The most effective measure of housing market value is rental parity analysis
Rental parity analysis provides a benchmark of value that enables buyers and sellers to anticipate changes in the market.
People who invest in stocks often use the price-to-earnings ratio among others to estimate value. People who trade stocks use a variety of technical indicators to both screen stocks to trade and to improve their timing. Both techniques of fundamental and technical analysis are widely accepted and used by securities investors.
Real estate is a different story.
Real estate investors utilize capitalization rates, cash-on-cash returns, and internal rates of return to evaluate individual properties, but these measures are far less applicable to assessments of entire markets.
To evaluate an entire market of properties, economists employ various ratios including price-to-rent, price-to-income, payment-to-income, and other aggregate measures to attempt to establish valuation metrics. Each of these metrics has strengths and weaknesses, but each of them fails because they don’t directly connect the actions of individuals to the activity in the broader market.
Common Aggregate Measures for Residential Housing Markets
Price-to-rent and price-to-income generally provide similar results. Since people pay their rent out of current income, the ratio of income-to-rent doesn’t vary much. The income-to-rent ratio measures how much people put toward housing costs, which is useful for policymakers concerned with how burdensome housing costs are for people, but it tells us very little about valuations in that market.
Price-to-income and payment-to-income are useful, but they often give conflicting signals.
If we examine the market using price-to-income, today’s prices look inflated. At very low mortgage rates, people can borrow cheaply, which means they borrow more. Thus they bid up prices and inflate house prices relative to incomes, which is why the housing recovery rally was so robust and prices are so high today.
If we examine the market using payment-to-price, today’s’ prices are either at fair value or a little below — the opposite of what the price-to-income ratio shows. Since mortgage rates are near record lows, the prices that look inflated relative to incomes are easily financeable with current incomes.
So what do we conclude when the indicators give opposite results?
We must look more deeply at the timeframe to see what these indicators tell us. Over the short term, it’s impossible to ignore the payment-to-price ratio. People bid up prices using their current incomes applied to current mortgage rates. Therefore, the payment-to-price ratio establishes the market equilibrium at any point in time.
However, over the long term, it’s hard to ignore price-to-income. As mortgage rates revert to the mean over time, the long-term price-to-income ratio will also come back into alignment.
So what implications does this have for market pricing over the long term?
Since the federal reserve drove mortgage rates down to record lows to prop up house prices and bail out the banks, the short-term equilibrium is much higher than the long-term equilibrium will likely support. Therefore, one of two things must happen: either prices will stagnate or decline in the future to correct for this short-term distortion, or wages will go up quickly to compensate for increasing ownership costs. If measured against inflation, either scenario produces weak financial returns, but nominal prices — the prices most people understand and focus on — will show gains, perhaps large gains if wages start to climb.
Due to the vagarities of the results these valuation measures produce, they don’t provide a clear measure of valuation investors can rely on.
Rental Parity Analysis
Rental parity represents a crossover point where renting and owning have an equal monthly cost. When prices are above rental parity, it costs more to own than to rent, and when prices are below rental parity, it costs more to rent than to own.
Rental parity combines income, rent, interest rates, and financing terms in a way that matches the activities of individual buyers to the overall price activity in the market. Unlike capitalization rates or other property-specific measures, rental parity is equally applicable to individual properties and entire markets.
For purposes of calculation, rental parity can be defined by the ratio of payment-to-rent. It is similar to the ratio of payment-to-income, but it’s more accurate because it more closely mirrors consumer behavior. People have two options when they want to occupy residential real estate: they either rent it or they own it. The payment-to-rent ratio accurately reflects the two options available to market participants, so calculations using the payment-to-rent ratio produces the best results.
Determining a Benchmark of Value
Rental parity or the payment-to-rent ratio is a fundamental value that lends itself well to technical analysis and establishing a benchmark of market value.
Some neighborhoods are very desirable, so move-up buyers take the profits from previous sales and bid up prices, and motivated buyers often stretch to the limit of their borrowing power to acquire homes in these neighborhoods; therefore, the most desirable neighborhoods often carry a premium to rental parity. The inverse is also true. Some neighborhoods are not as desirable, or may contain high concentrations of condos and other first-time homebuyer products. These neighborhoods generally trade at a discount to rental parity.
To value of any asset or market, it’s necessary to establish a standard considered “normal” for the asset. To achieve this end, historic data must be obtained and analyzed to establish a period of time within the specified geographic area when the asset was considered fairly valued under normal market conditions.
Real estate markets generally exhibit long periods of stability and normalcy; however, over the last forty years, the market endured a number of distortions to market value. It’s imperative for accuracy to identify and exclude periods when the data is distorted and does not represent a normal condition. There were real estate bubbles in California from 1976 to 1982, from 1987 to 1992, and from 2003 to 2009.
To weed out these distortions, the Market InSite Resale Valuation reports utilize the period from 1993 to 1999 (the last period of stable prices with good available data) to measure the neighborhood premiums and discounts. Rental parity valuations are adjusted accordingly to establish the baseline valuation for each neighborhood. When the report shows a neighborhood is overvalued or undervalued, it is not simply measuring against rental parity, it is adjusting for historical differences in value those markets typically experience.
Where’s the proof?
I personally used this analysis to avoid buying at the peak of the housing mania when everyone else had gone mad. Later, I used this analysis to go buy rental properties in Las Vegas from 2010 through 2012 when prices were depressed and nobody wanted to buy there. My belief in this measure of value provided the courage to go against the crowd, and I profited from my conviction.
I starting publishing these reports in Southern California in early 2011 so others could benefit from this insight. Shortly after I started, the mechanical rating system in the report based on rental parity became very bullish. In fact, it issued a strong buy signal six months before the market bottomed. Then once the market bottomed, this analytical method accurately predicted the price level where home prices would meet affordability resistance across each market.
Why is this a better method?
A reliable valuation metric gives investors guidance of when they should buy or sell in advance of the change of direction in the market. Unlike momentum indicators that need a positive reading to give a signal, a value indicator gives advance notice of a change in the market while investors still have time to act before the market turns.
Real estate assets are not liquid, particularly when the market turns bad. Advance notice of market changes is crucial to investment success.
So what does this method say about the future?
In nearly all Southern California areas, house prices are hovering near their historic payment-to-rent ratios. As mortgage interest rates go up (if rates go up), affordability will plummet unless wages rise rapidly enough to compensate, which is difficult considering it takes 12% higher income to compensate for a 1% rise in mortgage rates.
If affordability crumbles, sales will suffer, and if mortgage rates don’t go back down, prices will weaken as well. Realistically, the yearly predictions of rising mortgage rates will not come to pass just as they haven’t for the last five years. Mortgage interest rates will remain low for a very long time as incomes slowly rise.
Expect the periodic air pockets of weak sales as mortgage rates lurch up and slowly drift back down. The potential surge of Millennials and boomerang buyers will be tempered by their inability to leverage their incomes enough to afford market pricing.