The GRM comparison
Consider the cost of purchasing any type of property compared to renting it. The New York Times’ GRM of 20 times the annual rental value of an SFR is skewed way off target. Using a GRM of 20 will lead potential homebuyers to believe that buying patently overpriced housing is financially rosier than it actually is.
The real cusp of a buy or rent decision historically is a GRM of around 14, if not lower. If a GRM is at or above 14, a tenant may consider buying if he is motivated by pride of ownership or driven by an inculcated dogma to own rather than rent. To make financial sense, a great deal of sweat equity must be continuously invested in a property for a purchase at a GRM of 14 or greater. The owner must keep maintenance costs low enough to break even by matching his after-tax, out-of-pocket costs of ownership against the property’s implicit rental value. [See chart accompanying this article.]
For the owner purchasing a SFR at a GRM of 14 to be able to recover his principal investment on the resale of his property, the price of the property must first increase more than 10% beyond the price he paid just to cover all his purchase and resale costs. This amount of price increase necessarily includes recovery of transactional costs of around 2% of the purchase price incurred to initially buy the property.
Further, the costs of a resale generally run around 8% of the purchase price to pay for broker and escrow fees, and well as and repair costs associated with mitigating deferred maintenance. Often the costs of a resale are far more in an average or strong buyer’s market since sellers must be much more competitive. In these buyer’s market conditions, sellers often pay up to an additional 6% of the price to cover the buyer’s non-recurring and recurring closing costs.
Thus, a property has to appreciate in price by 10% to 15% just to get back the original downpayment and the equity built up by principal reduction on the mortgage, with no return on those amounts. The current outlook for inflation’s future impact on the value of property is comparable to the post-WWII rate of increase which limited annual price increases to consumer price index (CPI) inflation, this time around 2% after prices finally reach their bottom.
A buyer will have to stay in the property for a minimum of six or seven years just to break even on a resale and get his downpayment and principal reduction returned to him. This then leaves him with no net gain from the property with which to consider an upgrade or compensate him for inflation on his invested dollars.
A better rule of thumb exists for setting the approximate price a prudent buyer might pay for a residence when interest rates and private mortgage insurance (PMI) rates are around 6%. A potential homebuyer simply multiplies his gross annual income by five (5X) to calculate the price he most likely can pay for a property (of course he will need to have saved for a downpayment of up to 20% or that ratio is too high).
Further, to determine how much financing he can obtain, he multiplies his gross annual income by four (4X) since the conventional downpayment amount is 20% of the price. These multipliers are like all other multipliers — a rough indication of the dollar amounts involved.
For experienced income property investors, the market value of a SFR is based historically and fundamentally on the monthly rental amount being equal to roughly 1% of the property’s value. This 1% represents a GRM of 8.33, not the GRM of 20 as reported for homebuyers, or the GRM of 14 we have given homebuyers as a comparison. These multipliers represent the likely rental value of a mid-tier SFR property purchased in California.
In all this analysis, do not overlook the evaluation of property based on its cost per square foot replacement value. The lesser of these values is the basis for the maximum price a prudent buyer will pay for property.
Rather than blindly claiming buying is always the right thing to do or that now is always the right time to buy, buyer’s brokers make better advisors when equipped to place their buyer in a home at the right price – which they are duty bound to do. Buyer’s brokers and selling agents who are best able to care for and protect their buyers are those who are aware of the various rent and pricing ratios – the GRM – and replacement costs of SFRs under consideration by buyers: be they investors, speculators, homeowners or tenants who need to be informed whether a home is priced right to buy.
Well… I beg to differ… I have just purchased an investment home in the inland empire. $165000 purchase price, $1550 rental price. The mortgage is 115K at less than 4%, giving me a positive cash flow within 30 days of purchase. I’ve helped several clients buy investment property with similar or better results. They have taken money from the biggest non-performing asset – an interest earning bank account or stock portfolio– and moved it into something tangible with returns of 10-12% per year. And they are just getting started. Ask us in about 15 years how it all worked out…when my rental is fully paid for thanks to my wonderful tenants, still rented out month after month, and giving me $1500-1800 per month in rental income to supplement my retirement. I’d do this all day, every day, if I only could!
I’ll stick with the tried and true path of owing property, letting inflation and appreciation build my value while I slowly but surely build equity through debt pay down.
Your Jerry Springer scare tactics ignore that fact that people have to live somewhere. I have not seen any drops in rental prices, either.