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Apparently some economist types have recently
come up with a "new" way of valuing real estate, based on discounted
cash flows. This justifies property values much higher than the sort of
methods we used a few weeks ago, which are the methods smart investors have
used for decades. Here is a link to the paper.
http://www.brookings.edu/es/commentary/journals/bpea_macro/forum/bpea200603_smith.pdf
And here is a summary from the New York
Times:
http://www.nytimes.com/2006/04/01/business/01bubble.html?_r=1&oref=slogin&pagewanted=print
Whenever assets are highly priced, whatever they
may be, there will inevitably appear elaborate and sensible-seeming
justifications for the present pricing. Remember Dow 36,000? It appears to me
that the authors of the paper just wanted a handy justification to buy their
"dream house" in California, despite the fact that the market is
overpriced.
To summarize, the authors argue that rental
income tends to rise over time, while the coupon on bonds remains stable.
Thus, even if rental yields are lower than mortgages on the same property
today, that lack of cashflow today would be made up some time in the future
as rents rise at their average annual pace of 3% or so. Similarly, it may
"make sense" to buy today even if the monthly cash cost of owning a
property is greater than equivalent rent, because the monthly cash costs
would be stable while rents could rise.
Actually, that's true -- and it explains one
major reason why homeownership (and investment-property-ownership) tend to be
good long-term investments. The problem, of course, with pricing property on
that basis is that such pricing eliminates the advantage!
Let's look at a 30-year DCF model, based on
assumptions similar to those made by the authors.
So there you go. Simple, right?
This model makes several assumptions:
1) There is no allowance for occupancy or
management fees. People sometimes end up with a home they aren't living in,
because of a new job or other developments. As for management fees, while
theoretically it would not be necessary to find new tenants, nevertheless
there is some time and effort involved in keeping the property running,
whether filling out property tax forms or finding a good chimney expert.
2) The discount rate of 6% is equivalent to
30yr mortgage rates. However, there is "business risk" involved in
owning, while the bank doesn't get paid only in extreme circumstances. Thus,
one could argue that the 6% discount rate is too low.
3) Property taxes, insurance and
maintenance/capital replacement costs are assumed to go up only 2% per year,
while equivalent rents go up 3%. This is because a) property taxes typically
do not go up in line with equivalent rents, but lag somewhat, b)
insurance/maintenance is related to the structure, while land itself doesn't
need any insurance/maintenance.
4) Rents are assumed to go up 3% a year, which
has been typical over the last twenty years or so, and is in line with the
CPI.
That said, there are some advantages of having
a home over debt, primary of which is that it is a "hard asset" and
thus relatively inflation-resistant. Or in other words, in an environment of
inflation nominal rents could rise much faster than 3% per year. Also, it is
possible that you may be in a region that is enjoying a long-term boom and
above-average rent rises. But then, you may be an area that will experience
below-average rent rises. Who is to say that Phoenix is not the Cleveland,
Rochester or Buffalo of the future?
When you add up all these assumptions, we see
that, in terms of today's valuations, a home with a rent of $2000/month or
$24,000/year would be worth about $334K on a 30-year basis and $447K on a
50-year basis. (One could stretch it out to infinity, but how long are you
going to live there?) In terms of typical valuation measures, we see that the
first is 14x annual rents, and the second is 18.6x. This translates into
"equivalent net operating income yields" of 4.50% and 3.36%,
respectively.
Thus far, we are assuming that the home is
being bought for cash, no financing. On this basis, there are some additional
advantages: property taxes are typically deductible, and homes have better
capgains treatment than equities, though it's hard to say why that would
matter here.
Since this example is sort of a
consumer-finance exercise, it would be worthwhile to look at a situation
where the property was financed. In our case, we'll use a 30yr fixed-rate mortgage,
which Yahoo informs me is now going for about 6.02%. Plus, we'll use a 20%
downpayment. We'll use the 50yr NPV of $447K as a sale price, which gives us
a down payment of $89K and a mortgage of $358K. The property tax, insurance
and maintenance is summarized as "cash costs" to cut the number of
columns down.
 
Now we can see the problem with using these
"DCF" valuations -- you can't finance it. Even if you put up the
$89K 20% downpayment, the annual cost, even including a tax break, is about
$31,000 a year, compared with $24,000 to rent. If we assume that $24,000 is
all the household can afford, then where does the extra $7,000 a year come
from? You have to go 12 years out, to 2018, before the cash costs are less
than the rent, which is assumed to rise 3% per year. In terms of the time
when the total cumulative cash payments from buying is less than renting,
that is in the rightmost column. Here we see that you don't break even until
2036, when the 30yr mortgage is paid off. So, to buy this house at the
"50yr DCF" value of 18.5x annual rent, you don't really see any
advantage for 30 years versus renting.
We are assuming a big downpayment in this
example. That downpayment has opportunity cost as well. For example, you
could make 6.02% on it by loaning the money to someone who is buying a house.
We can easily factor in this opportunity cost by assuming 100% financing
(even though a bank wouldn't let you do this, or shouldn't anyway).
Note that we assume a 20% tax advantage on
interest costs. This is less than the marginal rate, it's true, but to get it
you have to give up your standard deduction. Also, with the AMT and other tax
nonsense, you aren't likely to get the whole marginal rate deduction.
Here's the same exercise with 100% financing:
Now we see that buying costs more than
renting, on a cashflow basis, for twenty years, or until 2026. The initial
annual cash cost of ownership is $36,157, compared with $24,000 to rent. And
where does this extra money come from? Not an easy question to answer. Not to
mention that people live in their houses for an average of seven years before
moving. Of course, on an NPV basis, the costs in the present are "worth
more" than the cash you get twenty years in the future. Since the
discount rate and the financing costs are basically the same, you would break
even at year 50 on an NPV basis -- minus a little bit for the tax advantage,
I expect. In other words, not real exciting.
However, it must be noted that, to the extent
that rent rises represent "inflation," a diversified REIT acts
something like a Treasury Inflation Protected Security. TIPS are yielding
about 2% now, plus CPI, so getting 3.5% for a REIT (common today) is arguably
intriguing, especially if one believes that inflation is in the future.
However, inflation also means higher interest rates and thus lower property
valuations (likely), and higher interest rates mean a depressed economy,
which means depressed occupancy. Unlike TIPS, there is definite economic risk
involved. No easy ways to win when you buy property at elevated pricing.
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.
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