Irvine payment affordability skyrocketed, hit 11-year high in 2011

For the first time in the nearly five years I have been writing for this blog, prices across most of Irvine are trading at or below rental parity. There are significant market headwinds which will likely prevent house prices from moving higher, so relatively affordable prices may be with us for a while, and I think that is great news.

Today, we are going to take a detailed look at the Irvine data. This is the same data I present in our monthly OC housing market presentations. We will be taking December off, but we will be back in January to provide a live presentation of the current market data.pay_mortgage_or_children_rental

In October and November, months of supply typically increases. Many sellers keep their homes on the market hoping for a late-year sale, but the demand dries up. With low demand and large supply, the months-of-supply calculations move much higher. The market is undeniably weak, but these numbers make circumstances look worse than they really are.

The importance of rental parity

I write frequently about rental parity because it represents the threshold of affordability. When prices are above rental parity, it costs more to own than to rent, so owning is not a wise financial decision. Owning may still be right for people, and many are willing to pay the premium to own to obtain the emotional benefits of ownership; however, on a purely financial basis, paying more than rental parity is generally not wise.

When prices are below rental parity, it costs less to own than to rent, so owning under these circumstances is generally a wise choice. Since a buyer who pays less than rental parity for a house is saving money, there is a clear financial benefit obtained irrespective of fluctuations in resale price.

When the cost of ownership is less than rental parity, an owner is far less likely to be forced to sell at a loss. The property can always be rented to cover costs rather than sell for a loss. Further, this ability to rent and at least break even provides the owner with flexibility to move if necessary. Mobility to take a new job or buy a different house is denied to those who overpaid and who are stuck paying more in the cost of ownership than they can obtain in rent.

With these advantages, buying at a price below rental parity using fixed-rate financing is critical. Every buyer should consider rental parity in their buying decision.

How rental parity is calculated

Each month I calculate rental parity using aggregate data from the MLS. It requires two data points to make the calculation:

  1. Average rental rate
  2. Current mortgage interest rate on 30-year fixed-rate loans.

I also make some key assumptions.

First, as mentioned previously, I assume a 30-year fixed-rate mortgage. It’s the only mortgage product which provides sufficient payment stability to ensure the property will always be affordable.

Second, only a percentage of the rent can be put toward a mortgage payment. It’s not as simple as assuming the rent equals the payment.

The payment is generally smaller than the actual cost of ownership (today’s featured property is a rare exception). The cost of ownership usually includes other costs like HOA dues, Mello Roos, maintenance expenses, and insurance. These costs erode the buying power of the rental payment. There are offsets with tax breaks and loan amortization, but generally, the cost of ownership is bigger than the payment.

Conventional financing

There are two assumptions which change depending on the type of financing used. A buyer using conventional financing does not pay private mortgage insurance or FHA insurance premiums. This means the cost of ownership is much closer to the actual payment. Or looked at another way, the rent which would be applied to the payment would be higher. When I make these calculations, I assume 90% of the rent could go toward making a loan payment. In areas with no HOAs or Mello Roos (like today’s featured property) that assumption is too low, but in areas where the HOA and Mello Roos is high, the assumption is too high.

I take 90% of the aggregate rent as a potential loan payment. I calculate the mortgage balance such a payment would service at today’s interest rate. The result is the loan component of rental parity. To the loan balance, I add an appropriate down payment. For conventional buyers, the down payment applied is 20%.

For example, if an area or zip code has an aggregate rent of $2,500 — a common number in Irvine — I will assume $2,250 is available to make a mortgage payment. At 4% interest, a $2,250 payment would service an astounding $471,288. If $471,288 were the loan balance, the down payment would be $117,822. The sum of those two is $589,110 which represents the rental parity equivalent of a $2,250 payment applied to a 4% fixed-rate mortgage using conventional terms.

FHA financing

FHA financing yields very different results, so I track both of these separately. The two main differences are the mortgage insurance and the lesser down payment. With FHA financing, I assume only 75% of the rent goes toward the loan payment, and the down payment is only 3.5%.

In the example above, the $2,500 rent yields only $1,875 toward a loan payment. At 4% interest, a $1,875 payment only services $392,740. Further, a 3.5% down payment means the borrower is only adding $14,244 to the loan balance. The resulting rental parity for an FHA buyer is only $404,984 instead of the $589,110 for the conventional buyer.

The added costs and smaller down payments make houses much less affordable for FHA borrowers than they are for conventional borrowers. It’s the main reason Irvine and other move-up communities are maintaining higher prices while those communities dominated by FHA financing are experiencing more serious declines.