The concept of Rental Parity is often discussed on this blog, but to date, I have never devoted a post to defining it and explaining it before today.
I first discussed Rental Parity in How Inflated are House Prices?, and later I added Rent Versus Own to explore the cost of ownership and relate it to the cost of rental. Finally, I added a subjective refinement to the rental parity basis in I Will Not Call a Bottom.
What is Rental Parity?
Rental Parity is a mathematical relationship between rental rates and property values where rent is equal to the monthly cost of ownership. There are many assumptions and variables that impact Rental Parity — so many that it takes a spreadsheet to try to explain it. (We have a calculator that provides the total cost of ownership on a monthly basis to compare to the cost of renting. What is perhaps more useful to buyers is the ability to run the calculation in reverse — If you know what you spend on rent, you can estimate how much house you can afford.)
The fluid relationship between rents and prices provides a conceptual understanding of value. Rental rates establish where property values should be. Rental Parity is a balance point where there is no financial advantage to choosing renting or owning; a point of theoretical indifference.
If we had a group of theoretically indifferent people who always acted rationally based on perfect information, prices would always be at Rental Parity; any price below rental parity would be perceived a bargain and bid upward, and any price above rental parity would be perceived as too high, and there would be no bid interest. Of course, we all know that people are not indifferent; in fact, they can become very emotional about buying and selling real estate. When they participate in a market, they get caught up with the herd and move prices without regard to fundamentals; short-term price movements become accepted as the market’s long-term trajectory. Trees really can grow to the sky.
Rental parity becomes a baseline — a fundamental. Prices are loosely tethered and may depart for long periods, but prices always manage to return to rental parity in time because as a logical point of indifference; it is the natural resting point for a market purged of kool aid intoxication.
Rents Capture Premiums
Rental Parity provides a useful measure of desirability and premium. When people are deciding between renting and owning and comparing costs (you all do that now, right?), some will chose to rent and some will chose to buy. Both parties are going to take a portion of their income and go obtain housing in their own way. Neighborhoods with high rents will have high home prices, and neighborhoods with high home prices will have high rents. The intrinsic desirability will be mirrored in the rental and for sale markets.
Applying Rental Parity
Each property is evaluated to determine its desirability as a long-term residence — this is an opinion; it is not a mathematically provable. If the best properties in the entire market would rank a 1, and if the very worst would rank as a 5. The little green dot represents a subjective evaluation of a property.
The black dots represent different important price points every buyer should be aware of. The first is the “value,” if you want to call it that, of comparable sales in the market. This has nothing to do with cashflow, and it is based totally on what people are currently paying for similar properties in the market. The Comparable Sales Value floats up and down this chart based on whatever people are currently paying.
The next black dot on the list is the asking price. This can also be just about anywhere. The frequent WTF listing prices I profile here would be off the top of the chart. Some short sales are priced well below comps to attract attention.
The next black dot on the list is the Maximum Cashflow value of the property. Do you remember the post, Investment Value of Residential Real Estate? As I described in that post, there is a legitimate financial reason to pay more than rental parity for blue-chip properties a buyer plans to own for 10 years or more. This is not a large premium over rental parity. The calculations in that post demonstrate you can pay up to 10% more than rental parity on a long-term hold because you obtain the benefit of the inflation hedge. This is not a price point for homes you know you will want to move up and out of in a few years.
The next black dot on the list is Rental Parity.
The zone between rental parity and cashflow investor levels is the gray area where all the less desirable properties fall. This would include most condos, any two-bedroom properties and what are commonly known as “starter homes.”
The final black dot is the cashflow investor level. This is the price point where an investor can acquire a property, rent it out, and turn a monthly profit from owning the property. This is the bottom of the line for Irvine properties, and it is usually about 25% below rental parity.
The final number on the chart would be those properties nobody wants to live in. Does everyone remember Dr. Housing Bubble’s series Real Homes of Genius? Those are the properties I am talking about. What they really need is a bulldozer.
Moving Beyond Rental Parity
Are their influences on the prices of homes beyond income and rent? Are there properties, neighborhoods or communities where money is stored like a reservoir, and values are sustained at levels not justified by incomes?
I have been contemplating the disparity between home prices and incomes in areas like Malibu to see if there really is something that makes certain neighborhoods or certain properties conform to a different set of rules.
In areas like Malibu where there are many cash buyers, prices are determined more by the wealth of a few than the income of the many. Any times you get truly unique properties of very high quality, and the people competing to own them are not wage earners, they are people of great wealth who see something they want. They are bidding on percentages of their net worth rather than percentages of wage income.
When the disparity of wealth sees a shift toward wealth concentration (our recent governmental policies have favored wealth concentration), special properties in a place like Malibu get bid up to very high prices. The prices go so high because the people bidding have very large fortunes. For some of these people, a $20,000,000 house is a small fraction of their holdings.
The implication is that real estate in places like Malibu will be subject to fluctuations in the general pool of wealth in society. Since deflation has ravaged people’s investments, real estate will likely fall in equal measure.
That is all very interesting for Malibu, but Irvine is a working-class city where property values are largely determined by income. Is there any stored wealth in real estate here?
Uniqueness and Quality
There are only two things that creates the capacity to hold wealth beyond cashflow value in real estate; uniqueness and quality. Uniqueness adds value. Wealthy people will compete with one another to obtain unique items, and they are not subject to pressures of financing. When you enter the realm of unique properties, you abandon ideas of Rental Parity.
If something is unique, substitutes are limited. An architect designed mansion on the beach is completely unique, and there is a limited number of comparable properties. When you see properties like the Hearst Castle, there simply are no comparables. In Irvine, there are few unique properties; most properties have many close comparables. Many floorplans are duplicated around town, and properties with comparable sizes and configurations are everywhere. Most of Irvine is an undifferentiated mass.
Quality adds value. Donald Trump, whatever you may think of the man, always strived to create the highest possible quality in his product, even if the pricetag was beyond ridiculous. Most people think pergraniteel is adding quality; it isn’t. Pergo wood flooring is imitation wood, and nothing of quality stands in imitation. Quality is not cheap. Most attempts at quality end up as over-improvements and return less value than cost. There are some very high quality, unique properties in Irvine, mostly in Shady Canyon because it is the only neighborhood where lots are big enough to create unique estates.
Reservoir of Value
Real estate can be a reservoir of value. When properties are unique and of very high quality, the wealthy become interested in possessing them, and prices become based on wealth rather than income. These properties are few and far between. Irvine is not a community where homes will be a tool of the wealthy. Our real estate is simply not that unique, and it is generally not at exceptional levels of quality. That doesn’t mean individuals in Irvine do not store wealth in real estate. Anyone who pays down their mortgage and enjoys appreciation from wage growth can accrue a substantial nestegg. The value of that nestegg in Irvine will always be determined by local wages not by the buying and selling of the very wealthy.