The rent an improved property can command is fundamental to the setting of that property’s value, called fair market value. For valuation purposes, rent is analyzed as being either the gross scheduled rents or the net operating income (NOI) remaining after deducting operating expenses from rents actually received. This process is called the income approach to property value. The income approach has historically set the ceiling for the price a buyer will pay and a mortgage lender will lend on a property, unless either the current cost to replace the property or the price to acquire comparable existing properties is less than the NOI, in which case those conditions set the ceiling price.
The value of rent generated by a property is converted into that property’s fair market value by applying an appropriate real estate capitalization rate to the NOI remaining from the property’s rents. Capitalization rates used for businesses are conceptually and economically inappropriate for application to real estate investments. Nevertheless, they have been erroneously applied to rents and mortgages during the past several years by Wall Street money managers in schemes such as real estate investment trusts (REITs) and adjustable rate mortgages (ARMs).
The rule of thumb for a quick calculation of an income property’s value has always been to multiply the monthly scheduled rent by 100. It can otherwise be calculated by multiplying the scheduled annual income by eight. These rules are applied to see if the price asked for a property is reasonably related to the property’s likely value, before contracting to buy or entering into a due diligence investigation. Since 1999, income property values have defied any such close analysis with prices artificially soaring to nearly 200 times monthly rents. The return to reality will be brutal, especially for REITs.
Rent is the price paid for the occupancy and use of space, whether the user/occupant is a tenant or an owner. A tenant pays “actual rent,” while an owner occupying his property is charged with “implicit rent.” Implicit rent is the actual rent the owner is foregoing, an amount equivalent to the rent a tenant would pay for the space. Implicit rent is the dollar amount of the value the owner is receiving by occupying the space himself, be it a residential or trade or business use.
Further, tenants set rents, not landlords. As wages paid local employees rise, rents rise through the basic function of supply and demand since the employee has more money to spend. Wage earners can afford to pay up to 38% of their income for shelter – in the tenant’s case, as rent to a landlord; in the owner’s case, as principal and interest to a mortgage lender. Also, when tenants buy property to own and occupy, and do so at a faster pace than the arrival of replacement tenants, they drive down rents.
Landlords can only watch and respond. Lowering rents to attract tenants initially cannibalizes tenants from other rental properties, a zero-sum game. Eventually the local population increases to fill up vacant units and inventories of unsold properties, or long-term mortgage rates rise and remain there for sufficient time to drive wage earners and businessmen toward rental properties and away from ownership.
Should availability of all types of housing and nonresidential properties run short of the need for space by the local population, landlords will then be able to raise rents beyond 31% to 38% of a wage earners’ income, properly called appreciation in value. This move will bring landlords excess profits, but only for a limited time. Soon the excess earnings will spur the ruinous competition of builders. When rents are high enough, valuations based on rents then justify the cost of new construction, empowers investors to convert excess hotel space into condos as was seen in the early ’90s, and sparks tenant-orchestrated rent control ordinances as occurred in the early ’80s.
Rent is the economic equivalent of long-term interest rates charged by mortgage lenders. Both are a return on the letting of an asset; one being real estate, the other cash. Both by agreement are to be returned. Thus, rent is in direct competitionwith the interest paid on fixed rate mortgage (FRM) loans which lenders make to tenants who wish to buy and occupy comparable space as the owner, leaving vacant rental space behind. Builders, mortgage lenders, and sales agents strive daily to convert tenants into owners, and their goal has been sold to Congress as good for the country (but not very good for Freddie Mac and Fannie Mae and the other third of the mortgage market).
The coupling of rent and mortgage payments as competitors for the dollars a user of property can spend on that occupancy is straightforward: a landlord expects a credit-worthy tenant to pay a rent amount no greater than 31% to 38% of the tenant’s gross income; likewise, a mortgage lender expects a credit-worthy owner/occupant to pay monthly interest (and a de minimis amount of principal) on a maximum FRM loan equal to 31% to 38% of his gross income. These are identical standards for the monthly out-of-pocket cost of occupancy; one applied to wage earners by landlords, the other applied to wage earners by mortgage lenders.
Thus, rents tend to rise or fall in sympathy with the rise or fall of long-term interest rates such as the 10- to 30-year Treasuries, not short-term rates which are applied to consumer loans and ARMs.
A further complication for rent stability during a recession is the falling price of properties. When property prices fall, the amount of the drop in the monthly interest payment on a purchase-assist loan is the same percentage drop in the loan amount needed to finance ownership. When prices drop enough, tenants benefit by becoming owners, since the mortgage payment on a maximally FHA-insured FRM loan is lower than the rent he is now paying for space. This condition will occur at some point in time during this recession, if it has not already occurred.
When the crossover from rent to mortgage payments does occur, tens of thousands of Californians will want to shift from tenants to owners, since the cost of ownership exemplified in mortgage payments will have fallen below the rent paid for comparable space. Only then will the real estate market reveal whether we have learned our lesson from the current real estate market bust.
Several other factors influence the future trend in rents. These factors include local changes in population density, foreclosure rates, vacant SFRs and condos, property values, wages, employment, migration/immigration, social mores, rent control, rental age of the population, and household formations.