Equality has power. Rental parity is a powerful price point because the cost of ownership is equal to the cost of rental. Theoretically, buyers should be indifferent at rental parity, but in the real world kool aid intoxication prompts many buyers to bid prices up above rental parity. The true power of this threshold doesn’t become apparent until prices fall and owners find themselves paying far more than comparable rentals for properties worth less than they paid.
Today’s post will be heavy on math, but I want to give everyone a look inside the black box of aggregate rental parity calculations. I use this analysis in Las Vegas to locate neighborhoods with the best rental property deals, but owner occupants can also take advantage of this analysis to narrow their search for properties to those cities or zip codes with the best bargains. In our deflating housing market, rental parity analysis is a useful tool for identifying which areas have deflated and which ones have not. I will be presenting the data for Irvine and select Orange County cities in my September 12 presentation at JT Schmids.
Rental Parity defined
Rental parity is the price point where the cost of ownership is equal to the cost of rental. Rental parity is an important price level because buyers who pay more than rental parity risk being trapped in a negative cashflow situation if they should need or want to move before the resale value has appreciated enough to cover their transaction costs on the sale. When people pay more than rental parity, they don’t have a viable plan B to get out of their property.
Because rental parity is such an important threshold, evaluating the costs of ownership relative to rentals is an excellent way to measure value. If a property is trading above rental parity, the price is inflated above reasonable valuation. Perhaps in a few of the most desirable communities where move-up buyers bring equity from previous sales, properties can trade consistently above rental parity. However, for the vast majority of the housing stock, valuations at or below rental parity are the norm and define fundamental value.
If a property is reselling below rental parity, it can be rented for a profit. If it selling well below rental parity, it may be a good cashflow investment. The only way to be certain is to perform a property-specific analysis taking account of recent comps for both resales and rentals and inputting specific property information for HOAs, Mello Roos, and other costs.
I developed the analysis I will cover today to identify areas in Las Vegas where cashflow properties are common. Rather than try to analyze all 40,000 properties on the MLS, I developed this technique to narrow my search to specific areas of town or specific zip codes. It also enables me to give a rough idea of cap rates and cash-on-cash returns in any area based on aggregate numbers.
Using Rental Parity Analysis to find bargains
I performed a detailed analysis of the Las Vegas housing market (PDF of analysis here). I use it to identify which zip codes and which areas of town provide the greatest returns to cashflow investors. However, this is a useful tool to anyone looking for a home, not just investors. Nobody wants to overpay, and its difficult to get a broad overview of prices and values across the whole of Orange County by browsing properties on Redfin.
A rental parity analysis will reveal if a specific property you are looking at is a good deal or just average for the area, it may prompt you to look in areas you previously never considered, or it may reinforce your desire to keep looking in your area of choice. It’s one more tool you can use to be sure you have made the correct decision on buying a home.
Rental parity analysis and the returns on real estate
Rental parity analysis gives me a broad overview of the market, but the point of the analysis is to direct me toward individual properties which yield results equal to or better than the rest of the neighborhood. Once I have identified the property, I put the information into an IHB Fundamental Value Report to calculate the cost of ownership and returns from the property as an investment.
The return on real estate is measured in three ways: capitalization rate, cash-on-cash return, and internal rate of return. Each of those is described in detail below.
Calculating capitalization rates
The basic calculation I perform is the capitalization rate, the net operating income divided by price. The capitalization rate is the return an all-cash investor would obtain from the property. It is always wise to examine the unleveraged returns of any investment as extreme leverage can exaggerate the returns of nearly any investment and disguise the underlying risk.
To obtain the capitalization rate for an entire zip code, I obtain four values from the MLS:
- Average rents over last 30 days
- Average square feet of rentals
- Median sales price
- Average square feet of resales
The square footage is necessary to normalize the numbers. Although not perfect, normalization by square footage is far superior than simply taking the raw rental number and dividing it by the median home price.
From these four pieces of data, I calculate the capitalization rate as demonstrated below.
Below is an example from the 89031 Zip Code in Las Vegas:
|Cap Rate||Avg Rent||Avg Rent SF||Avg Rent
|Avg Sale Price||Avg Sale SF||Avg Sale
So how does that compare with the reality of individual properties in that zip code?
The capitalization rate analysis correctly predicted where I could find properties with desirable characteristics.
Cash-on-Cash return calculations
The cash-on-cash return is more important than capitalization rates for the average investor who uses debt to acquire real estate. The cash-on-cash return compares the down payment to the cashflow remaining after interest is paid (includes positive cashflow plus amortization).
The calculation for cash-on-cash uses the capitalization rate calculated above and magnifies it — both up or down — based on the financing terms. The lower the down payment, the greater the returns are magnified. This is why speculators were keen to use 100% financing when it was made readily available during the bubble. Returns were infinite, and the risk of loss was passed on to the lender.
The debt ratio is the magnifying factor of leverage. The down payment is divided into 1 to obtain the multiplying factor.
The fulcrum point of leverage is the interest rate. The interest rate must be lower than the capitalization rate for debt to have a positive effect. This was one of the key mistakes investors made during the bubble. People were buying properties with 4% capitalization rates using 6.5% debt. That’s crazy. No sane investor would apply debt that is more expensive than the capitalization rate — insane speculators do this all the time, but the moment prices go down, and the property cannot be sold for a profit, the negative cashflow of inappropriately leveraged real estate eats people up.
The above property with a 7.7% capitalization rate yields 17.3% to an investor using leverage.
Internal Rate of Return
Current cashflows are not the only ways investors profit from real estate. The housing bubble was characterized by an overly exuberant opinion of future appreciation, and I have consistently decried considering appreciation as a reason to buy real estate in direct response to the foolishness of bubble-buyer attitudes. However, real estate can and does appreciate, and resale at a higher price in the future does have value. The best way to calculate this value is through a discounted cashflow analysis. When examining the rate of return of real estate, the internal rate of return is the best method available.
I won’t attempt to walk anyone through the math of the internal rate of return calculation. Like everyone else in finance, I use a spreadsheet to calculate it for me. The concept of internal rate of return is not nearly as difficult to understand as the math used to calculate it.
Imagine you are buying a house for $123,000 you believe will be worth $215,000 10 years from now. What is the current value of the $93,000 profit you will obtain in 10 years? It depends on the interest rate. That calculation is what finance people call net present value.
Now Imagine you could put $123,000 in a bank account earning a high interest rate (I know you can’t today, but just imagine). What interest rate would be required to have your $123,000 grow into $215,000 at the end of 10 years? That interest rate would be like the internal rate of return on the property that increased in value by the same amount over the same period.
Internal rate of return considers more than just the lump sum at the end. Internal rate of return compares the amount and timing of all the cash inflows and compares it to the initial investment amount to compute an overall rate of return on the investment. Internal rate of return is the most accurate measure of the financial performance of real estate.
A Las Vegas investment property
The property below is an property offered by the investment fund I manage. The second presentation on September 12 will focus on how investors can get involved with cashflow properties in Las Vegas. One of these methods is direct ownership and management of rental properties such as the one below.
Most properties in Las Vegas are trading below rental parity, even in the nicest neighborhoods in Summerlin. If you invest in areas outside of the ones most desired by owner occupants, the prices fall off quickly, but the rents do not. This creates opportunity to pick up properties with outstanding current cashflow and potential for rebound appreciation to rental parity many years from now.
The first page of the report shows the asking price and the rate of return as an unleveraged investment. This is followed with a detailed look at the returns on a financed purchase. Many properties in Las Vegas generate such good cashflow they can cover the payment on a 15-year mortgage.
The second page of the report gives greater detail on the cost of ownership. It provides a list of comparable resales and rentals to verify current value.
The third page examines the current valuation relative to rental parity, and it considers the possibility of rebound appreciation over 10 years taking prices back to rental parity (nowhere near the peak, but to where prices should be). Assumptions on appreciation impact the internal rate of return, but not the current cashflow. If you don’t believe Las Vegas housing prices will ever recover, it will not impact the cash returns you receive while owning the property.
The final chart is a graphical representation of the thousands of scenarios you can run to test different financing terms. If you develop your own spreadsheet and go through the exercise, you will find lower interest rates increase returns, and lower down payments increase returns — assuming the interest rate is lower than the cap rate.
Nicer and newer properties typically don’t provide the best cashflow. The property above is an 1814 SF 4/2 built in 2003. Owner occupants have kept these prices up to where cap rates are near 8%. An 8% cap rate is unheard of in Orange County, except perhaps for undesirable properties in Santa Ana, but 8% cap rates are quite common in Las Vegas.
If you are willing to own a smaller, older property in a less desirable but not bad neighborhood, the returns in Las Vegas are truly outstanding.
If you are interested in learning more about rental parity analysis and investing in cashflow properties, I suggest you come to the presentations on September 12. I will be available before and after the presentations to answer any questions you might have.