OC Housing News market rating system: Where is it safe to buy?

I developed the OC Housing News Market Newsletter to provide information on the local housing market useful to potential homebuyers. I believe people make good decisions when given good information. We all know the information provided by realtors on the housing market is manipulated to motivate buyers to act. realtors numbers are rarely accurate, and like the boy who cries wolf, nobody believes the realtor who cries buy.

I also follow a philosophy of constant improvement. When I first published the OC Housing News Market Newsletter, I assembled a great deal of data and struggled to find a coherent way to present it. Creating fancy charts and graphs is easy. Presenting and interpreting data in an easy to understand manner is much more difficult. The newsletter distills the market down to three key pieces of information: (1) value relative to rental parity, (2) yearly change in resale prices, and (3) yearly changes in rental rates. However, upon deeper reflection, I realized this was not enough. I needed to simplify the interpretation of this data further. To that end, I have developed a housing market rating system I am unveiling today.

Rating scale of 1 to 10

When I first contemplated a rating system, I considered an A to F grading system like the HELOC abuse grading system. As I worked this this system, I found the nuances were lost with only five potential grades. The next most logical choice was a rating scale from 1 to 10. It’s intuitively easy to understand, and it provides enough gradation to capture the subtle differences between markets under varying market conditions.

System Criteria

When considering the financial implications of buying a home, the non-kool-aid intoxicated want to know if now is a good time and if the location they are considering is a good buy. The rating system provides an accurate and unbiased method of evaluating the market. It is purely mechanical and ignores the narrative spun by market pundits. At times this narrative is important, such as in 2009 and 2010 when the artificial market props delivered a false buy signal, but much of the time the narrative is better off ignored because it is polluted by the manipulations of realtors.

I wanted the system to produce results consistent with my view of the housing market. It should have said not to buy during the bubble, but it should have given positive signals beforehand. A permanently bearish system is as useless as the realtor’s permanently bullish ones. The system should produce relatively consistent results from month to month with few abrupt changes. Housing markets don’t change quickly, so the results should not be so volatile as to suggest buying one month and catastrophe the next.

The system also needed to respond to the relative importance of changes in the market. The system uses the three key variables I tract: valuation, resale price change, and rental price change. By far the most important of these variables is valuation. It is also the least understood and most widely ignored fundamental by most homebuyers.

Valuation rating

Valuation is the least understood, yet most important, aspect of a housing market. Economists look at various ratios including price-to-income, price-to-rent, and other aggregate measures to attempt to establish valuation metrics. Each of these has strengths and weaknesses, but each of them fails because they don’t directly connect the actions of an individual buyer to the activity in the broader market. For this reason, I strongly favor rental parity as the best measure of valuation. Rental parity ties together 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.

When considering valuation, I use rental parity as a basis. People can obtain the beneficial use of real estate through either renting or buying, and rental parity represents the point of financial indifference where it costs the same to make either 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.

Rental parity does not capture the complete picture. Some neighborhoods are very desirable, so move-up buyers take the profits from previous sales and bid up prices; 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. I have the median loan and median resale figures for most of the coverage area. I calculate the average down payment during the 1993-2002 period (the last period of stable prices) to measure the neighborhood premiums and discounts. I adjust the rental parity valuations accordingly to establish the baseline valuation for each neighborhood. When my report shows a neighborhood is overvalued or undervalued, it is not simply measuring against rental parity, it is adjusting for historical differences in down payments those markets typically experience.

Rental parity is measured using formulas described on the page on market newsletters. I compare rental parity to the down payment-adjusted historical values to measure the degree of over or undervaluation — and yes, many OC markets have become undervalued using this measure over the last year of falling prices, falling interest rates, and increasing rents.

House prices typically rise about 3.5% per year to match wage inflation. If someone pays 10% more than rental parity, they must wait 3 years for appreciation to catch up with their purchase price. Overpaying may not cost them nominal dollars, but it may cost them time, which is costly when considering inflation-adjusted dollars. Underpaying is also a significant advantage. For example, I am attracted to Las Vegas’s market because I am paying the mid-90s prices for homes. In my opinion, this creates an opportunity for rebound appreciation back to rental parity levels. Valuation is critical in identifying the best opportunities for financial gain.

The rating system ignores any market within 6% up or down from its historic norms. The concept is simple: negotiation skills and motivations of the parties involved introduces at least 6% potential variability in resale pricing, so a market within 6% up or down of rental parity is within the margin of typical variability. For each increment of 6%, the rating is either increased or decreased by one. For example, a market that is between 30% and 36% undervalued would score 5 valuation points. And markets overvalued by 30% to 36% would lose 5 valuation points.

This point system based on 6% increments makes the system very sensitive to changes in valuation, and it does reflect the real-world. People who bought at inflated prices even as early as 2003 when prices were about 12% overvalued are living in properties currently trading at what they paid nine years later. Overpaying, even by small amounts, is nearly always a bad financial decision. From early 2002 to late 2010, the market was always overvalued, and most buyers during this period will come to regret it — if they don’t already.

Resale momentum rating

Most homebuyers look at short-term changes in house price and extrapolate those gains forever. Resale price change is exactly the wrong reason to buy a house. In my rating system, resale price momentum is given the least weight of the three factors, and I only look at year-over-year changes rather than the monthly noise subject to seasonal variations.

When rating the rate of price change, I have four categories:

  • (1) greater than 7% = 2,
  • (2) between 2% and 7% = 3,
  • (3) between 2% and -5% = 1, and
  • (4) less than -5% = 0.

A stable rate of appreciation is between 2% and 7%, and markets in this range get three rating points. This provides some room for minor fluctuations and recognizes that slow, sustained price increases are a normal function of healthy real estate markets.

Prices rising more than 7% per year are not sustainable. Rather than being considered a good thing, this receives two rating points rather than three. Most people see 7% per year appreciation and get excited. Most often, this means they are buying into a frenzy and overpaying.

Prices that are either rising slowly or falling slowly (between 2% and -5%) represent a weak market and receive one rating point. Some might argue that falling prices should not receive any points, but markets with gently falling prices often have more motivated sellers and better bargains on individual properties. Such markets should not be shunned just because prices are falling. Bargains can be found. However, the same is not true of markets where prices are falling more steeply.

Real estate markets typically display strong price momentum, a market falling in price by more than 5% per year is likely to continue to fall for the foreseeable future. Such markets may present good opportunities today, but the opportunities will be even better tomorrow. For that reason, these markets score no rating points.

Rental momentum rating

Next to valuation, momentum in rents is the most important determinant of good timing in a real estate market. Shevy recently closed a sale with a client employed by a major bond trading company in Orange County. When asked why he was buying now, he stated that with rising rents, locking in a stable cost of ownership with fixed-rate financing was going to provide him a return on his investment irrespective of any changes in resale price. This was not a man looking to sell for a profit on appreciation, although he did believe appreciation was due to follow in time. He recognized the importance of avoiding the rising cost of housing by locking in his housing costs. This is a valid reason to buy a home — assuming the buyer doesn’t overpay and negate the savings.

Rents are the basis of all value. Falling rents are a huge detriment to a housing market. In a market with falling rents, it makes little sense to buy and lock in a fixed cost of ownership unless the discount is very attractive. For example, if a tenant is paying $2,000 per month in rent, but he thinks he could negotiate a $200 price reduction, why would this person be motivated to lock in a $2,000 cost of ownership to buy a house? There is money to be saved by renting, and in all likelihood, resale prices of houses will fall to match the new level of rents.

When rating the year-over-year rate of rental rate change, I have five categories:

  • (1) greater than 7% = 3,
  • (2) between 2% and 7% = 4,
  • (3) between 2% and 0% = 2,
  • (4) between 0% and -2% = 1,
  • (4) less than -2% = 0.

Note that all rental ratings are generally higher than resale price momentum ratings. This recognizes their greater relative importance.

Similar to resale price momentum, rental rates increasing between 2% and 7% are normal and sustainable yielding a rating of four. This provides room for minor fluctuations. Rents increasing more than 7% per year are not sustainable and the rating drops to a three. Rising rents are always better than falling rents, so increases between 0% and 2% are given two ratings points. Slowly falling rents, ranging from 0% to -2%, are given one point, and rents falling more than 2% per year are given no points.

What would a typical market look like?

I write often about what a typical or healthy market would look like. Based on this rating system, such a market would score 7 out of 10 points. It would have resale prices and rents rising between 2% and 7% scoring three points and four points respectively. Since it would be trading at rental parity, it would receive no valuation points. For a market to get a boost from valuation points, it needs to be trading at a discount of more than 6% from its historic norms. To get points subtracted, it needs to be selling at valuations more than 6% higher. At the peak in Irvine, the market was 65% overvalued in August of 2006. During much of the bubble rally, the rating system gave five to seven points for increases in resale prices and rents, then routinely subtracted those points and then some for excessive valuations — which is what a good market rating system should have done during this period. In the bear rally of 2009-2010, the degree of market inflation was less, but declining rents and declining prices resulted in no points scored. The system would have largely avoided the bear rally. Only over the last six months or so with falling prices, falling interest rates and rising rents has the system begun to give markets favorable ratings.

What would be a perfect world?

So what market conditions would give ratings of eight, nine, or ten? It takes some combination of low valuations, rising rents and rising prices. Right now, three Orange County markets earn a nine: Laguna Hills, Ladera Ranch, and Tustin. Two more markets earn eights: Aliso Viejo and Placentia. With prices still falling, these markets rated so high because relative valuations are so low. In other words, it is so inexpensive relative to historic norms, the price discount negates the effect of falling prices. In my opinion, that’s how it should be. That’s how a bottom forms. Value buyers purchase and reverse the downward price momentum.

This system is not perfect. I will undoubtedly revise it over time. Further, it is not without its own drawbacks. Right now rental parity is relatively high because interest rates are so low. Will rising interest rates cause house prices to crash? I don’t know, but it is certainly a possibility. And what about the plethora of REOs on the way? Won’t that impact market pricing? Probably. That’s part of the narrative worth paying attention to.

No strictly mechanical system can capture the unusual circumstances surrounding any financial market. Right now, the math says it’s a good time to buy in many cities around Orange County, and many buyers are active. Will those buyers come to regret their decision? If they are locking in a cost of ownership less than rents, and if they have a long holding time, I don’t think they will.