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

[davelj]

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.

[CAwireman]

JG, as always, great graphs. Question to the group. Are you surprised that rent and prices track so closely through those years.

I would expect to see some tracking variations, especially during the run up in prices during the last 8 years or so.

[Anonymous]

CWM, my description wasn't clear. I hope that this helps.

Prices have sharply risen over '00-'06: 

[img_assist|nid=1842|title=
San Diego Resale Home Median Price, '88-'06|desc=|link=node|align=left|width=466|height=311]

The rent index and imputed rents have risen over '00-'06, but not nearly as much: [img_assist|nid=1843|title=
San Diego Rent Index and Imputed Annualized Rent, '88-'06|desc=|link=node|align=left|width=466|height=311]

When you divide the prices in the first graph by the imputed annualized rent in the second graph, you get the 'price-to-annualized rent' graph. Thus, due to the rapid increase in prices over '00-'06, when compared to the slower increase in rents over the same period, the price-to-annualized rent ratio has really taken off.

[powayseller]

davelj, I am counting on very high interest rates in a few years, as investors start selling their Treasury notes, thus lowring their prices and raising their yields. 15% – 20% is the range I’m expecting. iTulip.com’s KaPoom theory…. check it out, and tell me what you think. The guy is briliant, and he retired off the money he made in selling and buying into bubbles between 2000 and 2002.

[sdrealtor]

At a GRM of 10 my home would be sell for 20% less than what it cost to buy new in 1998. I have a hard time seeing that happening.

[davelj]

PS, I don’t think the KaPoom theory is completely crazy in general, but you have to remember that the inflation he talks about doesn’t even begin to get underway until 2012 and then takes a few more years just to get back to current levels before accelerating upward. That’s 10 years out… I don’t know about you, but my crystal ball gets pretty hazy that far out. I consider myself a pretty long-term oriented investor but even I have my limits. And I don’t think rates will go as high as he’s predicting although we could see some jump in long-term rates at some point several years out. I have a word for economic predictions made more than a few years out: “guesswork.” In my view, the fact that this guy made millions in venture capital has absolutely zero impact on his credibility as a forecaster. But if you want to invest based on this kind of stuff, that’s certainly your prerogative.

[sdrealtor]

PS,
Do you really believe we could see rates between 15 and 20%? When rates hit those levels during the Carter Era lots of people I know (including my parents)put everything they had into CD’s and turned a few hundred K into millions in cash.I would love to see it as I could retire today if rates were that high.

[(former)FormerSanDiegan]

If rates are 15-20% what will be the annual increase in rents ? Will they track inflation ? If they are even close, then in that scenario the bulk of the price correction will be in rent increases, not price declines.

In fact, if you believe that we will see 15% rates in the next few years, wouldn’t it make sense to lock in a loan now (even on a 40% overpriced property), if you can lock in 6% and pay back in a 15% interest rate environment. IF you assume inflation and rates roughly track eachother that might mean inflaiton in the 12% range.

At 12% inflation the dollars you borrowed at 6% are worth half as much 6 years later. Even if homes fall in value by 6% in real dollars per year you come out ahead.

Rates jumping 9% and the accompanying inflation over the next few years would not benefit a bubble sitter IMO. That scenario favors the property owners.

[sdrealtor]

Darn, I was ready to start planning my retirement. I still wonder whether the multiplier on my home could ever approach 10X annual gross rent which would be 20% below 1998 cost. I dont care if it does as I’m dug in here for at least 20 more years and have a 30 year fixed rate in the low 5’s.

If it hit 13, that would mean my house was selling for what it cost new in 1998. BTW, my home is in a very desirable location and community. I could rent it out quickly and it would go for top dollar relative to the market.

[Bugs]

SDR,

The 9.7 GIM occurred in 1995 based off of rents applicable at that time. As we already said, those prices were undervalued relative to the long term trendline by 20% or more. Your 1998 purchase price would have been at or even slightly above the long term trend line depending on what time of the year you bought and how well you did on your price. At that point, a taller GIM of 12.0 or higher would have already been in order. In 1998, a 10.0 GIM would have represented a 20% decrease if that had been what the rental and sales markets were doing at the time.

Obviously, rents have increased since 1998 and the sales market has far more than doubled. I think it’s safe to say we are in uncharted territory with these gains and the truth is we can’t know for certain whether this current correction will stop halfway to the trendline, go all the way, or as in busts of the past, overcorrect below the trendline.

We have yet to see a correction that didn’t overshoot, so from a past-predicts-the-future standpoint there’s no evidence to say it won’t happen that way again this time. But if we have only the past to explain that it might happen again, we have absolutely nothing that we could point to that would explain why it won’t.

—————–

The interest rate spike in the early 80s was just that – a temporary spike. It can be argued that the subsequent return to more normal rates helped to initiate and fuel the boom of the mid-late 1980s. Anyways, that interest rate spike evened back out after a couple years. If people are making a lot of money off of CDs it only begets more competition among depositers, thus resulting in lower yields. I see this as another example of what happens when there is an extreme – the forces of gravity will eventually bring it back into line.

Here’s something to consider, though. If the interest rates do go up, so too will inflation; and a loss of equity value through price inflation is just as much a loss as an outright price correction. So no, I don’t think we can justify overpriced @6% (based on the long term trendline) as being better than underpriced @12%.

[(former)FormerSanDiegan]

Bugs –

a loss of equity value through price inflation is just as much a loss as an outright price correction

I don’t think this is true if the property is leveraged.

If it is leveraged, then the real value of the debt is also reduced at the same rate.

[powayseller]

If rates hit 15%, then there are much better ways to profit than owning a house whose real value will shrink rapidly. Think bear funds, gold, and the euro. That’s were the real profits will be. Again, this is a few years out, maybe 2 -5 years, so selling a house now is still a smart move. Take the cash, and be ready for these other opportunities.

[no_such_reality]

Rates won’t hit 15% because inflation isn’t going to be double digits.

[sdrealtor]

PS,
I love my home and am not looking for better ways to profit off the equity. The joy of living there and spending time with my family are the greatest returns of all. In 20 to 30 years, I likely wont be around anymore. I’ll leave behind a healthy estate for my children but hopefully they will value their childhood more than their inheritance. That is the most valuable thing I could leave as a legacy. It could be longer or shorter but until then I’ll enjoy consuming the equity in my house through the daily pleasures of life.

You are so consumed with housing and the economy. I feel sadness that the runaway housing market has created that in your life. I would love to see greater affordibility for you and others. I hope it happens, I really do. In the same vein, I have trouble hearing you say you are “excited” about watching the economy and housing prices self destruct as I know what that would mean to alot of people. I prefer to create wealth through more positive thoughts and see great opportunity ahead in other areas that I am pursing in addition to keeping my hands in RE. There will not be great money making opportunities in RE for a long time. Rather than dwelling on something that won’t be profitable wouldnt your family be better served by you applying your great skills somewhere more positive and profitable than chronicling the demise of the economy?

[Author]

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