|
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!
Nathan
Lewis
Nathan Lewis was formerly the chief international
economist of a leading economic forecasting firm. He now works in asset
management. Lewis has written for the Financial Times, the Wall Street
Journal Asia, the Japan Times, Pravda, and other publications. He has
appeared on financial television in the United
States, Japan,
and the Middle East. About the Book: Gold:
The Once and Future Money (Wiley, 2007, ISBN: 978-0-470-04766-8, $27.95) is
available at bookstores nationwide, from all major online booksellers, and
direct from the publisher at www.wileyfinance.com or 800-225-5945. In Canada,
call 800-567-4797.
|
|