Housing Market Reports Understanding and interpreting OCHN monthly housing market reports HOUSING MARKET FORECAST
Housing Market
Reports
Understanding and interpreting OCHN
monthly housing market reports
HOUSING MARKET FORECAST
Housing Market Reports
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OC Housing News Monthly Market Report ..................................................................................................................... 3 Using the OCHN Monthly Report ........................................................................................................................................ 3 Interpreting an OCHN Monthly Market Report ............................................................................................................ 4
News Overview .......................................................................................................................................................................................... 4 Median Home Price and Rental Parity Trailing Twelve Months .......................................................................................... 4 Resale $/SF and Year-‐Over-‐Year Percentage Change Trailing Twelve Months ............................................................ 6 Rental Rate and Year-‐Over-‐Year Percentage Change Trailing Twelve Months ............................................................. 7 Historic Market Data Charts ................................................................................................................................................................ 8 Percentage Change Charts ................................................................................................................................................................. 10 Historic Valuation .................................................................................................................................................................................. 12 OCHN Rating System Chart ............................................................................................................................................................... 13 Investor Analysis ................................................................................................................................................................................... 14 Market Performance and Trends Table ....................................................................................................................................... 15 Market Timing Rating and Valuations Table ............................................................................................................................. 17
The importance of rental parity ..................................................................................................................................... 18 Rental Parity as basis of value ......................................................................................................................................................... 18
Premiums or discounts to rental parity .......................................................................................................... 19 Benchmark value of stable market .................................................................................................................... 19
How rental parity is calculated ........................................................................................................................................................ 20 Conventional financing ........................................................................................................................................... 20
Year-‐over-‐year percentage change ................................................................................................................................................ 21 Per-‐Square-‐Foot Basis ............................................................................................................................................. 21 Sales prices on a per-‐square-‐foot basis ........................................................................................................... 21 Rents on a per-‐square-‐foot basis ........................................................................................................................ 22
OCHN Rating .......................................................................................................................................................................... 22 System Criteria ....................................................................................................................................................................................... 22
Valuation rating ......................................................................................................................................................... 23 Resale momentum rating ....................................................................................................................................... 23 Rental momentum rating ....................................................................................................................................... 24 What would a typical market look like? .......................................................................................................... 26 What would be a perfect world? ......................................................................................................................... 26
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OC Housing News Monthly Market Report
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.
For those who are very technical and analytical, the information on the theory and the calculations behind the
report, the later sections of this work starting with The importance of rental parity on page 18, provides more
detail. For those more interested in using this information to find a home, keep reading.
Using the OCHN Monthly Report
When most people are considering renting or buying a home, they already have narrowed their choices for
location. Most want to be near work, but they may also want to be near family, friends, or a particular school
district. The table of contents on the front page of the OCHN monthly report organizes the reports by county so
people can narrow their search to the area they are most interested in. I suggest searchers start with the overview
of the county as this provides important data on the broader real estate market.
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Interpreting an OCHN Monthly Market Report
The first page of a county report breaks down into four parts: The news overview, Median Home Price and Rental
Parity trailing twelve months, Resale $/SF and year-‐over-‐year percentage change trailing twelve months, Rental
rate and year-‐over-‐year percentage change trailing twelve months.
NEWS OVERVIEW
The news overview provides concise descriptions of the facts and conditions in the market. It states whether the
market trades at a premium or a discount to rental parity and provides a measure of it. A market trading at a
premium to rental parity is more desirable, so buyers are willing to pay more than rental parity to live there. A
market trading at a discount is less desirable, and people must be motivated to live there by saving versus renting.
The news overview measures the current premium or discount, compares it to the historic premium or discount,
and states whether the market is currently overvalued or undervalued. This is an important measure of future
financial performance.
MEDIAN HOME PRICE AND RENTAL PARITY TRAILING TWELVE MONTHS
For those who want the bottom line without all the analysis and detail, the market rating is the first row of the first
section of data. The rating encapsulates all the conditions of the market into one figure. For more information on
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how this is calculated, see OCHN Rating on page 22. Suffice to say that a rating of 10 is good and a rating of 1 is
bad. Buyers can rest assured that a highly rated property or market is a good financial buy.
The chart displays three lines that reveal much about the market. The first two lines to note are the parallel green
and orange lines, rental parity (green) and historic value (orange). As mentioned previously, some markets trade at
a discount and some at a premium to rental parity. If the orange line (historic value) is above the green line (rental
parity), the market is a premium market. If the orange line (historic value) is below the green line (rental parity),
the market is a discount market. The larger the gap, the greater the premium or discount is.
The third line plotted against these two parallel lines is the median resale price for the area. This line reveals
whether the market is currently trading at a premium or discount to rental parity and historic value. The more
important of these relationships is between median resale price and historic value. Over time, the market has
shown a tendency toward trading at historic value. If it trades above for a while, over time it will revert back to this
value. That may happen either by an extended period of little or no appreciation or an outright decline in prices. If
the market trades below its historic value, it’s likely to see a rebound back to this value in the future. The best
markets are those trading at a steep discount to its historic value.
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RESALE $/SF AND YEAR-‐OVER-‐YEAR PERCENTAGE CHANGE TRAILING TWELVE MONTHS
Since the historic value is so important, the first column in next section displays the premium or discount from
historic value over the last year. The second column and the chart shows the dollars-‐per-‐square-‐foot resale price in
the market. The line on the chart visually shows the general direction of prices, and the third column shows the
actual percentage change.
It’s important to note that the percentage change in resale prices can be misleading. Most buyers foolishly
extrapolate short-‐term movements in market prices will continue forever, motivating them to buy at what is often
the worst possible time. In reality, buying in a declining market when valuations are low is generally the best time
to buy because sellers are motivated and supply is abundant. Buying in an appreciating market may not be wise,
particularly if valuation signals a bubble. In short, valuation is much more important that price movement.
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RENTAL RATE AND YEAR-‐OVER-‐YEAR PERCENTAGE CHANGE TRAILING TWELVE MONTHS
The final table and chart on the page is similar to the first grouping; it displays three lines, two of which are parallel
and show current rent and the historic cost of ownership relative to rent, and the third line is the current cost of
ownership. The relationships are similar, the charts will look similar, and the interpretations are the same.
This method of looking at the data is more revealing to those who like to focus on monthly costs rather than
purchase price. It reveals how affordable properties are relative to monthly rent, which is what rental parity
analysis is all about. The first column of data shows the rate of rent growth over the last year, and the next two
columns show the cost of renting and the cost of owning during the same period.
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HISTORIC MARKET DATA CHARTS
The next page of the report shows two charts: County median home price since January 1988, and County median
rent and monthly cost of ownership since January 1988. These charts are designed to put current circumstances in
historic context. They answer questions like, “How volatile are prices?” and “How does today’s pricing compare to
the fluctuations of the past?” and “How much danger is there in buying today?”
The chart above displays LA County through early 2014, but the pattern is similar across California. With the green
line for rental parity and the orange line for historic value, it’s easy to tell when the market is fairly valued, over
valued, or under valued.
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The chart above shows rent and monthly cost of ownership. It looks similar to the rental parity and resale home
price chart, as it merely converts that information to a monthly format. For those who have difficulty relating to
the large numbers of purchase price, viewing the data in terms of monthly expenses is easier to put into context.
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PERCENTAGE CHANGE CHARTS
The follow page in the report contains two more charts displaying historic information. This time, the data shows
percentage changes over time. This is important because many people believe more is always better. That’s not
the case. When house prices or rents go up quickly, it’s often a sign of some underlying distortion in the market,
and buyers should be cautious. As mentioned previously, most people erroneously extrapolate recent past price
behavior as a permanent trend, motivating them to buy at the worst possible time – as many who purchased in
2004 and 2005 found out painfully.
Throughout 2013, house prices rose very rapidly causing some analysts to proclaim a new housing bubble. Though
such price action is certainly a cause for concern, it must be placed in context; prices rose from an extremely
undervalued condition. The price rally was abrupt, but it does not represent a new bubble until valuations soar
above historic norms.
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When prices go up very quickly and rents do not, affordability plummets, like it did in 2013. When both go up
together, it may be a sign of an overheating economy, and when both go down together, it’s a sign of a weak
economy.
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HISTORIC VALUATION
The next page in the report shows two charts: Historic Median Home Price Relative to Rental Parity: County since
January 1988, and OCHN Market Timing System Rating: Los Angeles County since January 1988.
The chart above shows, at a glance, how close the market trades to its historic norm. The benchmark period is
shown in green, and the degree of market volatility can be inferred from the scale to the left. For example, LA
County traded for as much as 42% below rental parity and 84% above it during the 26-‐year period shown. Needless
to say, that is very volatile, and people who bought during the overvalued periods endured painful price
corrections when their houses were worth far less than they paid.
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OCHN RATING SYSTEM CHART
The market timing rating system mechanically identifies both good and buy dimes to buy based on valuation,
resale price change, and rental rate change. Since 1988, in LA County, it was wrong in its recommendation in only a
single two-‐year period from late 1999 to mid 2001 as the local economy tipped into a recession. The system
correctly identified the housing bubbles from the late 80s and the mid 00s as well as the buying opportunities in
the mid 90s and early 10s.
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INVESTOR ANALYSIS
The final page of the county market analysis contains two charts focusing on investment opportunities: Cash
Investor Capitalization Rate: County since January 1988, and Financed Investor Cash-‐on-‐Cash Return: County since
January 1988. This page can be ignored by family home shoppers.
The chart on capitalization rate (shown above) displays the mortgage interest rate (yellow) and the capitalization
rate (purple). The capitalization rate is the net rent divided by the purchase price. It goes up when rents go up or
house prices go down; and it goes down when rents go down or house prices go up. Most of the volatility in
capitalization rate is caused by changing home prices.
When the capitalization rate is greater than the mortgage interest rate, properties become cashflow positive to
financed investors. This usually brings many buyers to the market and helps a housing market stabilize after a price
crash.
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The cash-‐on-‐cash return for financed investors is based on the relationship between capitalization rate and
mortgage interest rates. The cash-‐on-‐cash return is positive when the capitalization rate is greater than the
mortgage interest rate and visa versa.
MARKET PERFORMANCE AND TRENDS TABLE
The market performance trends table provides a tabular summary of the current market conditions by city and zip
within the county. It displays the same performance metrics detailed in previous sections including: median resale
price, resale percentage change year-‐over-‐year, resale dollars-‐per-‐square-‐foot, rent percentage change year-‐over-‐
year, median rent, monthly cost of ownership, the ownership premium or discount based on rent, and the
capitalization rate. For how to interpret these numbers see previous sections for more detail.
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To use these tables effectively, users should have a short list of potential cities they would consider living in. These
tables allow the user to search alphabetically for city data. It’s suggested to consult both the city data and the zip
code data that often provides more detail, particularly in larger cities that may have significant neighborhood
variability. For example, in Canyon Country, the two zip codes demonstrate that 91387 is more desirable than
91351 because the former costs more to own than to rent whereas the later costs more to rent than to own.
By compiling and comparing data from the various cities in a users search area, they can determine how much they
would have to spend to either own or rent in each area, suggesting how desirable and affordable each area is. This
will also allow users to eliminate areas they may not be able to afford.
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MARKET TIMING RATING AND VALUATIONS TABLE
The next table shows the ratings and valuations for each city and zip within the county. This information is most
valuable for those hunting for bargain properties or fearful of overpaying in an overvalued market.
In the example above Artesia is a prime market for buying a home. The market usually trades at a 12.9% premium
to rental parity, but at the time of this report, it was trading at a 16.9% discount, making it 29.6% undervalued! A
buyer in this market should experience above average appreciation as the market rebounds to its historic norm.
This table helps buyers spot those markets where the best deals are to be found. Helping buyers target their
search to where deals are best is the primary value of this report.
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The importance of rental parity
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. Owning may still be right for
people, and many are willing to pay the premium to own to obtain the emotional benefits of ownership; however,
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.
When the cost of ownership is less than rental parity, an owner is far less likely to be forced to sell at a loss. The
property can always be rented to cover costs rather than sell for a loss. Further, this ability to rent and at least
break even provides the owner with flexibility to move if necessary. Mobility to take a new job or buy a different
house is denied to those who overpaid and who are stuck paying more in the cost of ownership than they can
obtain in rent.
With these advantages, buying at a price below rental parity using fixed-‐rate financing is critical. Every buyer
should consider rental parity in their buying decision.
RENTAL PARITY AS BASIS OF VALUE
Valuation is the least understood, yet most important, aspect of a housing market. Economists look at various
ratios including price-‐to-‐income, price-‐to-‐rent, and other aggregate measures to attempt to establish valuation
metrics. Each of these has strengths and weaknesses, but each of them fails because they don’t directly connect
the actions of an individual buyer to the activity in the broader market. For this reason, I strongly favor rental
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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.
Premiums or discounts to rental parity
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.
Benchmark value of stable market
To value of any asset or market, it’s necessary to establish a standard of measure considered “normal” for the
asset. To achieve this end, historic data must be obtained and analyzed to establish a period of time within the
specified geographic area when the asset was considered fairly valued under normal market conditions.
Real estate markets generally exhibit long periods of stability and normalcy; however, there have been a number
of distortions to market value over the last forty years. It is imperative for accuracy to identify and exclude periods
when the data is distorted and does not represent a normal condition. There were a real estate bubbles in
California from 1976 to 1982, from 1987 to 1992, and from 2003 to 2009. Further, from 2010 to 2013 prices were
undervalued as prices crashed below stable levels.
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.
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House prices typically rise about 3.5% per year to match wage inflation. If someone pays 10% more than rental
parity, they must wait 3 years for appreciation to catch up with their purchase price. Overpaying may not cost
them nominal dollars, but it may cost them time, which is costly when considering inflation-‐adjusted dollars.
Underpaying is also a significant advantage because this creates an opportunity for rebound appreciation back to
historic norms. Valuation is critical in identifying the best opportunities for financial gain.
HOW RENTAL PARITY IS CALCULATED
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. It's the only mortgage product that provides sufficient payment stability to
ensure the property will always be affordable. The payment is generally about 6% smaller than the actual cost of
ownership. The cost of ownership usually includes other costs like HOA dues, Mello Roos, maintenance expenses,
and insurance. These costs erode the buying power of the rental payment. There are offsets with tax breaks and
loan amortization, but generally, the cost of ownership is bigger than the payment.
Conventional financing
There are two assumptions which change depending on the type of financing used. A buyer using conventional
financing does not pay private mortgage insurance or FHA insurance premiums. This means the cost of ownership
is much closer to the actual payment. Or looked at another way, the rent which would be applied to the payment
would be higher. When I make these calculations, I assume 94% of the rent could go toward making a loan
payment. In areas with no HOAs or Mello Roos (like today's featured property) that assumption is too low, but in
areas where the HOA and Mello Roos is high, the assumption is too high.
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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%.
YEAR-‐OVER-‐YEAR PERCENTAGE CHANGE
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. The financial media often shows the monthly changes that fluctuate wildly.
This information is often useless or outright misleading as to the real direction of prices. These fluctuations make
for interesting headlines, but they don't provide any meaningful information to help buyers or sellers make an
informed decision.
Per-‐Square-‐Foot Basis
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. When prices are volatile, the mix of sales may change causing wild swings in the
median sales price which is not representative of the prices of individual properties in the market. Looking at per-‐
square-‐foot data eliminates much of the data distortion caused by a change in sales mix.
Sales prices on a per-‐square-‐foot basis
Sales prices on a per-‐square-‐foot basis reveal much about what people are actually obtaining for their money. If
buyers in a market are able to pay $500,000 for properties, the median may stay at $500,000, but if high-‐end
properties are competing for buyers, they may be lowering their prices to attract buyers. When these buyers
purchase, they still spend $500,000, but they get a better home for the money. Median sales prices reveal what
people are spending, but only price per-‐square-‐foot reveals the value buyers are getting for their money.
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Rents on a per-‐square-‐foot basis
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. If prices are rising and rents are falling, a
bubble is forming. If rents are rising and prices are falling, a bottom is forming.
If you know the value relative to rental parity, the yearly resale price momentum, and the yearly change in rents,
you can evaluate the risk of short-‐term and long-‐term price declines. This is valuable information for making an
informed decision regarding buying or selling real estate.
OCHN Rating
When I first contemplated a rating system, I considered an A to F grading system like the HELOC abuse grading
system. As I worked this this system, I found the nuances were lost with only five potential grades. The next most
logical choice was a rating scale from 10 to 1. It’s intuitively easy to understand, and it provides enough gradation
to capture the subtle differences between markets under varying market conditions.
SYSTEM CRITERIA
When considering the financial implications of buying a home, the non-‐kool-‐aid intoxicated want to know if now is
a good time and if the location they are considering is a good buy. The rating system provides an accurate and
unbiased method of evaluating the market. It is purely mechanical and ignores the narrative spun by market
pundits. At times this narrative is important, such as in 2009 and 2010 when the artificial market props delivered a
false buy signal, but much of the time the narrative is better off ignored because it is polluted by the manipulations
of realtors.
I wanted the system to produce results consistent with my view of the housing market. It should have said not to
buy during the bubble, but it should have given positive signals beforehand. A permanently bearish system is as
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useless as the realtor’s permanently bullish ones. The system should produce relatively consistent results from
month to month with few abrupt changes. Housing markets don’t change quickly, so the results should not be so
volatile as to suggest buying one month and catastrophe the next.
The system also needed to respond to the relative importance of changes in the market. The system 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. It is also the least understood and most widely ignored fundamental by most homebuyers.
Valuation rating
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 6% 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. For example, a market
that is between 35% and 42% undervalued would score 5 valuation points. And markets overvalued by 35% to 42%
would lose 5 valuation points.
This point system based on 7% increments makes the system very sensitive to changes in valuation, and it does
reflect the real-‐world. People who bought at inflated prices even as early as 2003 when prices were about 14%
overvalued are living in properties currently trading at what they paid nine years later. Overpaying, even by small
amounts, is nearly always a bad financial decision.
Resale momentum rating
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.
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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. Some might argue that falling prices should not receive any points, but markets with gently falling
prices often have more motivated sellers and better bargains on individual properties. Such markets should not be
shunned just because prices are falling. Bargains can be found. However, the same is not true of markets where
prices are falling more steeply.
Real estate markets typically display strong price momentum, a market falling in price by more than 5% per year is
likely to continue to fall for the foreseeable future. Such markets may present good opportunities today, but the
opportunities will be even better tomorrow. For that reason, these markets score no rating points.
Rental momentum rating
Next to valuation, momentum in rents is the most important determinant of good timing in a real estate market.
Shevy recently closed a sale with a client employed by a major bond trading company in Orange County. When
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asked why he was buying now, he stated that with rising rents, locking in a stable cost of ownership with fixed-‐rate
financing was going to provide him a return on his investment irrespective of any changes in resale price. This was
not a man looking to sell for a profit on appreciation, although he did believe appreciation was due to follow in
time. He recognized the importance of avoiding the rising cost of housing by locking in his housing costs. This is a
valid reason to buy a home — assuming the buyer doesn’t overpay and negate the savings.
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. For
example, if a tenant is paying $2,000 per month in rent, but he thinks he could negotiate a $200 price reduction,
why would this person be motivated to lock in a $2,000 cost of ownership to buy a house? There is money to be
saved by renting, and in all likelihood, resale prices of houses will fall to match the new level of rents.
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.
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What would a typical market look like?
I write often about what a typical or healthy market would look like. Based on this rating system, such a market
would score 7 out of 10 points. It would have resale prices and rents rising between 2% and 7% scoring three
points and four points respectively. Since it would be trading at rental parity, it would receive no valuation points.
For a market to get a boost from valuation points, it needs to be trading at a discount of more than 6% from its
historic norms. To get points subtracted, it needs to be selling at valuations more than 6% higher. At the peak in
Irvine, the market was 65% overvalued in August of 2006. During much of the bubble rally, the rating system gave
five to seven points for increases in resale prices and rents, then routinely subtracted those points and then some
for excessive valuations — which is what a good market rating system should have done during this period. In the
bear rally of 2009-‐2010, the degree of market inflation was less, but declining rents and declining prices resulted in
no points scored. The system would have largely avoided the bear rally. By mid 2011 with falling prices, falling
interest rates and rising rents the system began to give markets favorable ratings. It turned bullish about 6 months
before the housing bottom.
What would be a perfect world?
So what market conditions would give ratings of eight, nine, or ten? It takes some combination of low valuations,
rising rents and rising prices. When prices were still falling, many markets rated high because relative valuations
became very low. In other words, it was so inexpensive relative to historic norms, the price discount negated the
effect of falling prices. In my opinion, that’s how it should be. That’s how a bottom forms. Value buyers purchase
and reverse the downward price momentum.
This system is not perfect. I will undoubtedly revise it over time. Further, it is not without its own drawbacks. Right
now rental parity is relatively high because interest rates are so low. Will rising interest rates cause house prices to
crash? I don’t know, but it is certainly a possibility. And what about the potential for future REOs? Won’t that
impact market pricing? Probably. That’s part of the narrative worth paying attention to.
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No strictly mechanical system can capture the unusual circumstances surrounding any financial market. Right now,
the math says it’s a good time to buy in many cities around Southern California, and many buyers are active. Will
those buyers come to regret their decision? If they are locking in a cost of ownership less than rents, and if they
have a long holding time, I don’t think they will.