Do you apply the price-to-rent ratio (GRM) in any way when considering real estate pricing?
- Yes (49%, 20 Votes)
- No (32%, 13 Votes)
- I was unaware of the GRM method of pricing. (20%, 8 Votes)
Total Voters: 41
This article examines various methods for determining residential real estate’s “fair” price and argues for a mean pricing model when establishing the value of a parcel of real estate.
Is residential real estate undervalued today?
Nationally, residential real estate in the U.S. appears to be undervalued by 19%, according to a recent analysis of global real estate values by The Economist.
Some international real estate markets hit by the global financial crisis have recovered, even exceeded historical equilibrium pricing. However, the value of real estate – specifically homes – in the U.S. has continued to fall far below fair market value (FMV), according to The Economist.
The Economist defines the FMV as:
- the historical measure of the price-to-income ratio, a personal income multiplier used to set the price one can pay for a home; and
- the price-to-rents ratio, a gross revenue/rents multiplier (GRM) that is comparable to the price-to-earnings (P/E) ratio used to measure the value of publicly traded stocks.
Median incomes and median price for the nation were used to arrive at their conclusion, figures that apply to no particular person or property, half being above and half below the figure.
Understanding fair market value
What The Economist refers to as FMV is in stark contrast to how the term is used in the U.S. real estate market. In the U.S., FMV is determined by using the price of comparable properties (comps) as the primary metric to measure a property’s value, together with controls such as current replacement cost and the property’s market rental rate. FMV in this scenario is a unique snapshot, in one moment of time, used to set a reasonable asking or offer price (among other things) for a given property listed for sale.
In contrast, The Economist’s use of the term “fair value” refers to the mean price, and thus acts as an indicator of what real estate prices ought to be on a historical price trendline. The ensuing discussion shows how this is both similar and different from first tuesday’s approach to judging the historical equilibrium price — the mean price — for real estate.
California residential real estate remains overvalued
Although the current snapshot of housing prices in the U.S. may be gloomy for sellers, the horizon is decidedly sunnier. Job creation is steady if still quite weak, and home sales volume nationwide seems to have stabilized with sales volume rising slowly but consistently for nearly a year.
Further, as rents continue to rise, the scales will eventually tip more favorably in the direction of homeownership to satisfy the public’s demand for housing — that is, shelter.
By our mean price calculations, the California housing market remains overvalued in all three pricing tiers by 10-15%, some 30% higher than The Economist’s estimates of housing values nationwide (they do not separately judge California, though we are the seventh largest economy in the world, at the level of Italy and Brazil).
If The Economist is right about widespread under-pricing across our nation, and if their pricing methodology applies to California home pricing, buyers are in for a shock. Prices will not continue to drop but will soon rise to correct the undervaluation in current pricing as expressed by The Economist, when user demand for homeownership picks up. Buyers, they feel, can and will pay more for a property if the sellers collectively will just hold out.
This pricing scenario is unlikely to happen for several years, well into 2017. The reason is buried in market volume facts:
- monthly sales volume of around 35,000 is half of the pace in the hot year 2005;
- 60% of today’s sales are to users, those homebuyers that actually occupy the stuff; and
- 40% are speculators who temporarily remove from the marketplace the homes they purchase, to be re-listed and sold to a user/homebuyer when prices rise. Expectations for this price increase vary from six months to two years.
Thus, today’s demand for homes as shelter is disastrously low, a lousy 20,000 to 25,000 homes monthly in California. Speculators assuming (at too high a price) the seller’s risk of locating an actual user in the form of a homebuyer are all that is keeping home prices from falling to and below the mean price level.
That low point in pricing must be reached before homeownership demand will automatically return, eventually driving sales volume up, then prices. Inventories of homes must swell dramatically before any of that will happen.
Prices are local
The obvious disparity between our mean price calculations and their FMV has to do with several factors. Foremost, the difference lies in the fact our mean pricing is limited to California real estate. Further, we separately review the low-, mid- and high-tier valued homes. The Economist looks at a nationwide singular median price for all homes sold, covering with one price the range from dirt-cheap to mega-priced housing. This is problematic since real estate is profoundly local and median pricing has been intellectually discredited as a measure for accurately determining the value of any property in any market.
When looking for pricing trends, whether they are based on a personal income ratio, a GRM or the historical mean pricing trend based on Consumer Price Index (CPI) figures, the numbers only compute when considering specific markets and then only when applied within each price tier — state, county or even neighborhood calculations being the most accurate.
The affordability factor
Aside from the geographic and price-tier differences between our calculations, the metrics vary widely as well. The Economist relies heavily on the price-to-personal income ratio to determine “fair value” of a property. This is erroneous. This ratio has always been considered a measure for setting the amount of a loan or the price for property a buyer has the ability to pay, not a way to determine a property’s value.
As an aside, when looking at the oft-used but unusable concept of affordability, the typical model determines what percentage of the population in a local market can afford to purchase a median-priced home. This is achieved by comparing the median property price to the median income in the same market region. Meaningless for all but the one person at the median income spot who just happens to also be buying that one home at the median price spot.
A better approach is based on locating a property with pricing at an 80% loan-to-value ratio (LTV) for a mortgage amount with monthly payments at roughly 31% of a buyer’s monthly gross income. Thus, each and every potential homebuyer is considered to be able to “afford” any property priced at an 80% LTV ratio for the mortgage amount they qualify to borrow. This does not mean that any property is priced fairly; it simply means the buyer can qualify to finance whatever property they might agree to purchase for that price.
Affordability is a concept we prefer to keep our distance from, especially when discussing equilibrium pricing. Setting a specific property’s price is a separate and unrelated analysis from setting a homebuyer’s maximum limit in a mortgage or price he is qualified to pay. Affordability is an abstract notion depending on many variables that are notoriously difficult to pin down. Worse, it uses the mathematical abstraction of the non-existent “median priced home” and worse yet, median incomes to set affordability indexes, all meaning nothing to you or your buyer.
Wealth, both liquid and illiquid, comes into play, as does the crucial parallel issue of financing a property. The cost of borrowing and availability of credit is key to whether or not one’s income qualifies them, and thus determines the home they can “afford” when sufficient wealth has not been accumulated to pay cash (the typical scenario for most low- and mid-tier buyers).
Also at issue is the amount of financing available at different rates for different credit scores, and whether the LTV requires default insurance premiums (an additional annual rate of 1.1% which reduces the amount one can borrow). All this is settled by a lender preapproval commitment setting the amount the buyer can borrow.
The GRM — use initially with caution
Comparing the price-to-rent ratio of homes by way of a GRM is potentially a very informative means to initially approximate a property’s fair value — stated in plain words: a property’s proper price.
Price-to-rent ratios (GRMs) compare two numbers existing in the marketplace. Both numbers are hard data gleaned from rent tenants are actually paying for their shelter and prices sellers are asking for their properties. This provides a solid baseline for what people are paying for two competing goods (renting vs. owning) rather than what they ought to or could pay for either.
But the current use of GRM analysis is fraught with problems as well. In its most basic form, the GRM is calculated by dividing a given property’s asking price by the annual rent someone would pay to rent that property. If you know what the property will rent for, the use of the multiplier sets a price one might pay for the property.
As a rule of thumb, real estate prices are above mean (overvalued in The Economist’s parlance) when a low-tier property’s asking price in today’s 4% mortgage market is above 12 to 14 times the property’s annual rent. At this point renting is deemed a better value.
As mortgage interest rates rise, the multiplier figure must be reduced. 6% mortgage rates would thus drive the rent multiplier down toward 10. As interest rates move up or are thought will move up to 8%, you are faced with a GRM closer to 8. Here it seems the price-to-rent ratio is inherently a method for pricing property, unrelated to a buyer’s ability to qualify for financing to purchase any home.
At issue here as well is the often substantial monthly and annually recurring costs of ownership, unaccounted for when you use a multiplier to set a property’s asking price. Maintenance costs, mortgage interest expense and operating costs can increase the overall carrying cost of one home over another home, from one buyer to the next, by 5- 10%. Thus, multipliers are for measuring whether the seller’s listing price is realistic, and giving a rough estimate of what the property is worth to the buyer.
So for buyers the GRM can be useful when shopping to rent or buy, but it cannot be used as other than a ball-park guesstimate to determine whether the current state of real estate price levels are “fair.”
Towards perfecting pricing
So in the final analysis, it becomes clearer that a multitude of factors need to be taken into account when determining the current state of California real estate’s fair pricing.
The method, however, need not be quite so convoluted.
first tuesday employs a very straightforward analysis: index figures for tiered home prices (three) are compared to the historical movement of the CPI.
As CPI is essentially determined by the movement of personal incomes across time, it quite simply reveals the likelihood sellers of a home will locate a buyer based on the level of the asking price in relation to the equilibrium trendline for pricing. Thus, when real estate prices received by sellers run above this fundamental indicator of purchasing parameters in the mean price analysis, real estate is overvalued.
Despite the fact that real estate prices have fallen precipitously since the Millennium Boom, they have yet to reach their mean level of pricing and, in California at least, remain temporarily overvalued.