Rental parity establishes the value of residential real estate
Rental parity is the price of real estate where the monthly cost of ownership equals the cost of rent. It is the best benchmark for establishing residential property value.
The importance of rental parity
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, so owning is often 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 creates a negative cashflow situation where owners pay more to enjoy a house than they have to. Over time fixed-rate financing and rising rents may tip the balance the other way, but depending on how much more than rental parity an owner paid, it may take many years to realize this benefit.
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, which is why the new upgrade to the OC Housing News shows the cost of ownership and the cost of a comparable rental for every property on the MLS.
Rental parity as the basis of value
When considering housing market valuation, I use rental parity as a basis. 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.
Premiums or discounts to rental parity
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, 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.
Benchmark value of stable market
To value of any asset or market, it’s necessary to establish a standard of measure 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, there have been a number of distortions to market value over the last forty years. It is imperative for accuracy to identify and exclude periods when the data is distorted and does not represent a normal condition. There were a real estate bubbles in California from 1976 to 1982, from 1987 to 1992, and from 2003 to 2009.
For these calculations, I am using the period from 1993 to 1999 (the last period of stable prices with good available data) 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 value those markets typically experience.
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 because this creates an opportunity for rebound appreciation back to historic norms. Valuation is critical in identifying the best opportunities for financial gain.
OC Housing News monthly market report
OC Housing News monthly market report and newsletter provides a clear picture of the health of the housing market. Both buyers and sellers find the information on location, valuation, and price trends, timely and relevant to their decision to buy or sell a home. The OC Housing News report answers the most important questions to buyers and sellers: (1) Where should I look for bargains, (2) Are current prices over or under valued in my area, and (3) what direction are prices headed, up or down in my area? Armed with better information, people make better decisions.
There is too much information about housing floating around the Internet, and most of it is bad. It is easy to take data and create pretty charts and graphs that don’t provide any useful information someone might use to make a good decision. The OC Housing News has eliminated the useless information and distilled 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.
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Using the OCHN monthly report
When most people are considering renting or buying a home, they already have narrowed their choices for location. Most want to be near work, but they may also want to be near family, friends, or a particular school district. The table of contents on the front page of the OCHN monthly report organizes the reports by county so people can narrow their search to the area they are most interested in. I suggest searchers start with the overview of the county as this provides important data on the broader real estate market.
Interpreting an OCHN monthly market report
The first page of a county report breaks down into four parts: The news overview, Median Home Price and Rental Parity trailing twelve months, Resale $/SF and year-over-year percentage change trailing twelve months, Rental rate and year-over-year percentage change trailing twelve months.
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The news overview provides concise descriptions of the facts and conditions in the market. It states whether the market trades at a premium or a discount to rental parity and provides a measure of it. A market trading at a premium to rental parity is more desirable, so buyers are willing to pay more than rental parity to live there. A market trading at a discount is less desirable, and people must be motivated to live there by savings over renting. The news overview measures the current premium or discount, compares it to the historic premium or discount, and states whether the market is currently overvalued or undervalued. This is an important measure of future financial performance.
MEDIAN HOME PRICE AND RENTAL PARITY TRAILING TWELVE MONTHS
For those who want the bottom line without all the analysis and detail, the market rating is the first row of the first section of data. The rating encapsulates all the conditions of the market into one figure. Suffice to say that a rating of 10 is good and a rating of 1 is bad.
The chart displays three lines that reveal much about the market. The first two lines to note are the parallel green and orange lines. These are rental parity and historic value. As mentioned previously, some markets trade at a discount and some at a premium to rental parity. If the orange line (historic value) is above the green line (rental parity), the market is a premium market. If the orange line (historic value) is below the green line (rental parity), the market is a discount market. The larger the gap, the greater the premium or discount is.
The third line plotted against these two parallel lines is the median resale price for the area. This line reveals whether the market is currently trading at a premium or discount to rental parity and historic value. The more important of these relationships is between median resale price and historic value. Over time, the market has shown a tendency toward trading at historic value. If it trades above for a while, over time it will revert back to this value. That may happen either by an extended period of little or no appreciation or an outright decline in prices. If the market trades below its historic value, it’s likely to see a rebound back to this value in the future. The best markets are those trading at a steep discount to its historic value.
RESALE $/SF AND YEAR-OVER-YEAR PERCENTAGE CHANGE TRAILING TWELVE MONTHS
Since the value is so important, the first column in next section displays the premium or discount from historic value over the last year. The second column and the chart shows the dollars-per-square-foot resale price in the market. The line on the chart visually shows the general direction of prices, and the third column shows the actual percentage change.
RENTAL RATE AND YEAR-OVER-YEAR PERCENTAGE CHANGE TRAILING TWELVE MONTHS
The final table and chart on the page is similar to the first grouping; it displays three lines, two of which are parallel and show current rent and the historic cost of ownership relative to rent, and the third line is the current cost of ownership. The relationships are similar, the charts will look similar, and the interpretations are the same.
This method of looking at the data is more revealing to those who like to focus on monthly costs rather than purchase price. It reveals how affordable properties are relative to monthly rent, which is what rental parity analysis is all about. The first column of data shows the rate of rent growth over the last year, and the next two columns show the cost of renting and the cost of owning during the same period.
The OCHN is your resource for finding property
Some of you may have noticed the changes at the site. I haven’t written about the new features because I am still working out some of the bugs (the calculations are all correct, but some search functions don’t work yet, and we are in the middle of an update, so the rents are in flux). When it’s all ready to go, I will write daily on specific improvements and features of the site. My intention is to create a comprehensive property search resource: I created a number of useful guides to educate homebuyers, I provide detailed market reports designed to help homebuyers identify good market conditions and good places to search within the market, and I designed a custom property search system to help people find specific properties within their search area. It’s these new features to find specific properties I am most excited about, probably because I spent the last 10 months of my life working with programmers to get the calculations right. It’s been no small task.
Since I first started writing about real estate seven years ago, I envisioned a site with the resources available here. When the programmer first displayed the cost of ownership information breakdown for each property on the MLS, I stopped and stared; it was the realization of a dream nearly seven years in the making. For the last five years or more, my daily posts have included the cost of ownership calculations for the featured property. Now, those calculations are available for every property. Take a look for yourself; explore a little. I’ll be telling you much more about it in coming posts. Thank you for your patience during the construction.