Inland Empire housing markets are still extremely undervalued

Many housing sub-markets in Coastal California have already reflated to affordability limits, and many are surpassing peak bubble prices. The beaten down housing markets of the Inland Empire (Riverside and San Bernardino Counties) have bounced significantly off the bottom, but they are still extremely undervalued by historic norms between rent and cost of ownership. The rising prices are turning off private-equity funds, but mom and pop investors can still find plenty of good deals with upside potential.

Riverside County

Riverside County, California, is directly east of Orange County. It’s population exploded over the last 40 years as Los Angeles and Orange Counties were built out and house prices were pushed up by high wage earners to levels many could not afford. Riverside County offered the chance for a large house at a low price — and a hellish commute. Despite the traffic on the roads connecting Riverside County to LA and OC, housing development continued unabated right up through the collapse of the housing bubble.

Riverside County houses typically trade at a discount to rental parity. In fact, the nearly 25% discount puts Riverside County properties near payment parity, the price point where PITI equals rent. Owners in Riverside County benefit fully from tax savings and amortization whereas OC buyers need this to offset their higher house payments.

Note the orange line below. This represents the fundamental value of Riverside County homes relative to rent. Notice in particularly the period from 1993 to 1999 when house prices hovered near this line. That is the resting point where a normal market would find equilibrium. As you can plainly see, house prices bubbled enormously, then crashed below fundamental value, and even with the big rise off the bottom, the market is still significantly undervalued.

The charts below show the yearly percentage change in resale and rental prices. A few things jump out. First, the housing bubble with its 35% Y-o-Y appreciation was obviously a cause for alarm — for anyone who understood value. The current rate of appreciation is equally alarming, but since the market is so drastically undervalued, this rapid increase may cool off without leading inevitably to a price crash.

The second thing that catches your eye is the dramatic spike in rents in 2007 and 2008. This certainly isn’t due to any improving fundamental. House prices were crashing, and the economy was imploding along with it. The huge increase in rents was caused by foreclosed owners becoming renters and bidding up the available rental stock. The conversion from owner-occupied status to rental units did not keep up with the new demand. However, once investors started buying up these properties and converting them to rentals, rents declined for a while, and only recently have they begun growing again, albeit at a tepid pace.

The charts below show the relationship between house price and rental parity. Again, you can see the stable period from 1993 and 1999 that serves as a basis for establishing value. This market went from nearly 30% under rental parity to an astonishing 100% above rental parity during the housing bubble. What’s equally astonishing is the depth of the crash. House prices bottomed out more than 50% below rental parity. No wonder investors were flocking to this market.

The OCHN rating system was lukewarm on this market for much of the 1990s. The market was stable, but never really undervalued. The housing bubble dropped the rating to its lowest possible reading for several years, and the crash raised it to the highest possible rating for the last several years. This market is still a very good value.

The final two charts show exactly why investors are focusing on this market. During the 1990s, cap rates exceeded mortgage interest rates making most of Riverside County cashflow positive. The bubbles both caused cap rates to plummet.

The bottom chart shows the conditions facing financed investors. Cash-on-cash returns peaked at nearly 25%. The recent price increases have dropped these returns to 15%, but that’s still very good by historic measures. Unlike OC, properties in Riverside County are still cashflow positive.

San Bernardino County

San Bernardino County, California, is due east of Los Angeles County and north of Riverside County. It shares much the same settlement history as Riverside County, and the two are often referred to as a single unit, the Inland Empire.

San Bernardino County shows the same pattern of valuation and trends as Riverside County, but San Bernardino is even more undervalued.

San Bernardino County has not recovered as quickly as Riverside County. I expect to see more investor activity there as the large funds leave Riverside County looking for better cap rates.

San Bernardino County did not get quite as overvalued as Riverside County, but its crash was even deeper. At the bottom it was a jaw-dropping 60% below rental parity.

The attractiveness of San Bernardino County to investors is clear. Cap rates are higher, and therefore, so are financed returns.

San Bernardino County properties are not as desirable, and many of the markets have difficulty keeping renters in place. The returns are enticing, but the management headaches are greater.

Rising interest rates won’t hurt these markets

Because most of the readers of this blog live in Coastal California, it’s easy for us to have a skewed impression of the broader housing market. Many housing analysts have been claiming rising interest rates won’t impact the housing market. It will impact OC, but it won’t impact the Inland Empire. As I reported last week, Coastal California housing markets will hit affordability ceiling first. Rates would have to rise quite a bit to hurt the Inland Empire.

Today’s featured property is a short sale in Aliso Viejo. The owner bought in 2003, and managed to extract about $200,000 in refinances and HELOC money before prices went south. He’s struggle to pay the mortgage, and he just got a loan modification. I wouldn’t be surprised to see this one taken off the market. If prices keep rising, by next year, he can get out without losing any money. Of course, if prices don’t keep going up, he is stuck in a house he can’t afford hoping that something will work out.

Perhaps he shouldn’t have extracted that $200,000. His life would be easier today if he hadn’t.

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[idx-listing mlsnumber=”OC13145411″ showpricehistory=”true”]

17 CUERVO Dr Aliso Viejo, CA 92656

$490,000 …….. Asking Price
$387,000 ………. Purchase Price
5/6/2003 ………. Purchase Date

$103,000 ………. Gross Gain (Loss)
($39,200) ………… Commissions and Costs at 8%
$63,800 ………. Net Gain (Loss)
26.6% ………. Gross Percent Change
16.5% ………. Net Percent Change
2.3% ………… Annual Appreciation

Cost of Home Ownership
$490,000 …….. Asking Price
$17,150 ………… 3.5% Down FHA Financing
4.38% …………. Mortgage Interest Rate
30 ……………… Number of Years
$472,850 …….. Mortgage
$146,244 ………. Income Requirement

$2,362 ………… Monthly Mortgage Payment
$425 ………… Property Tax at 1.04%
$0 ………… Mello Roos & Special Taxes
$102 ………… Homeowners Insurance at 0.25%
$532 ………… Private Mortgage Insurance
$357 ………… Homeowners Association Fees
$3,778 ………. Monthly Cash Outlays

($656) ………. Tax Savings
($636) ………. Principal Amortization
$27 ………….. Opportunity Cost of Down Payment
$81 ………….. Maintenance and Replacement Reserves
$2,594 ………. Monthly Cost of Ownership

Cash Acquisition Demands
$6,400 ………… Furnishing and Move-In Costs at 1% + $1,500
$6,400 ………… Closing Costs at 1% + $1,500
$4,729 ………… Interest Points at 1%
$17,150 ………… Down Payment
$34,679 ………. Total Cash Costs
$39,700 ………. Emergency Cash Reserves
$74,379 ………. Total Savings Needed
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