years.

Bugs, I also find it implausible that rental rates would climb at double digit rates. Rents track wages as far as I know, and something that I need to confirm. When rents exceed wages, people exercise their options and leave town, as they are already doing. The Fed Sept. 04 study concluded that price/rent ratio would normalize by prices stabilizing, not by rents rising. In my bearish view, I’d say by prices dropping.

I agree with Bugs that interest rates can rise. Some good arguments have been made for a rate as high as 15% of more in a few years, as we need to make our interest rates attractive to retain the $1.5 TRILLION of foreign investment in our country. If foreign conservative investors like insurance companies start to worry about the dollar losing value and pull out even a tiny bit of their holdings, like 10%, it would have a catastrophic effect on our economy. So the Fed has to keep the interest rates and dollar high enough that we are more attractive than other options, and with the Europeans now raising rates, it’s getting tougher. Inflation is also getting higher, and with rents rising, CPI has to keep going up (rents are 40% of the CPI).

As far as prices being down 20% nominal, we’re half way there and we haven’t even hit the loan resets yet. I’m excited for the big drops when the loans reset, in 2007 – 2009.

Bugs, thanks for the GRM explanation. I think jg annualized it because the OFHEO data is quarterly.

[Anonymous]

LS, glad you find the analysis helpful. To get a sense of the ratio for 1/2 BR places, I’d need historic data on 1/2 BR homes, but I don’t have that. I just have historic data on the median price of resale homes, which includes small and large homes.

I think that DataQuick has historic condo data, which would be a good proxy for 1/2 BR homes, but such data isn’t cheap (~$250).

Having said all that, I can think of no reason why a 1/2 BR would have a higher P-to-AR ratio than the full range of resale homes; it would be unsustainable, given the ability to get a higher return on a 3/4 BR house by folks who are rational investment property managers.

Excellent calculations, FSD.

Bugs, I think we’re going to have depressed demand (recession/depression). I think that nominal rents may go up for awhile, maybe years (that’s why I’m in gold), but real rents are going down, IMO, given the exodus of people and jobs. I feel comfortable that we’ll see 8-12X.

My father-in-law has been a San Diego real estate investor since the ’70s, and he uses 8-10X for his calculations. He’s seen 8-10X before in commercial properties (apartments, strip malls, industrial parks), and I don’t see why residential would be any different (see SE’s fine explanation on how, over the long haul, money moves, affects prices, and equalizes risk-adjusted returns).

[Bugs]

I’ve seen sub-8.0x gross on certain property types other than residential. I have one lending client that bases the value upon which they’ll lend at 7.0x gross. I think that’s being overly conservative and I know they’ve passed on a lot of profitable deals in this runup because of it, but I also know they don’t have problems with foreclosures or late payments.

I can think of a couple reasons why a single family residence or condo would routinely justify a higher income multiplier than commercial or industrial properties. For one thing, residential properties are subject to residential lending programs. This means they can qualify for 30-year mortgages with minimal downpayments and favorable interest rates; whereas a non-residential property (including 5+ apartment units) are subject to commercial lending programs. For comparison, most commercial loans are written at higher interest rates and get re-written every 5 years. The loan may be amortized on a 30-year rate but it comes due in 5, at which point it rolls over into a new loan at the prevailing interest rate, usually with additional origination fees. The increased demands on the mortgage side of the income stream result in lower returns on the equity side. Financing terms are one reason SFRs tend to show higher rent multipliers.

Another reason is that, just as they say, a house can always be used for shelter. Not so with a commercial property. A commercial property has no utility to a failed company, except as a disposable asset.

Yet another reason is that the price point for investors is much lower for a house than for an investment-grade commercial property. Simply put, more people can participate in that particular game because of the lower prices and the larger number of available opportunities.

For these reasons (and others) I’d be surprised to see housing and non-residential properties ever working off the same rent multipliers. There’ll always be some relation between the two, depending on the economy, but there’ll always be a spread.

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