Ho ho ho.
Ho ho ho.
We are Santa’s elves.
We are Santa’s elves,
Filling Santa’s shelves With a toy
For each girl and boy.
Oh, we are Santa’s elves.
We work hard all day,
But our work is play.
Dolls we try out,
See if they cry out.
We are Santa’s elves.
We’ve a special job each year.
We don’t like to brag.
Christmas Eve we always
Fill Santa’s bag.
Santa knows who’s good.
Do the things you should.
And we bet you,
He won’t forget you.
We are Santa’s elves.
Ho ho ho. Ho ho ho.
We are Santa’s elves.
Ho Ho!
We are Santa’s Elves — Burl Ives
.
Today I want to look at a property that is both for sale and for rent to see where the gross rent multiplier in the market can be found. This was sent to me by SawItComing.
Asking Price: $589,900
Income Requirement: $168,750
Downpayment Needed: $147,475
Purchase Price: $590,000
Purchase Date: 3/22/2004
Gross Rent Multiplier: 222
Address: 145 Topaz #15, Irvine, CA 92602
1st Loan $471,900
2nd Mtg. $88,500
Downpayment $29,600
Beds: 3
Baths: 2.5
Sq. Ft.: 1,500
$/Sq. Ft.: $393
Lot Size: –
Type: Condominium
Style: Townhouse
Year Built: 2001
Stories: Two Levels
Area: West Irvine
County: Orange
MLS#: S510794
Status: Active
On Redfin: 29 days
From Redfin, “Magnificent West Irvine Townhouse boasting high ceilings, large bedrooms and custom paint. End unit with lots of upgrades and one of the best locations in the tract with a extra wide front walkway. Nice size fenced front patio with slate tiles. Great neighborhood, fabulous schools, close to Tustin Marketplace and 5/55 freeways.”
When referring to those tiny front patios, what constitutes a “nice size?”
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The purchase data on Redfin is incorrect, but my data source shows this property was purchase in 2004 for $590,000. If the seller can get their asking price, they stand to lose $35,494.
For those of you who want to better understand the gross rent multiplier concept, lets look at the math on this property:
$589,900 Purchase Price
6.75% Interest Rate
30 year fixed Term
_____________________________
$3,826 Payment
$185 HOA
$590 taxes @ 1.2%
$123 Insurance @ 0.25%
_____________________________
$4,724 Monthly Cash Expense
($830) Income Tax Savings @25%
_____________________________
$3,894 After Tax Cost
$2,695 Rent
_____________________________
$1,199 Monthly Operating Loss
A note on downpayments: I have not included a downpayment in this calculation because it does not change the math. If you take the money out of a high-interest CD to put into a downpayment, you are giving up earning 5% interest on that money. The effective, after-tax interest rate on the mortgage is about 5%. In short, it is a wash to the calculation. Whether you pay cash and give up interest income or finance the entire deal and obtain the interest deduction, the cost of money is the same.
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As you can see, a GRM of 222 makes for a significant loss when compared to renting. So how far do you have to drop the price to get to breakeven?
$399,169 Purchase Price
6.75% Interest Rate
30 year fixed Term
_____________________________
$2,589 Payment
$185 HOA
$399 taxes @ 1.2%
$83 Insurance @ 0.25%
_____________________________
$3,256 Monthly Cash Expense
($561) Income Tax Savings @25%
_____________________________
$2,695 After Tax Cost
$2,695 Rent
_____________________________
$0 Monthly Operating Loss
148 Breakeven GRM
Take $200K off the price and the property breaks even with a 148 GRM.
This is the math I would use to evaluate whether or not I will buy a home, but others may use different assumptions. I will not take out an interest-only loan, so the cash-on-cash breakeven I am looking for is actually better than breakeven because a certain amount of equity is hidden in the mortgage payment as principal. If you want to calculate the absolute breakeven, you must look at the interest-only scenario:
$589,900 Purchase Price
6.75% Interest Rate
30 year fixed Term
_____________________________
$3,318 Payment
$185 HOA
$590 taxes @ 1.2%
$123 Insurance @ 0.25%
_____________________________
$4,216 Monthly Cash Expense
($830) Income Tax Savings @25%
_____________________________
$3,386 After Tax Cost
$2,695 Rent
_____________________________
$691 Monthly Operating Loss
.
$462,495 Purchase Price
6.75% Interest Rate
30 year fixed Term
_____________________________
$2,602 Payment
$185 HOA
$462 taxes @ 1.2%
$96 Insurance @ 0.25%
_____________________________
$3,345 Monthly Cash Expense
($650) Income Tax Savings @25%
_____________________________
$2,695 After Tax Cost
$2,695 Rent
_____________________________
$0 Monthly Operating Loss
172 Breakeven GRM
As you can see, this comes out very close to the 160 GRM we have been using here at the blog. The gross rent multiplier is just a shortcut that will let you know if a property is “in the ballpark” and worthy of a more detailed analysis. Some properties with a 160 GRM may still not be at breakeven if the HOA fees or Mello Roos taxes are very high (which they are in the new neighborhoods.) The only way to know for sure is to crunch the numbers. However, if you want a convenient shortcut, the gross rent multiplier is a handy tool to use.
You’re neglecting an important part of ownership: capital appreciation. Since you’ve done everything in nominal dollars, you also need to consider that the house will appreciate roughly at the rate of inflation. Assuming 3% inflation, that’s $1,475/month, so this house will actually make money for a renter who chooses to buy it (and is willing and able to save $1200/month). You haven’t included maintenance or purchase costs, or the cost of having money locked up in a slowly-appreciating asset, and after those are accounted for this property is still a loser. But, it’s not going to be a huge loser and so this suggests prices are not outrageously high anymore.
Of course, this assumes you can actually *get* that rent and since it’s “active” they’re not at the moment. Still, if that rent isn’t from cloud cuckoo land I’d guesstimate no more than 10-15% of a drop to reach a truly fair value for an owner-occupier.
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“You’re neglecting an important part of ownership: capital appreciation.”
Yes I did. It is the belief in continual appreciation which drives asset price bubbles. If it doesn’t make sense the day you buy it, then you are betting on appreciation that may or may not occur. If you experience depreciation for any length of time, when appreciation resumes, you will have a long way to go to catch up. Besides, once you start trying to guess at appreciation, you find that small changes in your assumptions make a huge difference in the valuations. I prefer to evaluate what is current rather than guess at what is to come.
I agree that this asking rent is probably too high.
These are the exact kind of properties that potential renters need to stay away from. This seller is (1) upside down on their mortgage balance, and (2) trying to sale while also trying to rent. This shows desperation.
Nobody likes having to guess at future valuations but inevitably any asset decision contains implied assumptions about future valuations. Assuming that houses will appreciate by 10%+ per year led to a lot of underwater owners today, and many more who will be underwater soon. But, assuming 0% appreciation, as implied by your approach, also leads to a mistake (namely not buying a house when it will probably be in your long-term financial interest) which can be fairly costly although it won’t lead to the financial catastrophe you can get from overbuying. You always expect to be best off with a hard-nosed accurate appraisal of reality. Long-term appreciation of housing stock at approximately the rate of inflation isn’t just a belief, it’s very well supported by historical facts. To make the best decision you want to account for (accurately) expected increases, as well as to account for the extremely high variability, which introduces a high risk level.
Can you help me out with a simple question? Where do you get the rent figure from?
I suppose that house appreciation over the long-term can be argued, but in the short-term (5-10 years), houses will most likely not see any appreciation. I can’t imagine why you would factor in house appreciation when prices will clearly be dropping for the next few years (at least). IrivineRenter is definitely correct in keeping that out of his current calculations.
I like the way you are assessing this.
Capital appreciation is something to analyze (in fact, that kind of logic caused the current problem), but with everything out of balance, it will be a long time before that is viable.
The “asking” rental rate and GRM are great stats for the properties you profile.
I believe legislation is in the works to give renters a 90 notice after foreclosure and the honoring of the original lease by the new owner (I mean bank of course.)
Before I signed my current lease in Oak Creek (2 years ago), I pulled title to make sure how leveraged the property was (it wasn’t.)
This site keeps getting better every day 🙂
“Nobody likes having to guess at future valuations but inevitably any asset decision contains implied assumptions about future valuations.”
I would argue that only speculators are concerned about future valuations. If you are investing based on cashflow, future valuations are not relevant because your investment is being recouped by the cashflow. If fact, this is the key distinction between speculation and investment.
It’s one of these “I’ll just rent it out” scenarios.
Couldn’t you get an apartment for roughly the same size for less than 2695 per month?
Personally, I would be a little worried about renting from someone who is obviously just trying to ditch the property.
I would much rather pay an apartment complex that kind of money where I at least know they have a staff whose job it is to respond to the needs of the tenants.
This guy will just be around long enough to collect your check each month.
The asking rental rate on this property is too high… It’s not quite equivalent to an apartment, but it’s close. Attached walls, but no one above or below. Mandeville is a pretty dense West Irvine development and has parking problems. Market rent rate for that unit is probably more like $2,300-2,400 right now.
IR – love analysis today. Great for the non-financial types to see where these figures come from. Couple of points to add:
1. The effective tax rate on the property goes up as the price goes down since the Mello Roo portion is not tied to price. For example, at a price of $399K, the effective tax rate on this property is almost 1.3%. Between Mello Roos and the 1915 Bond, the unit has almost $1K of fixed property taxes. For higher Mello Roo areas, this makes a significant difference so people should always use actual property taxes vs. a simple 1.2% multiplier.
2. I think you under estimate the tax benefit on this calculation. For 2007, the 28% Federal bracket starts with a taxable income of $77K. I would assume most home buyers looking to purchase between $400-600K make at least this much. You also save on CA income taxes, at a rate over 9%. It would seem more accurate to project the tax savings at 37% on just the monthly mortgage and prop tax figures. Wouldn’t that be considerably more accurate?
Follow the link in the post. It will lead you to the realtor’s web page, and the rental listing will be at the bottom.
IR,
Can you explain how you get (in more detail) the $830 income tax savings in your first example. Seems like it should be a bigger number than $830.
The tax benefit estimates are difficult to evaluate because each potential buyer’s tax situation is different. It certainly possible that the marginal rate would be in excess of 25%, particularly for higher wage earners. Also, when you itemize, you give up the standard deduction that a renter would get, so you give up the tax benefits on the first $9,500 (or whatever the current number is.)
That’s a somewhat idiosyncratic definition of speculation vs. investment; most people say they “invest” in the stock market even though stock purchases are mostly about future valuation. But in any case, you’ve defined all house purchasers – or even those considering house purchases – into speculators because they’ve buying something almost certain to change in value. If they don’t consider the effects of value change they’re making a mistake (possiblya small one, but probably not based on my seat-of-the-pants calculations)
SDChad – yes, very good point. Until prices level off, considering appreciation leads you to delay purchases. Because of herd behavior, prices will probably keep dropping until cashflow considerations drive large numbers of homebuyers into the market. So on the downside IrvineRenter’s approach works great.
On the upside, however, it doesn’t, and I regret having given bad advice (based on just this approach) to a number of my friends around 2000. Fortunately most of them ignored me, and fortunately none bought after things really started going crazy around 2003/2004.
It was computed by taking the interest portion of the payment times 0.25. Part of the payment is principal which is not deductible.
Using an interest only loan at 6.75%, a 37% tax savings on mortgage interest and prop taxes, and a more realistic rent rate of around $2400, I get a breakeven GRM of about 210 at a price of $505K.
“But in any case, you’ve defined all house purchasers – or even those considering house purchases – into speculators because they’ve buying something almost certain to change in value.”
In California almost everyone purchasing a house is a speculator. It is the only real reason anyone overpays for an asset. If you are purchasing to save money on rent, it really doesn’t matter much what happens to the value, and in the real world, if you are paying that value, it is unlikely to decline much further.
I agree they are difficult. Also have the AMT effect, which could effectively eliminate all Fed tax savings.
For the average family looking to buy in Irvine, I would think a 33% tax savings rate would be safe to assume – 25% Fed + 8% CA. Just need gross income of $85-90K to hit those numbers. Heck, I feel like an average buyer and as a family, we gross way more than that…
It seems to me that if you are going to consider probable future events such as appreciation (which, I will concede, over the long term will occur), I would think you would also need to account for other probable future events, such as increases in property tax (base, and possibly mello-roos at 2% + per year), maintenance, and increases in HOA dues among others.
My poor little mind simply can’t model all those variables, so I need to stick to the simple formula. At the same time, I’m not as disciplined as IR, so if a home I like is affordable to me and pencils out somewhat higher than the 160 GRM, I’m buying it. YMMV.
A detailed explanation would take pages, so bottom line, 25% is a more realistic percentage to use when estimating tax savings from RENTAL property.
“Investing” in real property is completely different than investing in equities because of the liquidity, tax, and dividend issues. When penciling the profitability of investment in real property, one should never use capital apreciation as part of the calculations. Positive cash flow is paramount.
The problem with assuming appreciation as per Fair Economist is that you would also need to calculate the value of the lost utility of the money, ie, what return you could have made investing in another asset during the same time period. A pure investor/speculator would not touch this house at this point because the risk of losing value is much higher than investing, in say, a higher interest CD or decent bonds. While there is still risk I dare say it is no where near the risk of buying this place and looking for positive appreciation over the next five years. Therefore, you would need to actually deduct the loss of appreciation to make a decent calculation. I think IR’s decision to more or less leave this out avoids this can of worms.
2 corrections,
You still need to account for the lost interest on the down payment. Not so much in this case, but it can be much larger with larger down payments…
$29,000 down x 0.05 (% interest) / 12 months = $120/month lost interest on down payment
As an owner, you are responsible for maintenance and repairs (thermocople in heater, paint, plumbing etc), this will be higher on larger homes but as a very conservative estimate I would add another $80/month for maintenance and repairs.
So in your example, I would add $200/month to the ownership cost to account for lost interest on the down and maintenace costs.
IR,
Excellent post! Thanks for breaking the numbers down in detail on all the different scenarios. I understand cap rates on commercial but don’t quite grasp the GRM. Is the GRM# derived from the purchase price divided by the amount of rent you get?
How’s this for a rent vs buy comparison…
http://homes.realtor.com/search/listingdetail.aspx?zp=92782&
bd=5&bth=6&typ=7&sid=28444eeeaacf4263b39427769fb1b753&pg=6&lid=1086973589&lsn=56&srcnt=64#Detail
http://rentals.realtor.com/rentals/search/listingdetail.aspx?zp=92782&ml=3&bd=5&bth=6&typ=40&sid=59862e8b90c44cf9a32538ea44e00e7a&lid=1088777336&lsn=9&srcnt=11#Detail
Vacancy Factor – IR, first of all kudos for the insightful article. One factor that could also tilt the calculation totally in favor of renting is the vacancy factor. How many months in a year can you successfully rent?
Maintenance Costs – Typically the owner will incur expenses on account of inspecting, upkeep, maintenance and additional investment to keep the house rentable and marketable. Quite often you will find renters being quite disrespectful with larger property rentals and the effor for upkeep may be a lot.
Conclusion – It is a no-brainer that it is better to rent here in So Cal versus owning a property unless of course you have considerable equity in the home and have bought it quite cheap or unless you have too much money lying around and do not know what to do with it.
The key flaw here is not “an assumption of appreciation in line with inflation” but the basis on which that appreciaion rests. If the property is “overpriced” right now, it’s not going to appreciate at the same pace as inflation compared to a “fairly” priced property, which has a greater probability of doing so.
So at $389,000 today ($200,000 off the asking price as per IR’s analysis above), this may very well appreciate (in the long-term) at a rate approximating inflation. But at this asking price, it will not come close. Therefore, at today’s wishing price, a potential buyer should factor in DEPRECIATION, not appreciation, when considering the long-term consequences.
IR – In computing the net loss from rental, you don’t include the cost of the current owner moving out and having to rent a double-wide in Barstow. If they move and “rent it out,” don’t they end up with additional cash outflow for rent on their new abode that they didn’t have when they occupied this anchor?
Yes. If you want to make a cap rate comparison, take the monthly income times 12 and divide it by the purchase price. In this case it yields about 5.5%.
Good analysis today IR. Obviously a lot of assumptions can be debated, but the fundamentals of the analysis remain the same.
A couple of points: 1) I agree with Fair Economist on including some level of appreciation. I don’t think anybody should buy when the market is in such clear decline….but once the market stabilizes, then using an inflation level rate of appreciation is appropriate.
2) I think some down payment needs to be included. IR mentioned the 5% return on cash….but that is taxable. The analysis compared the after tax interest rate with the pre-tax return on cash.
Also, it just seems that doing a cash flow based valuation analysis needs a downpayment. Can anybody reasonably expect to get positive cash flow with no down payment? Wouldn’t that be the easiest investment in the world if you could?
Makes sense now.
The comparison to the cap rate was very useful, thanks for the reply.
I actually did a very rough calculation for that and found the lost utility to be a lot less than I expected. The opportunity cost for being forced to invest in a relatively poor investment (housing going up at inflation) obviously depends on how long you hold the alternative investment, its return rate, and your tax rate, since the house is tax-advantaged for an owner-occupier. I assumed a 5.5% investment, 33% tax rate, and a 15-year occupancy and found the opportunity cost was only 8% of the forced savings. At a 7% return it goes up to 18% (13% in a 33% tax bracket). Not trivial but expected appreciation remains pretty important, more than twice as large as taxes.
This post isn’t really about buying a rental property awgee, it’s about the economics of the buy vs. rent decision. If you are a family in Irvine, grossing $100K per year, not deferring anything pre-tax because you can’t afford to save, and using this kind of analysis to determine whether or not buy, I can’t see how 25% is a good number to use for the tax savings. It’s in the ballpark but very conservative… Most Irvine families are probably in the 28% bracket just on the Federal side.
If that family with a $100K/year income family was renting this property for $2400, they would likely be better off on a monthly cashflow basis to buy it in the high $400s assuming they could get a loan at 6.75%. I’m not advocating they do such a thing, as I am ignoring the depreciation/appreciation aspect and think these units will float down into the mid to low $400K range before it’s all over, but from a pure monthly budget perspective, they would be better off.
The California “my house is an ATM” mentality is buttressed on Ronald-Reagan-era massive defense spending that poured billions into SoCal. I recall working at (an industrial-military) contractor in the late 80’s. A co-worker pulled me aside and urged me to buy because he had watched a KCET special that said the sky was the limit. It was infectious so we desperately house-hunted, looking at the sort of garbage 50K would pull down in those days (that was actually a good salary in 1989). Simi Valley. Yech.
This time around, the mentality was even worse than the frenzy of the late 80’s. But I remembered how I had been lied to in 1989: get in now or you will be priced out.
My point about the defense spending is that those bills have yet to be paid: think about the insanity — the bills for the last runup are still coming due. We haven’t even paid that 1980’s binge down, let alone the unprecedented debt party we had over the last 7 years.
and this “economist” thinks that we can just live off of debt forever, trees will grow to the sky, and OC houses will just dance along at 3%. Of course economic theory supports an appreciation of real estate according to prevailing inflation. But by that theory, we have a long fall ahead of us because our funny-money lending practices allowed the housing prices to zoom way past that rate. Check your mailboxes, you have some past due notices coming in for the way we have kept our economy humming for 20+ years: through endless debt.
Just like our corporations (see, e.g., GM) spiral down hill because of our short-term-keep-the-stock-prices up mentality, so has the federal government operated: so what about the future, keep the economy humming for now through endless deficit spending. let’s just borrow 3 billion per day, let the next administration worry about that. instead, let’s concentrate on shutting down abortion clinics, yeah, that’s more important.
oh but don’t worry about that man behind the curtain, buy this POS at 500k because it will just appreciate. You’re killing me, stop it.
mid 300ks, this is a townhome, remember psychology will be a big factor on the way down. if it was a SFR, maybe. 😆
Great post, IR. Thank you for continuing to focus on the fundamentals for those of us who plan to buy a home to live in for the long term, rather than falling into the home as investment trap most bulls take. To me, this example again supports the 160 GRM. I have adopted this as the fundamental for when I jump off the fence, but use the GRM in conjunction with a focus on price per sq ft, which I also find really important.
On forum thread I posted what I thought were fair price per sq ft numbers for various Irvine neighborhoods….West Irvine was $250 sq ft. That puts this place at $375k. When I look at this place, I have a hard time imagining anyone wanting to pay more than $375k-$400k for this glorified apartment — assuming you were buying it to live there.
“At the same time, I’m not as disciplined as IR, so if a home I like is affordable to me and pencils out somewhat higher than the 160 GRM, I’m buying it. YMMV.”
Agreed. There are SO many variables when considering where and how you live, and the current value (as well as prospective future value) is just one of the many factors used in your evaluation. It’s probably the most important, but it’s certainly not the only factor in your decision process.
That’s why TurboTax is so great! If you’re considering a purchase, you can run the numbers through and know what your “tax shift” will be exactly (based on your current situation).
Rates on prime mtgs are in the very low 6s right now, which, as always, will affect affordability and therefore price.
Then, if you’re adding those fair assumptions, you must also add the average annual rent increase. Since the two may offset each other, it’s probably best they’re left out.
As a personal preference, I don’t like to over complicate things. When I move into a house, I would like my lifestyle to stay as before which means the total amount of cash going toward housing each month needs to be equal to my rent (or the rent of an equivalent house.) I refuse to give up my life to have a house, and I refuse to fake a life through HELOCs and miscellaneous borrowing.
The absolute breakeven point is not what I am looking for, it is the monthly cash-on-cash breakeven point that interests me. If I get the benefit of a forced-savings account through principal payments, so be it. That should be my benefit of being an owner.
Major correction, Cap Rate is NET income / capital cost.
In this case, Property Tax & HOA only drives the Cap Rate below 4% without any other expenses.
Jeebus,
Have we forgotten that with appreciation is negated by higher rental rates?
The reality is that the DCF is based on so many assumptions. If you hold rents steady, you have to assume no appreciation. Because, after all, rents are the CF of you DCF.
Fair Economist… did they teach DCF in your econometrics? I’m a friggin MBA and picked that up with as stupid as I am.
Chuck Ponzi
http://www.socalbubble.com
I meant to add that the whole purpose of a GRM sliderule is to strip out all of the noise of a purchase decision. If you want analysis paralysis, be my guest, but if you want to be a tool and jump in before the fundamentals make sense, be my guest.
Making the case that homes should go up on average by the rate of inflation from this point forward is not so easy anymore for me. When I look at price inflation I see it as the increased cost of goods. Homes have continually year after year been FINANCED rater than PURCHASED. Each year a greater percentage of homes are financed.
As the rates of monetray inflation and price inflation increase, long term lending rates will follow suit. In the absence of bubble mania this will put downward pressure on home prices not upward. I have a hard time comparing the avergage cost of a gallon of milk rising, which isn’t financed, to the avergae cost of a home, which is financed.
Methinks you might be right mmg. My detached condo, right up the street from this place, is just a smidge bigger with a small backyard, and is selling (yes, selling not listing) in the $580-600K range right now.
I expect my place will settle down into the mid to low 400K range before we bottom. $470K would be a 5% annualized appreciation from purchase price in 2001. That means that this unit could definitely drop down into the mid to high $300K range.
Graham/Buffet use a concept called “margin of safety” when evaluating an investment. Its just what it sounds like: If your calculations of the fair value of any asset (house, stock) depend on its future appreciation, you are decreasing your margin of safety and increasing your risk. If the fair value can be justified exclusively with present cash flows, your risk is lower, but not non-existent.
Clearly, the value of the asset at the end of the investment has a big impact on the performance of the investment. It works both ways. If you buy a house/stock and it declines significantly in value, cash flows may not be enough to save you. On the other hand, if you buy a house/stock with bad cash flow, but it appreciates substantially, the appreciation might bail your overall investment out.
I think cash-flow-breakeven is a pretty high bar to set, especially given the myths and irrational thinking about real estate in the US and California. But, if the psychology turns enough that you could get it, it certainly would provide a nice margin of safety on the investment.
The hard thing, however, will be that if prices do get driven down this far, it will probably be in the context of popular fear about real estate and the economy. In that environment people will be saying “don’t buy now, the cash flow is positive but the asset price is going to continue to decline.” It will be an environment similar to 1970’s equities, when magazines declared the ‘death of equities’ on their covers, and buffet was buying companies at 7x earnings. He could do that because people were so pessimistic, and trusted reversion to the mean over their emotions. If we get there, it will probably (almost necessarily) be in a context where most people say you are foolish for buying.
You are correct. I was too hasty with my response.
Ironically, the $830/month tax savings is pretty much dead on if you quickly crunch the numbers on the 1040 assuming no deductions versus just an interest, property tax, State tax deduction.
That has two key assumptions in it:
1. The family can survive spending 52% of their gross income on the mortgage and property tax alone.
2. AMT doesn’t blow you out of the water for writing off over 50% of your income.
For a family of four, I get a tax savings of $837/month with $100K income gross, for a family of 2, I get $895/month.
“I think cash-flow-breakeven is a pretty high bar to set, especially given the myths and irrational thinking about real estate in the US and California.”
California, yes.
US, no.
It is only in areas like California where people believe in the myth of continual rapid appreciation that you get financial bubbles and distortion. Prior to this nationwide, lender-driven real estate bubble, you could purchase a property at cashflow breakeven in nearly every market other than California.
Thank you for not using the phrase “Pull the trigger” I hate hearing it.
I understand that the rule of thumb capital appreciation on houses is 5%. Note that the rule of thumb for inflation is 3%. So it seems that houses are not a very exciting investment. They are a very safe investment, however. 2% is what you get for safe investments. California is just going to have more wild swings, but it is still going to adhere to this risk/reward ratio.
You are right NSR. I wasn’t considering the loss of standard deduction eliminating some of the tax benefit to the mortgage interest and prop tax deduction. Since I am a homeowner looking to buy, I already itemize, so my tax shift is totally at the margin. I do this kind of analysis personally often when looking at potential upgrade homes. While my tax savings rate may be 37%, for the renter that likely does NOT itemize already, the shift % will be lower.
I ran a married filing joint couple scenario @ $100K gross through Turbo Tax and the tax savings I came out with are 23% of the spend on mortgage interest and property taxes @ a $500K purchase price or 27% of just the spend on mortgage interest. I used a family of three and took some extra deductions you don’t get when you standard – car reg, charitable, etc. For renters, IR as usual is almighty, and his 25% figure is a good benchmark.
I’m curious Playa, did you recheck the AMT for the hypo-$100K family?
It sounds hellish saying 67% of their gross goes to pay P&I, HOA & Taxes (State, Fed, FICA & Property) but that still leaves nearly $3000/month for spending.
Oops
I am obviously no economist or MBA either BUT:
If you do a present worth analysis, the PW of housing costs are decreasing each year because they are fixed while the PW of rents are approximately stable (assuming they rise with inflation). So you either need to include rental inflation OR discount the future value of housing costs in the analysis to be fair. The two work against each other, not cancel each other.
I don’t think it is overly complicated to make basic conservative assumptions about either to see how much of a difference they make.
I would propose a present worth analysis over say 7 or 10 years to judge rent vs. buy.
I’ll get back to cleaning toilets.
Thanks.
So tell me how this one works out.
http://rentals.realtor.com/rentals/search/listingdetail.aspx?zp=92782&ml=3&bd=5&bth=6&typ=40&sid=59862e8b90c44cf9a32538ea44e00e7a&lid=1088777336&lsn=9&srcnt=11#Detail
http://homes.realtor.com/search/listingdetail.aspx?zp=92782&bd=5&bth=7&typ=7&sid=ff89005d73fd43f783b0066b87c0945e&pg=3&lid=1086973589&lsn=29&srcnt=37#Detail
It’s been listed for sale or rent for at least a couple of months.
Probably the easiest thing to do is simple assume you can get out even at some point in time and figure out when you get to breakeven on the costs.
I’d use 2 to 3 years sans selling costs. The reason is pretty simple. One to two years out, you’re fairly likely to be right on the general direction and stability of the rental market and even if not, you can correct. You can re-evalauate at that point in time to determine realitive long term value.
Frankly, if your model needs appreciation in the home or significant appreciation in rents to make sense, buying doesn’t.
More importantly, at a GRM of 200, even a one half percent appreciation in price equates to a 10%+ rent increase. Quite simply that means all your assumptions are pointless compared to the one assumption you make regarding price appreciation.
Today’s housing prices are so leveraged that any cashflow discussion is pointless compared to a short simple decision of are prices 3, 6 or 12 months from now, higher or lower.
That’s all you need to know, higher or lower. If higher buy, if lower, wait.
No discounted cash flow needed, no present value of a series of payments, no guessing on rental increases, no need to even guess which way the Fed Rate, mortgage rates or economy going.
Just one simple decision is needed based on today’s price. Is it higher or lower tomorrow?
Tomorrow you can ask the same question.
All the other assumptions pale in comparison to that one assumption.
ipoplaya,
are the percentage numbers (23% and 27%) what you save on taxes? so if you spend about 30k/year on mortgage interest and property taxes, you get back about 7.5k/yr on tax deductions? thanks..
TT automatically calcs AMT and it did not include any AMT. I used $34K of mortgage interest and $6K of property taxes. The disparity between the figures kept the hypo family out of AMT territory. Even with 2 kids, hypo family does not get hit with AMT. With a family of four, I got a 22% tax savings on interest + prop tax payments.
Now for a single person, earning $100K per year, the tax savings goes way up. Based on same assumptions, $500K I/O loan @ 6.75% and prop taxes of $6K per year, the single person’s tax savings are over 32% of the interest + prop taxes paid. That is 38% of just the mortgage interest. A single filer is probably already itemizing due to state tax withholdings, which would typically be higher than the standard deduction. Their savings would essentially be at marginal rates without any loss related to taking the standard deduction.
Personal tax situations make a big difference. While a family of 3-4 making $100K might not be better off buying at $475K vs. renting at $2400, a single person would likely be. Again, I am discounting the effect appreciation/depreciation on the buy vs. rent decision…
“Can anybody reasonably expect to get positive cash flow with no down payment? Wouldn’t that be the easiest investment in the world if you could?”
Son, those were the good ol’ days. Nothing down, IOs, Neg Ams, HELOCs. Hell, people even camped out and wrote letters to sellers, beggin’ ’em to sell their abode.
***long drag on a dusted cigarette***
Then the damn rates adjusted and the NoDs started showing up, and all hell broke loose….
So netting it out, to save $12000 on income tax. The person must pay $6000 in additional property tax for a net tax savings of $6000.
Or $500/month.
who says tuition isn’t financed?
Actually, I have heard of stories when the first month, last month, deposit etc… were collected and the property “owner” took off right away with the cash and mailed a “key” to the lender!
I’m talking about long term lending rates. Mortgage rates have eased in the past month, but mortgages in general are higher than what they were 3 years ago. Mortgage lenders still need to price in risk when lending money. Risk premiums are rising and so are required profit margins. Look at the rates on depository accounts. Three years ago, savings accounts were paying less than 1%. Now you can get them near 5%.
The market is becoming overwhelmingly risk averse right now and money is flying into treasuries, depressing the yields. Even during the last 2 rallies on tues and wed, people were still buying treasuries. I believe that there is an abnormal amount of people right now who are are simply searching for wealth preservation and principle protection.
moreover, i would posit in regard to *your* discussion, Let’s Go Anteaters, that it is precisely the financing of education by grants, easy student lending, and gov’t subsidies (via tax revenues, stafford programs, et.al.) that is a huge driver of escalating costs with tuition and books.
shall we say: easy money = increased demand = escalating costs ?
I’m not the economist in this conversation, but would guess that the inflation rate includes the cost of commodities and raw materials that you mentioned.
kishore,
For a hypothetical family of 3-4 grossing around $100K per year and currently renting, $30K spent on interest and property taxes would likely yield a tax savings of around $7K per year. For a hypothetical single person, making the same amount of money, that savings would likely go up to around $10K per year.
Actually, that is why I only focus on current cashflows. Once you start projecting into the future, anything can happen, and it opens up a level of complexity that is not necessary. If the current cost of ownership is equal to or less than the current cost of rental, it is safe to buy. Even if prices do drop further, you are still saving money versus renting. The only danger is if prices drop further and you have to move. That is another reason you should not buy unless your timeframe for ownership is greater than 3 years. If you are worried about your job, or if you might get transferred, you should rent even if ownership is less expensive. IMO, rental should carry a premium because of the freedom it provides. Ownership is a burden. It is not something you should pay a premium for.
For a hypothetical single person, making the same amount of money, that savings would likely go up to around $10K per year.
For hypothetical single person, that doesn’t want to be a landlord, one would ask why they want to spend 3X the rent of a nice 1/1 to own?
Without a fundamental need for something beyond a 1/1 which can be had for $1400/$1500 and has massively lower utility and maintenance cost and bank the $40K a year difference.
Oops, $20K a year difference.
Yeah, wouldn’t think most single persons would need a 3/2. At most, maybe a 2/2 so they could have a home office and guest bedroom. When I first came to Irvine, I rented a 2/2 from IAC that I was very happy with…
IrvineRenter,
“…that is why I only focus on current cashflows”
– I agree with this concept primarily because focusing on CURRENT cashflows gives you a more objective foundation on buying a property rather than projecting the future equity of a property.
“If the current cost of ownership is equal to or less than the current cost of rental, it is safe to buy. Even if prices do drop further, you are still saving money versus renting.”
– If most of us adhere to the underlying reason for investing: calculated risk. So many people would have less tears on their eyes right now-take for example what happened in our market:
http://renomarketblog.typepad.com//reno/2007/08/reno-sparks-m-2.html
It’s a painful lesson we need to learn(if we don’t learn from others) once in our life.
Renters do have freedom in so many ways. Like yesterday my mother’s bath tub clogged. How much would you pay for that if you owned your own home? of course there’s some disadvantages too(in renting). But by and large in this kind of market. Whew! renting sure feels like a winner.
Value of $776,000 and an asking price of $1,750,000?
I am thankful I am not that owner.
Unfortunately, Turbo Tax is the 2006 version and it has expiring AMT reform figures built-in. AMT could cut down on the tax savings in the scenarios I ran.
Hopefully HR 3996 passes in the Senate although I think Bush will veto the bill as it is currently constructed. I think at a minimum the AMT relief extended in prior years will get passed and signed in some form before year-end. Can’t believe any politician wants 20 million unsuspecting voters to get hit with a bigger tax bill than they expected.
As someone who runs financial models all the time, I have some comments.
1. Instead of arguing over the appropriate appreciation rate to assume, you can simply run your model and see what appreciation rate constitutes a breakeven.
2. HOA fees aren’t tax deductible. Neither is insurance on your personal residence. However, property taxes are deductible.
3. Using the interest-only scenario, and these assumptions:
$589,900 Purchase Price
6.75% Interest Rate
30 year fixed Term
_____________________________
$3,318 Payment
$185 HOA
$590 taxes @ 1.2%
$123 Insurance @ 0.25%
_____________________________
$4,216 Monthly Cash Expense
deduct 25% tax relief for interest and property taxes ($977) and you get $3,239 as cost of ownership with zero appreciation.
4. What does long term appreciation have to be for this to make sense? If the rent for the same place is $2695, you need about 1% long term expected appreciation.
5. However, we know in the short run prices are coming down, quickly. Thus, in later years (e.g., 2010 and later) prices would have to rise at much more than 1% per year to break even.
6. These types of calculations apply in the short run as well as the long run. The long run equations answer a question more like “If my assumptions about appreciation are right, is real estate a good long run investment?”
In the short run, you can use this type of analysis to answer the question “Should I buy now?” or a similar question “What will be my cost of ownership for the next year?”
If you include housing price depreciation of 10% over the next year, it’s HORRIBLE. You lose $59,000 in a year, raising the cost of ownership by $4,915 a month. That raises the cost of ownership from $3,239 a month for 2008 to $7178, a whopping 152% increase in ownership cost versus assuming stable prices.
7. At a 15% loss in 2008 (the low end of what my models predict), we are talking about an ownership cost of $9,635 a month for having been dumb enough to buy in a declining market because you thought the long term prospects for appreciation were good. It takes a pretty strong future appreciation, or a very long time horizon, to make that work.
8. At a 20% loss in 2008 (at the high end of what my models predict), how about $12,093 a month in ownership costs, and over $100,000 down the drain because you bought a year earlier. This is a stunning 273% increase over what you might have expected ownership cost to be with zero appreciation. You could just as cheaply stay at the Ritz Carlton for the whole year, and get room service everyday.
I just rented a very nice house. For sale at $799,000, two offers accepted in the high 700s, neither one closed. Rented for less than $3000, that’s a price to rent ratio of 273.
They took it off the market and accepted our rental offer. Might be a good place for $500-550k in two years.
Hi MalibuRenter,
You seem like a sharp person. I have a couple of models I would like to get some feedback on. Send me an email to fixedpower at yahoo dot com and we can talk. Thanks!
I was able to buy a rental home in ’02 with positive cashflow. I sold it because of personal reasons, but up until ’03 you could still find somewhat “downtrodden” SFHs that you could break even on.
Irvine condo wise it’s a different story.
But you all are forgetting is that to rent a condo you are fighting the Irvine Company. They own the land so their cost is minimal. And they set the rates. They can undercut you any time they want and their product is very good.
So in Irvine, one homes drop back to ’03 prices you might be able to start finding SFHs that will break even. But condos? No way. Bren and Co. will eat you alive any time they decide they need money and start offering incentives.
IR, I am a big fan of yours…but I respectfully disagree with a few of your statements:
1) That before the bubble, breakeven rent vs. mortgage cash flow existed everywhere in the U.S except CA. While I’ve been in CA for 15 years now, the other markets I’ve lived in previously (among them, NJ, NY, IN) were also far cheaper from a CF perspective (using a method very similar to yours) to rent than to buy…which is why I always rented in those places! It was more convenient because I didn’t know how long I’d be there. I think there’s probably markets that it’s true, but having friends in cities like Seattle, Chicago, DC…it just seems there are lots of desirable markets where rent vs. buy cash flow has not been breakeven in a long, long, long time.
2) That the cash flow break even bar should be the standard driving what a reasonable person would pay for a home instead of renting …I think this is your point, and my apologies if I’ve misread…but cash flow break even is far from the most important factor for a lot of folks when purchasing a home. Speaking only for myself, when I was ready to really put down roots in a community, and not just ‘live’ somewhere (let’s say having kids had something to do with it and considering their future schooling options), that cash-flow-break-even bar became less important. Forget the obvious differences between a rental home and a home that you ‘own’, like being able to completely customize it to your family’s needs and wants without hassle and approval (i.e. when your child begs to paint her room pink and purple). Stay with me here – but if you want to reduce homeownership vs rent down to dollar and cents, the extra dollars I might pay in monthly cash flow to own a home buy me ALOT of tangible benefits. Care to play hoops with your friends or kids in your own driveway by attaching a basketball net/backboard to your garage? (NOTE: I choose not to live in a newer community with an association that has rules against things like basketball nets but I recognize those restrictions do exist for many). Want to get a dog without asking the landlord or geez, would you have to move just to have the ability to have the darn dog in your own home? Paint Christmas ornaments with the neighborhood kids on the lawn, even if the grass gets a little paint on it ? Value: to you, may be worth nil, to others, could be priceless.
3) In California almost everyone purchasing a house is a speculator, because it is the only real reason anyone overpays for an asset ? C’mon now, that’s rough! By way of background, bought my first house here in 94 and sold it in 98 at breakeven (it went down 25% in the timeframe and then back up and i was happy to get out without a loss). I just wanted to be closer to the beach, so I bought a house where I wanted to live. Moved once more in early 2002 when I needed some more space for a growing family. I consider it a benefit that my house is worth more now than in 2002 (at the moment, but who knows, I’m not counting on it to stay that way), but my home value has never impacted the way I live or my spending habits, so to speak. I don’t trade up to a nicer car, or buy nicer clothes, in an up real estate market, vs. a down real estate market. I know lots of people like me. Not everyone is a speculator. I just think we’re not as ‘noticeable’ as the Jones’s with their new (leased) S-class benz’s in the driveway. Have some faith that there are well grounded homeowners out there.
Keep up the great posts and comments, IR and all you regulars, and I’ll keep reading them!
of course, CPI and the GDP deflator only measure finished goods. but in the long run (your six year figure could legitimately be considered “long run,” right Mr/Ms. Economist?), commodity costs are factored into finished goods.
you still haven’t addressed my main point on tuition. was it too close to home?
Incidentally, the current proposal to freeze subprime teaser rates feels awfully similar to the trend of colleges and universities forgiving student debt.
both situations all but acknowledge the buyers were oversold a good/service.
again, the main point is on tuition.
with respect to cpi, in the long run, the costs of raw materials should influence finished goods, unless there is something else in play — like, maybe, ohhh, exports to developing countries perhaps?
anecdotally, i have close friends who work for a well known hardware manufacturer. they turn raw copper into finished fixtures. they have to pass the increases on to the home depots and lowe’s of the world, which they are successful at doing, but only in the intervals of the contract come up.
any irony in the current trend to forgive student debt and the plan to freeze teaser rates?
IR – great post about the fundamental issue facing the Irvine Company. How do you get the currently renting but income qualified to buy a house when the desperate owners are renting a SFR for $3,000/month with taxes, HOA and Mello Roos included. As your calculations demonstrate the actual cash carrying cost on this same house exceeds $6,000, even with a sizable principal investment.
The interesting half of this question may be understanding what drives property owners to accept a rental rate far below the carrying cost. Is it just the desire to hang on until the property re-appreciates to the level at which they dream of selling? I am continuously amazed by the amount of good houses that are for rent at far less than the ownership cost. Why not just reduce the price to market and sell? I wonder if the IC can find a way to force the issue. As long as these rental properties are available to the high income/high FICO family there is absolutely no reason for this otherwise high potential market segment to buy. 401(k)s and IRA’s are much better investments for the marginal dollar. If maxed out then build a portfolio of equities that can be used to finance simple low risk options strategies.
Now, if the powers that be find a way to get family friendly properties off the rental market then the scenario could change. I am not moving my kids into an apartment.
“The interesting half of this question may be understanding what drives property owners to accept a rental rate far below the carrying cost.”
What choices do they have? The market is what it is. They can ask for rental rates to cover their carrying costs, but they will never get it, so the property will sit vacant. That is the core issue here. Sale prices should never have gotten so high because the rents do not justify them.
Wow, that’s pretty low.
I guess being 94K in the hole is better than being down 100K.
A good portion of the people renting for much less than the ownership carrying costs you see here are owners who have had the property for a while. If they bought the house 2001 or prior, it’s cashflowing quite nicely for them. Their mortgage payment is much less than half of what you get using the “current market” for sale price. Their property taxes are similarly much lower.
Malibu Renter,
To be more precise I only look at properties in the new communities, such as Woodbury which was not in existence in 2001 or sooner. With HOA, property tax and Mello Roos there is no way that the rental payment is covering the carrying cost.
Thanks.
So, if I do the calculation myself, I come up with 70% for the interest portion of the payment. Is this the standard number typically used for the interest portion. I remember doing this kind of calculation a while ago and concluding that the interest portion comes out to about 100% for the first 5 yrs or so. And I have been using this number since then. Sounds like I need to adjust my numbers going forward.
Over the first five years of a 30-amortization schedule, the interest component will be approximately 82% of the amount paid.
Here’s a helpful tool if you have Excel:
http://office.microsoft.com/en-us/templates/TC010197771033.aspx
Great. Thanks. This is very helpful. I’ll start using 82% going forward.
I know that mortgage payment and property taxes are federal tax deductible. How about HOA and Insurance? Are those tax deductible also?
HOA – no. Homeowners insurance – no. For 2007, private mortgage insurance (PMI) became deductible. The deductibility of PMI is set to expire this year but may be extended into 2008.
The Mello Roos portion of a property tax bill is not technically deductible if those taxes are related to amenities, benefits, construction that could or does increase the value of a home. So, let’s say for example you were buying into Columbus Grove at the Village of Columbus. Mello Roos there are $6-7K per year, acounting for perhaps a third of the total property tax bill. Those funds are to pay back the cost of building the streets, sewers, sidewalks, community center probably, etc. The vast majority of that $6-7K is not deductible, although I’m guessing everyone takes them as a deduction on their returns anyway.
ipoplaya,
Again very useful information. Really appreciate it.
So, if I plug the numbers back into IR’s equation and use 82% (for interest portion), I get $905 after tax cost:
($3,826 + $590) * 0.82 * 0.25 = $905.28
To get close to IR’s after tax cost of $830, I had to use 75%:
($3,826 + $590) * 0.75 * 0.25 = $828
Above assumes that property taxes are fully deductible.
If I only deduct half of property taxes, then I get closer to IR’s number using 80%:
($3826 + ($590 / 2)) * 0.8 * 0.25 = $825
My word! That price is insane.