A person can go through life and never buy either a stock or a bond. Given the level of investing knowledge of the typical nonspecialist, that might be a good strategy. However, everyone has to live somewhere, and virtually everyone thinks about buying a house at some point. For most people, it is their biggest financial undertaking. Yet, after two decades of consumer finance magazines like Kiplinger’s or Smart Money, most people know more about stock and bond valuation than they know about real estate valuation.
It’s not too hard to figure out how much a property costs, or, perhaps, what someone might be willing to pay for it if it was put up for sale. But what is a property worth?
This is a question that can be as complex and varied as valuing stocks. But, just as is the case with equities, it tends to boil down to one word: cashflow. For equities, the cashflow is earnings, or other such measures of cash generated through the process of business. For properties, the cashflow is the rental income of the property. It is a very good exercise to look at the financials of a half dozen or so big public property owners, such as Equity Residential, Equity Office, Archstone-Smith, Aimco or the other REITs.
Just as is the case with valuing equities, one can make a variety of academic arguments as to what constitutes fair value, but the fact of the matter is that historical valuation tends to stick within a well-recognized band. For equities, the band lies between about 20x earnings on the upside and 6x earnings on the downside, with some excursions outside this range in extraordinary circumstances, which are inevitably “corrected” in relatively short order. The inverse of the p/e ratio is sometimes known as the “earnings yield”, so a p/e of 20x is an earnings yield of 5%, and a p/e of 6x is an earnings yield of about 17%. The earnings yield is, fundamentally, the amount of cash generated by the company after all expenses have been paid, divided by the purchase price of the company.
In real estate, the “earnings yield” of a property is known as the capitalization rate, or “cap rate.” It is — big surprise — the cash generated by the property after all expenses have been paid, divided by the purchase price of the property. There tends to be a market cap rate, which is determined by various macro-themed factors, particularly yields on other fixed-income investments. What is a fair cap rate for a property? A good rule of thumb is that it should be a little higher than the rate on a mortgage for the property. Which mortgage rate? 2 year or 30 year? Academically, I would say that an appropriate mortgage rate is one that matches the inherent duration of the rental income, i.e. the term of typical leases. Within this must be embedded any inherent stickiness: for example, though apartment leases may be for one year, often there are regulations restricting rises in rent. As a margin of safety, I just take the 30 year fixed rate mortgage. The bank gets paid first, of course, so just as is the case in other businesses, the implied expected rate of return for the equity holder (property holder) should be a little higher than the mortgage rate, to accommodate the extra risk involved. How much higher? Let’s add half a percentage point.
So, what we’ve concluded is that a fair cap rate is the 30 year mortgage rate plus half a percentage point or so. With mortgages now about 5.8% for good credits, that gets us to 6.3%, or equivalent to 16x earnings for a stock. Not particularly cheap, but not unreasonably expensive either, at least in today’s cushy-for-the-moment macro environment.
Let’s say you live in an apartment that you rent for $2000 a month. That is a fair market rate for your neighborhood. If a real estate investor was to buy the apartment you live in from your landlord, and demanded a 6.3% net return on his investment (cap rate), what would an appropriate price be? Let’s figure it out.
Annual gross rental income: $24,000
Occupancy (sometimes it’s empty): 93%
Management fee (paying the management company that you call when the refrigerator’s busted, and who finds new tenants if necessary): 5% of gross
Adjusted gross rental income: $24,000 * 93% * 95% = $21,204.
Now, out of that revenue we have to pay the expenses of the business:
Property tax: $4000 per year
Insurance: $1000 per year
Maintenance and capital replacements: $4000
Net rental income: $21,204 – $4,000 – $1,000 – $4,000 = $12,204
Note that the net is ($12,204/$22,320): 55% of the (occupancy adjusted) gross rental income. This is about in line with major operators of apartment buildings like Aimco or Equity Residential, which own hundreds of thousands of apartments across the United States. (They do their own property management so I didn’t back that out separately.)
So, if we apply our standard of a 6.3% cap rate, then $12,204/6.3% = $193,714.
Surprised? Lower than you thought? Let’s be a bit more aggressive (don’t do this with real money) and apply a 5.5% cap rate: $12,204/5.5% = $221,891.
So we see that a reasonable valuation is $194,000 and an aggressive valuation is $222,000.
“Hey,” you say, “I’m paying $2,000 a month for my place now, and there’s no way I could buy a place like this for $222,000, much less $194,000.” Indeed. Are you beginning to suspect that real estate might be overvalued? And that’s even at today’s historically low interest rates. How about with a 7.5% mortgage rate? That implies an 8% cap rate by our standards — which is where cap rates were just a few years ago. And then, let’s discount the price another 20%, due to the collapse of property prices caused by higher interest rates. $12,204/8% = $152,550 * 80% = $122,040. Yes, $122,040.
Now let’s look at some other ratios. We now have three prices: $222K, $194K and $122K. Our nominal rental income is $2,000 a month. The first figure is 111x a month’s rent. The second is 97x and the third is 61x. Now there’s an easy measure: a multiple of a month’s rent. Keep it in mind. As you can see from our example, it is quite hard to justify a multiple above about 120x. Since there are twelve months in a year, that works out to 10x annual nominal rent.
As an owner/occupier of your own home, you are in essence renting it to yourself. There are some advantages in this arrangement: your occupancy is 100% (unless it’s not — over the course of years you might find yourself with an empty house) and there are no management fees. You also get a tax break. The result is that owning tends to be cheaper, on a per-month cash outflow basis, than renting an equivalent property. As it should be.
With our 30-year fixed rate mortgage example, you would also be paying amortization. At 5.8% you’d actually be paying 7.04% of the total mortgage amount per year in payments. Thus, to be cashflow-positive you would need to have cap rates in excess of 7%.
And what could happen in a real disaster? Remember that we considered cap rates as high as 17%, comparable to 6x earnings in the stock market. Plus, let’s give ourselves another 20% discount as a “crash discount,” reflecting the flood of foreclosures hitting the market and depressed occupancy. That gets us down to $57,430 for our hypothetical property, or 2.4x annual nominal rent. However, such an environment would likely be one in which rents were rising fairly briskly due to inflationary considerations, even despite a depressed economy.
The fact that so few people have ever thought about property valuation at all practically guarantees that the collapse in valuation will be just as extreme as the overextension. Even the stock market, dominated mostly by fulltime professionals, shows comparable valuation swings. The New York Times had some interesting statistics not too far back on the annual rent/price ratios in various markets. Back in 2000 — not exactly a time of “cheap property” — the ratio was roughly 10x-12x across the country. A bit on the high side, but not ridiculous. More recently? Popular markets on the coasts had multiples in excess of 25x, and in some cases in excess of 30x. I think it will go back down to 8x or maybe even 6x. Be careful out there!
