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OC Housing News monthly market report and newsletter provides a clear picture of the health of the housing market. Both buyers and sellers find the information on location, valuation, and price trends, timely and relevant to their decision to buy or sell a home. The OC Housing News report answers the most important questions to buyers and sellers: (1) Where should I look for bargains, (2) Are current prices over or under valued in my area, and (3) what direction are prices headed, up or down in my area? Armed with better information, people make better decisions.
There is too much information about housing floating around the Internet, and most of it is bad. It is easy to take data and create pretty charts and graphs that don't provide any useful information someone might use to make a good decision. The OC Housing News has eliminated the useless information and distilled the market down to three key pieces of information: (1) resale value relative to rent, (2) yearly change in resale prices, and (3) yearly changes in rents.
Rental parity is important because it represents the threshold of affordability. When prices are above rental parity, it costs more to own than to rent, so owning is often not a wise financial decision. On a purely financial basis, paying more than rental parity is generally not wise because prices will inevitably return to this price level in time.
When prices are below rental parity, it costs less to own than to rent, so owning under these circumstances is generally a wise choice. Since a buyer who pays less than rental parity for a house is saving money, there is a clear financial benefit obtained irrespective of fluctuations in resale price.
I strongly favor rental parity as the best measure of valuation. Rental parity ties together income, rent, interest rates, and financing terms in a way that matches the activities of individual buyers to the overall price activity in the market.
Rental parity does not capture the complete picture. Some neighborhoods are very desirable, so move-up buyers take the profits from previous sales and bid up prices, and motivated buyers often stretch to the limit of their borrowing power to acquire homes in these neighborhoods; therefore, the most desirable neighborhoods often carry a premium to rental parity. The inverse is also true. Some neighborhoods are not as desirable, or may contain high concentrations of condos and other first-time homebuyer products. These neighborhoods generally trade at a discount to rental parity.
To value of any asset or market, it’s necessary to establish a standard of measure considered “normal” for the asset. For these calculations, I am using the period from 1993 to 1999 (the last period of stable prices with good available data) to measure the neighborhood premiums and discounts. I adjust the rental parity valuations accordingly to establish the baseline valuation for each neighborhood. When my report shows a neighborhood is overvalued or undervalued, it is not simply measuring against rental parity, it is adjusting for historical differences in valuations those markets typically experience.
Each month I calculate rental parity using aggregate data from the MLS. It requires two data points to make the calculation:
(1) Average rental rate
(2) Current mortgage interest rate on 30-year fixed-rate loans.
I assume a 30-year fixed-rate mortgage.
I take the aggregate rent as a potential loan payment. I calculate the mortgage balance such a payment would service at today's interest rate. The result is the loan component of rental parity. To the loan balance, I add an appropriate down payment. For conventional buyers, the down payment applied is 20%.
Real estate market exhibit strong seasonal patterns and a strong tendency to trend for long periods. The only way to gain an accurate understanding of what's happening in the market is to ignore the month-to-month fluctuations and focus on year-over-year changes.
Further, I prefer to look at data on a per-square-foot basis. The median is too susceptible to fluctuations based on the change of mix to be reliable. Looking at per-square-foot costs provides a more accurate picture of what buyers are obtaining for their money.
Sales prices on a per-square-foot basis reveal much about what people are actually obtaining for their money. Median sales prices reveal what people are spending, but only price per-square-foot reveals the value buyers are getting for their money.
Rental parity is a comparison of the cost of ownership to the cost of rent. Therefore, the direction of rental rates is important to the health of the housing market. Rising rents will eventually put pressure on prices as people will chose to buy to save money. Falling rents will have the opposite effect.
A rating scale from 10 to 1 is intuitively easy to understand, and it provides enough gradation to capture the subtle differences between markets under varying market conditions.
The rating system provides an accurate and unbiased method of evaluating the market. It is purely mechanical and uses the three key variables I tract: valuation, resale price change, and rental price change. By far the most important of these variables is valuation.
The valuation rating is the most important, and most volatile, measure in the rating system, mostly because house prices are so volatile. The rating system ignores any market within 7% up or down from its historic norms. The concept is simple: negotiation skills and motivations of the parties involved introduces at least 7% potential variability in resale pricing, so a market within 7% up or down of rental parity is within the margin of typical variability. For each increment of 7%, the rating is either increased or decreased by one.
Most homebuyers look at short-term changes in house price and extrapolate those gains forever. Resale price change is exactly the wrong reason to buy a house. In my rating system, resale price momentum is given the least weight of the three factors, and I only look at year-over-year changes rather than the monthly noise subject to seasonal variations.
When rating the rate of price change, I have four categories:
(1) greater than 7% = 2,
(2) between 2% and 7% = 3,
(3) between 2% and -5% = 1, and
(4) less than -5% = 0.
A stable rate of appreciation is between 2% and 7%, and markets in this range get three rating points. This provides some room for minor fluctuations and recognizes that slow, sustained price increases are a normal function of healthy real estate markets.
Prices rising more than 7% per year are not sustainable. Rather than being considered a good thing, this receives two rating points rather than three. Most people see 7% per year appreciation and get excited. Most often, this means they are buying into a frenzy and overpaying.
Prices that are either rising slowly or falling slowly (between 2% and -5%) represent a weak market and receive one rating point.
Next to valuation, momentum in rents is the most important determinant of good timing in a real estate market.
Rents are the basis of all value. Falling rents are a huge detriment to a housing market. In a market with falling rents, it makes little sense to buy and lock in a fixed cost of ownership unless the discount is very attractive.
When rating the year-over-year rate of rental rate change, I have five categories:
(1) greater than 7% = 3,
(2) between 2% and 7% = 4,
(3) between 2% and 0% = 2,
(4) between 0% and -2% = 1,
(5) less than -2% = 0.
Note that all rental ratings are generally higher than resale price momentum ratings. This recognizes their greater relative importance.
Similar to resale price momentum, rental rates increasing between 2% and 7% are normal and sustainable yielding a rating of four. This provides room for minor fluctuations. Rents increasing more than 7% per year are not sustainable and the rating drops to a three. Rising rents are always better than falling rents, so increases between 0% and 2% are given two ratings points. Slowly falling rents, ranging from 0% to -2%, are given one point, and rents falling more than 2% per year are given no points.