Friday, July 31, 2009

What Price: a Home?

Recent housing market statistics have many asking if the housing bottom is at hand. This is an important question for many reasons, particularly the health of the banking sector, but a more important question for most individuals is: are prices right for me? Calling a bottom is a fool's game for most people, but that does not mean that purchasers can't determine a fair value for a home.

Housing has a rational price based on economic fundamentals, but this comes as a surprise to many. I hear people cite metrics such as comps (the price of a similar, or comparable, property in the same area), price per square foot, and cost to build. But in my view, the single best determinant of property value is the amount it would return as an investment. That is, how much money could you earn if you bought the property to rent to others (discounted using a risk-adjusted rate).

To those who believe that renting is just throwing money away, look closely at the statistics of the last few years. Most American home owners lost significant equity during that time and now may be upside down (the mortgage principal is greater than the value of the home). Home ownership entails many responsibilities, including property taxes, maintenance, mortgage, and insurance. By and large these costs do not exist for renters. Renters don't put 20% (or more) down for the "privilege" of ownership, an amount which can exceed $100,000 in many areas of this country for a very ordinary home. That amount of money would make a nice safety cushion for a rainy day. There are more than a few cons to renting, but I'll focus on the pros. Every year your lease comes up, which gives you the flexibility to move with no need to sell a very large and illiquid asset (a home). With that flexibility comes (potential) mobility in career, ability to take advantage of falling rents (of course, the converse is true as well), and limited downside should you lose your income--you won't lose your home and the significant savings you sunk into it.

The main tool used to value assets is the discounted cash flow (DCF) model, and there are many good resources for learning this (Aswath Damodaran's Investment Valuation is my favorite), but you could use rules of thumb as well. A good one is price to annual rent. The point is, however, that the value of a home should be based on fundamentals, such as the rent (and cash flow) you could generate from a home as an investment. Due diligence in evaluating value this way adds a level of protection in the form of healthy skepticism. After all, most home buyers can't afford to make such an expensive mistake, and it is possible to overpay, even in an environment of falling prices.

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  1. Interesting post, E.C. >> as someone who has limited interest in owning and operating rental properties, I have not considered home values in this way.

    But what about the non-economic costs of leasing to- or renting from- ? Difficult to attach a value to, but no less real as issues that must be dealt with.

    So for ie., for renters, non-econ costs may include: lack of stability, no equity in exchange for cash payments (and as a result, those cash payments have no positive representation on my credit report and subsequent credit score), and subject to landlord whims (at the end of my lease, the landlord could not only raise the rent, as you acknowledge, but end the lease, adjust my service access, or alter other provisions of the lease).

  2. These really are all economic issues. Let me take them one at a time:

    1) threat of eviction (stability)- yes, this is a possibility, one where a potential homebuyer can price what it is worth to be safe from that, assuming potential eviction is no fault of the renter.

    2) There is no guarantee you are building equity with each payment. As we have seen, home prices fall as well as rise. You may be paying into a sinking ship if your home value is dropping while paying the mortgage. If you rented instead, you might have cash placed elsewhere (opportunity cost) earning real equity, such as in a business investment

    3) Credit score? Really? You can't build that up via leasing? Or paying off credit cards, or auto loans? There are safer ways to get a good score.

    4) All of these issues, if you were to put a value on them, could be offset (at least in part) by the following: if you own your home, and it is worth less than the mortgage and you lose your job, you are in trouble. You lost some of your savings in the down payment on the home (which you could now use because you are out of work), and you may lose the home and your credit score will be hurt. This is a real potential cost.


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