What are the “standard” fundamentals?

[23109VC]

i see many people here talking about pricing returning to fundamental levels….

i have read in some places, elsewhere on the web that there are “standard” / FUNDAMENTAL ratios for real estate.

such as the average sale price of a home should be roughly 200 x the monthly rental price

or that a person should spend no more than XX percent of their gross or net? monthly income on a house payment….

can any of you post here the “fundamentals” we are all talking about… so i know what they are.

like rent/sale price
mortgage size vs. income
other basics

thanks.

[kewp]

I don’t think there is a ‘right’ answer to this. You will see lots of opinions, however.

My personal opinion is that Rich’s famous ‘income to median home price’ chart is right on the money.

http://piggington.com/images/primer/sdpricetoincome.gif

The red line is about what I would call the ‘fundamental’. You either buy on the bottom and get a short term gain, or at the top and weather a loss. Some might call the bottom the fundamental, however.

[temeculaguy]

One of the fundamentals you can figure out on your own for specific towns using some web data is median income to median housing price ratio. Rich and many other analysts consider median housing price at five times median income to be part of a dwonside or bust and seven times income to be the high side or a boom. If the median income (not the average but the guy in the middle with half making more and half making less) is 50k a year for a zip code, 250k for a house is a deal and 350k is a rip off because in the past it fluctuates between the two. You can go to SANDAG’s website and get estimates of median income by town, zip code, school boundaries, etc.

http://profilewarehouse.sandag.org/

find the place you want to live, look at the median income (the real dollars, not the inflation adjusted 1999 numbers) and multiply it by 5 and also by 7, that is the historical range for houses there. The trick is, you may need a real estate veteran for the area to determine the median house for that area if you are unfamiliar with it, communities vary incredibly by median sq ft and median lot size. On Sandag, choose “current estimates”, the most recent data is 2006, new data may become available soon but incomes don’t skyrocket. San Diego city is at 61k, Carlsbad at 90k, paying anything more than 420k for the average house in S.D. is as risky as paying more than 630k in Carlsbad both were multiplied 7 x earnings. Keep in mind if you are looking at the smallest or the biggest house the fundamentals support more or less, real estate has more factors than just median, it’s just a basis. I am not in the RE industry, but ultimately you may need a local RE pro to help you determine if something is above or below average just be wary of the hype and find someone who didn’t jump in the biz in the last few years. You should refine it to zip code or even elementary school boundaries. Using countywide numbers quoted in the papers are interesting but if you are looking at buying, get specific.

Income went up 33% in S.D. city but 38% in Carlsbad from 2000 to 2006, housing went up much more in both, therefore the price increase violated the fundamentals of economics and have always returned, usually overcorrecting and going below the price supported by the fundamentals temporarily, and that my friend is the time to buy. Unfortunately I have but an SDSU education and never got better than a B in an economics class, so I could easily be wrong.

[kev374]

rough guide is that the median price should be 2.5 (on the low end) to 4 (on the high end) times median HH income. We are currently between 7.5 to 10 times here in SoCal depending on area.

I would be judicious towards a value of 4..perhaps buy if I were in it for the long term, but just wouldn’t buy anything over 4.

Currently median HH income hovers somewhere around $80-85k for South OC. 4 x 80-85k = $320-340k or so is the upper limit for median home price, so we’re at just under a 2X overvaluation.

*In my opinion*, South OC commands a median home price of $280-320k, nothing more! Even this price point requires STRONG income at reasonably conservative guidelines 35% DTI, 90% LTV.

[an]

The two things I consider as fundamental are rent vs buy and income vs buy. If it reach equality in term of monthly payment on a 30 years fixed w/ 0% down to make the calculation more fair and monthly rent of a similar house, I consider that close or at fundamental. income vs buy is just used to compare a whole area. But since RE is local, you have to get down to each individual house level and see if a particular house is far or close from fundamental. Also, income vs buy will tell you what you can truly afford, but that doesn’t tell you much about how over priced a particular house is.

Here’s an example: A 1200sq-ft house on a 6000+sq-ft lot in Mira Mesa is being sold by the bank, asking $375k-$400k. If you work out the number, that would put P+I around $1900/month. A similar sized place would rent for around $1600-$1700/month. a 2bed/2bath apartment near there would rent for around $1400-$1500. So I would say it’s about 10-15% from fundamental. If you take in tax deduction, then it’s about at fundamental.
Then you have a 1500sq-ft $540k house, still in Mira Mesa. The rent of a similar house is around $1800/month. But the monthly payment of the mortgage would be around $2400/month. That’s more than 20% over monthly rent. Bottom line is, RE is even more local than just Zip Code. Every house is different and you have to do your calculation individually.
Another way to calculate to see where the fundamental is to calculate the monthly payment of a similar house around 1996-1998, add on 3-5% inflation each year, then you get a monthly payment for 2007. That’s your fundamental. This will take care of the rate difference. Who knows what the rates will be in the future. The best you can do is calculate the rate now and the price now.

[temeculaguy]

I just recognized your screen name and realized you are a fellow Temeculan, SANDAG only covers San Diego but Temecula’s median household income is 78K, their stats are current as of Jan 07. There is a difference between Median Family Income and Median Household Income, household is higher and I don’t remember which one Rich used for his 5x and 7x examples so my examples may need to be adjusted. But i think you get the point of what a fundamental is.

I think I like the rent vs. buy formula mentioned above even better than Hh income because it truly lets you know if something is worth buying or renting because those are the two choices when you boil it all down.

[cashman]

I am wondering if much of the way we calculate the fundamentals, such as 3X or 4X income was based on times when interest rates were much higher. For much of my lifetime, except my early childhood, interest rates were between 8-12 percent, probably averaging about 9-10 percent. Is it possible that we have entered a new age of relatively low interest rates which therefore change all the equations? These lower rates have been around now for several years, and it looks like they will stay low or lower for the forseeable future. Perhaps we are witnessing the evolution of the fundamentals themselves.

[Cow_tipping]

200 X … heck no … 100 X is what I shoot for. In Charlotte NC that actually is a sign that both renter and owner are happy. But when I lived and rented in CA, I dont think any of my land lords were doing better than 150-200 X and that was from 95 – 2002. By 2002 we were firmly in 200 X territory. In 95 I was probably in the 150 X and I’d call that a fundamental. That was in northern CA BTW in the height of the IT growth … as in before we sent those jobs to India and china.
Cool.
Cow_tipping.

[LA_Renter]

Cashman,

I found this article explaining the ratios using a 7% interest rate. It used to be that you should only use 28% of your gross income for a mortgage with 36% as a maximum. I guess our new paradigm of lending changed all that at least for the first couple of years of the mortgage. There is a awful lot of pain out there right now.

“If we do take this as an assumption and apply what most lenders call affordable (paying a maximum of 28% of your monthly income for your mortgage), we can figure out what medium home price to medium family income ratio is for a given down payment and mortgage interest rate. What we have then is a number that represents the maximum multiple of income that a home could cost and still be affordable (again by the conventional definition of affordability) to a medium income earner. Given the assumption above, this ratio is valid across the entire US housing market and allows us to directly compare one market to another (assuming, of course, we are using local values for median family income and median home price).

To figure out what the maximum affordable home price to income ratio is, let’s assume we earn a medium family income of $1000 a year (we can assume anything and it will not change the ratio). Again, lending standards say that we can use a maximum 28% of our monthly income to service our home mortgage debt. So we have (1000/12)*.28=23.33 dollars available each month that we can use to pay the mortgage. Now we need to figure out the monthly cost for each $1000 we borrow so that we can know how much we can spend on a home. For a 7% fixed rate 30 year loan (for example), it costs $6.65 a month to borrow 1000 dollars. Therefore we can afford to borrow 23.33/6.65=3.5 multiples of 1000 dollars (i.e. 3.5*1000=3500 dollars). 3.5 is then the maximum affordable medium home price to medium family income ratio for a mortgage with 0 dollars down and a fixed 7% interest rate. Said in a more realistic way, a family making $100,000 a year can afford at most a $350,000 home (350000/100000=3.5) with this mortgage.

For rates of 6% and 8% (all other conditions the same) the ratios are 3.9 and 3.2 respectively. The ratio is larger for smaller interest rates because the cost of borrowing money is cheaper and we can do more with the 28% of our income we are allowed to use. Again, these ratios hold true for any locale given our assumptions.”

http://www.benengebreth.org/archives/2005/06/housing_priceto.php

[(former)FormerSanDiegan]

The assumption that median priced homes and median incomes should line up in way that the median household income qualifies for the median priced home is flawed.

In Southern California the percentage of homeowners is historically between 50-60% and the price to median income at the bottom of the cycle exceeds the value I compute when I use median income and qualifying standards. Look at the charts in Rich’s primer.

Why is the ratio higher than what would be supported by median income at the bottom of the cycle ?

Remember that half the population makes more than the median income. The bottom 25% in income distribution are not likely home buyers (assuming lending standards are back in force) so the median income of home buyers will tend to be higher than the overall income median.

I prefer to use the approach that asianautica outlines when comparing rent to own. Comparing monthly carrying costs of mortgage to rent. When those are close to even for a broad category of people (not necessarily the median income) the bottom is near. This is what happened in the mid-late 90’s. The nice thing is that this is what a reasonable prospective home buyer would use to determine whether or not to purchase, and it inherently takes into account interest rates, inflation, etc.

[davelj]

I would be careful about assigning too much value to price-to-income ratios, although they do convey some important information. In my view, there is only one thing that matters in valuing the “typical” home or condo: rental equivalents. At the end of the day, the only thing in finance of any importance is CASH: How much is there? How do I get my hands on it? How much risk is associated with getting my hands on it? For the vast majority of assets on the planet, everything else is, ultimately, just smoke and mirrors. Doesn’t mean that other approaches won’t work for a while… but when the dust settles the only thing that matters is CASH.

The typical home is just a housing unit that you decided to purchase instead of rent. Figuring out the cash flows from it isn’t rocket science. As I’ve said before, a rational person will be willing to pay a premium to own versus renting because ownership has certain advantages that are worth the premium, including: (1) Your “rent” won’t increase (much) if you get a fixed-rate loan (this has value), (2) For some people there is a peace of mind associated with ownership and being “settled” (this has value), and (3) There is a tax advantage to ownership (this has value as well).

Now, what premium a rational person should be willing to pay depends the value attached to these three issues (and perhaps other lesser issues I haven’t mentioned). For some people the premium may only be 20% (that is, they would be willing to shoulder total gross housing-related payments that are 20% greater than the cost of renting the same unit). For others #2 has more value such that maybe the premium is 35%. But no matter how you slice it it’s probably not greater than 50%… which is the REAL problem with the SoCal housing market (and others).

To use an example, a condo in my building just sold for $510/sq. ft. (which is eggregious, by the way). Applying that PPSF to my unit (which I own) implies a valuation for my unit of 19x rent. If I apply a 20% ownership premium to my unit’s rental equivalent (using standard conforming financing) I come up with a “real” value of about 12x rent. So, I fully expect the value of the units in my building to decline 30% (more than they already have), give or take, by the time this bubble hits bottom.

Now, once you get to homes above $1 million this analysis largely goes out the window. Because here you’re talking about art, not housing. The value is in the eye of the beholder. Rental equivalents will send you a signal regarding the value of the piece of house/art, but ultimately it’s “pure” supply and demand – the cash flows aren’t so relevant.

But for the vast majority of housing, the value is ultimately determined by how much cash it’s capable of generating with some premium attached for the items listed above. The biggest mistake a person can make in evaluating an investment decision is losing sight of the cash.

[greekfire]

I personally feel that analyzing the cost to rent vs the cost to buy, both short and long term, is the best fundamental way to view the RE market.

Using percent income or monthly expenditure calculations brings far too many variables into the equation and are based on the assumption that every person places a similar value/percentage on the property that they sleep in on a regular basis. Some people might place a higher or lower premium on this, depending on a number of variables.

Would you recommend the same for purchasing a vehicle? Some might find the need to spend a bit more (or less) on their vehicles for various reasons. The same goes for any other personal asset (retirement, life insurance, etc.). Why would purchasing a home be any different?

Renting and owning a home, on the other hand, are the only two competitors when it comes to a home. It is reasonable to expect that these two competitors would fall under the forces of supply and demand, and would compete against each other for customers.

[barnaby33]

Or as you so elequently put it, “who’s ox is being gored.”

Josh

[sdrealtor]

Is it me or does a 20% ownership premium seem obscenely low? Lets look at DLJ’s 3 factors.

1.) No rent increases: If we assume a modest 3% rent increase for an average ownership period of say 10 years we are paying 35% higher rent in year 10. Sure you may stay shorter but if you are buying it should be in your plan to stay that long. Also an average of 3% annual increases is probably overly optimistic. Any way I look at it, this alone has to be worth a 10% premium. Note this is subjective and different folks may feel differently about how long they would stay.

2.) Peace of Mind: Not only peace of mind but moving is expensive and disruptive to one’s life. Don’t know about you, but I would pay 5 to 10% higher rent to have security knowing I was in control and could do what I want with the property. Note that this is very subjective and some folks actually enjoy moving every 12 to 24 months.

3.) Tax Advantage: Most of us are in a 28% marginal tax bracket federally and 9% state taxes in CA. If you figure that about 80% of what pay in PITI is tax deductible that’s another 30%. This is not subjective and depends only upon your marginal tax bracket.

I just dont see how anyone can claim a 20% premium is reasonable. I think a 40 to 50% premium for a white collar professional is not unreasonable.

[bigmoneysalsa]

sdrealtor,

While there are many subjective benefits to owning, there are also many for renting. As a white collar professional myself, the ability to easily relocate easily with 30 days notice and not have to worry about selling a house is HUGE. Considering that the tendancy is towards a more mobile labor force and that many people change jobs every few years I think this benefit is quite underrated.

However, we can argue all day about this factor or that factor. Quite frankly I think the equation is just too complicated to work out by pure reasoning… you have to look at the stats as to what the premium historically has been. There are different ways to measure that I am sure, but I bet the consensus estimate is actually quite a bit less than 20% after the taxes/etc have been factored in.

Also, don’t forget that the willingness to pay a huge premium does not imply that a huge premium must actually be paid. The price is set by the marginal buyer (people who are “on the fence” about choosing whether to rent or buy). And while there are certainly some people who would gladly pay a 100% premium (aka today’s buyers) there are also lots of people who are not willing to pay any premium at all after taxes.

The price of a venti Starbucks coffee is not set by the guy who is willing to pay $5 for it, it’s set by the guy who is willing to pay $1.80 but not $1.90.

[Author]

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