The Housing Chronicles Blog: Cost to Own vs. Rent

Friday, January 4, 2008

Cost to Own vs. Rent

One key reason that many speculators can't make their payments is because they assumed they could cover unknown months of negative cash flow since prices would continue going up, allowing them to refinance into a fixed-rate mortgage and eventually pay themselves back.

Considered less important at the time was what these same homes could command in rents, and whether it would be enough (or close enough) to cover mortgage, insurance, taxes and HOA fees, if any. A simple rule of thumb used by most long-term income property investors is to ensure that rents not only cover these costs, but also allow for the occasional vacancy as well as continuous maintenance; that way they can count on a nice nest egg once the mortgage is paid off without having to worry about the vagaries of the stock market, 401k balances and whether or not Social Security will still be solvent when they retire.

According to a story in the Wall Street Journal, between 1960 and 1995 rents averaged 5% to 5.25% of home purchase prices, but fell to less than 3.60% in mid 2007, or about one-third below the long-term average.

So what does this mean for future values? From the article:

To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade.

Of course, the link between house prices and rents can remain out of whack for years.

The U.S. study is by Morris Davis, an economist at the University of Wisconsin-Madison and until 2006 a staff economist at the Fed; and Andreas Lehnert and Robert F. Martin, staff economists at the Fed...

In an interview, Mr. Davis said lower long-term interest rates can explain only a small part of the drop in the ratio. "To justify current price levels, you need rapid growth in rents." But it's hard to imagine the scenario that would justify such rapid growth in rents, he added. Indeed, it's possible rents will grow more slowly than 4%, reflecting the overhang of unsold homes that might be rented out.

Mr. Davis said the authors postulated a five-year horizon for the rent/price ratio to return to normal by looking at previous downturns. "When a downturn begins, it will last for a while."

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