Where does this 160 multiplier come from?

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Irvine Allergy Dr_IHB

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I know IR has cited 160x rent as a "reasonable" multiplier to figure out the value of a property but am unclear on how he got to that number. I was curious as to what I would find reasonable so I'm going to go over a hypothetical scenario.





What is the "breakeven" point between renting and buying? In my opinion, it is when your mortgage interest + property tax + HOA + maintenance costs - tax savings = rent - reasonable investment returns on your saved downpayment. Any principal payments you make should not be included as it serves basically as an enforced savings plan. This calculation also depends on the buyers believing that the real estate market prices will be stable or will actually appreciate over the duration they will hold the property. In other words, if you feel that the market will depreciate for the next 3 years but then bottom out and return to your original price after another 5, you need to be able to hold the property for 8 years.





So, some assumptions. The buyers are a married couple making $150k/yr, have excellent credit, and are purchasing a $500k property with 20% down. They will be using a 30-yr fixed loan with a rate of 6.5% and paying no points. Their tax bracket, in terms of benefiting from mortgage interest deductions, is effectively 34.3% (25% federal + 9.3% CA). They are purchasing a new or fairly new property. The property has an effective property tax rate of 1.8% including Mello-Roos and a HOA of $150/month. I will assign monthly maintenance costs at $56 given its a new house. Buy an older home and trade higher maintenance costs with lower property taxes and HOA. I know you may take issue with these assumptions, but I'm making them just for the purpose of calculations.





Here is what the calculation turns out to be on a monthly basis: $2130 + $750 + $150 + $56 - $874 = $2212. Add in a safe investment return (after taxes) on $100k had they put it into CDs instead of using it as their downpayment of $288/month and you get a rental equivalent of $2500/mo. So, I get a reasonable rent multiplier of $500k/$2.5k = 200.





The 200 is a good baseline, I think, but a homeowner may be reasonably expected to pay a bit more, as homeownership conveys a few other advantages such as a hedge against housing inflation (in the few years I've rented, I've never seen rent go up less than 4% a year). And, if you're willing to wait several years, you may also benefit by catching periods of aggressive real estate appreciation.





What do you think?
 
<p>Doc,</p>

<p>I have been following IHB for awhile and have been pondering the 160x multiplier too. Take another look at IR's "The Market Bottom" post from yesterday:</p>

<p><a href="http://www.irvinehousingblog.com/2007/09/13/the-last-market-bottom/">http://www.irvinehousingblog.com/2007/09/13/the-last-market-bottom/</a></p>

<p>This really made me believe in the validity of the 160x rent multiplier to determine the fair value of a property The rent amount that is highlighted in the ad is $802. Using the 160x multiplier yields an estimated value of $128,320, yet the condo that was highlighted in the ad was priced at $85,900. If you were a proponent of the 160x multiplier and were in the market for a small condo back in 1997 you would likely jump all over this deal. The 200x multiplier that you highlight above would put the value of the property in the ad at $160,400 - almost 2x the "market bottom" price...</p>
 
I get around $180 factor. Two assumptions you made seems a bit off: First, a "new" place that would only require $700 annual maintenance would charge more than $150 for HOA. It should be more like $250-300. Also, earnings on $100,000 these days should yield around $400/mo. I come up with a $2800 denominator for a $180 using these assumptions. I think this makes more sense. In Irvine, for example, a 3+2, 1400sf townhouse would probably go for around $2400 with that similar "newness". That works out to around $430K. I don't believe you can get a 1400sf TH less than 10 years old for less than $500K in Irvine these days. So it needs to come down another 15%, IMO.
 
Well, they are *assumptions*. HOA is kinda variable. I pay only $70/mo on my 5-yr-old SFR, but our community doesn't have all of the amenities of most Irvine Ranch communities (i.e. we have parks and outdoor BBQs but no community pool, gym, or tennis courts). Northpark homes have HOA of around $120-130 last I checked. Westpark, around $100. However, you are correct in that some of the newer condo developments have HOA of $200-250. I think buying a home where HOA is $300/mo is just the buyer asking for it.





An after-tax yield of 4.8% given a combined tax bracket of 34.3% would be pretty darn good and achievable probably only through stocks/bonds etc. I don't believe double-tax-free MUNIs are paying that much yet.
 
Irvine Allergy Dr.,





I think the main difference between the GRM of 200 you calculate and the GRM of 160 I use comes down to the assumptions. The two that stand out the most to me is that you were only counting the interest rather than the interest plus principal, and the tax benefits.





When I think of the breakeven price, I like to think of it in terms of how much is coming out of a paycheck and going toward housing. The principal you are paying down on a 30 year note is a forced savings account as you have noted, but it is part of your monthly payment coming out of your paycheck, so I would prefer to count it.





When considering the tax benefits, these don't come back to you until you get your tax return, unless of course you file a W-4 with about 25 exemptions to prevent the withholding. Personally, I would rather ignore the tax benefits entirely and consider them a bonus of ownership, but to make a truly accurate breakeven calculation these benefits should be considered. In practice, the effective rate is almost always less than people figure. The marginal tax rate on the amount of the deduction is rarely entirely in the highest bracket, and you are giving up a $10,000 deduction for your personal exemption in order to itemize. This is particularly true of lower wage earners who may only be slightly better off with itemizing. Very high wage earners often end up getting hit with caps or the AMT. Plus, in an amortized mortgage, the deduction decreases each year because you a paying off principal and paying less interest. All of these factors impact the calculation.





The GRM number is intended as a rough estimate. It is no substitute for a detailed analysis of the costs and benefits of each individual property and each individual buyer. People may differ with the 160 figure, as it may be higher or lower depending on ones circumstances. In fact, in the original post where I introduced the idea on the blog, I used a range of 150-180 to express the variability in this number.
 
<em>"anyone can explain why newport beach / newport coast has only one foreclosure this year, according to OCRegister?"</em>





Prime borrowers are more skilled and sophisticated at borrowing from Peter to pay Paul. These neighborhoods will fall last, but they will fall hardest.
 
<i>"anyone can explain why newport beach / newport coast has only one foreclosure this year, according to OCRegister?"</i> <p>


I would tend to think that most very expensive homes rarely have mortgage amounts of more than $1,100,000 because of the lack of tax deductibility of interest on mortgage amounts of more than $1,100,000, therefore most very expensive homes have large amounts of equity and will be sold long before they go into foreclosure.
 
I have no knowledge or facts to say the high priced neighbourhoods will be hit the hardest or not. I am just curious ON AVERAGE, what facts do we have to say those folks making 1/4 million or more a year in their late 40s or 50s with large equity and have been staying their home for at least several years will be selling their home at large discount?



Also, there are many Chinese in Irvine's high price $1million plus communities, like Turtle Ridge, Quail Hills, and Woodbury. I seldom hear Chinese forecloses on their homes. That is 30% to 50% of home populations in those high price neighbourhoods.
 
I know of two foreclosures in Newport. So the OCR data is off somehow. I have yet to see one in Newport Coast. But there are some more scheduled for this month. I know there is a home on 42nd Street in Newport that is scheduled for the auction.
 
All these coastal communities were hit hard in the last housing recession. They drop less on a percentage basis than fringe markets, but because the valuations are so high, they drop more on a dollar basis.
 
"When I think of the breakeven price, I like to think of it in terms of how much is coming out of a paycheck and going toward housing. The principal you are paying down on a 30 year note is a forced savings account as you have noted, but it is part of your monthly payment coming out of your paycheck, so I would prefer to count it."





I just don't see that as being financially sound. In fact, that's the kind of thinking that leads to people leasing cars based entirely on monthly payment instead of comparing leasing rates to purchasing a car, where part of your monthly payment goes towards finally owning the car (obviously not a complete analogy as cars do not usually have the ability to appreciate in value, but you get the idea). Unless you're flipping homes and not buying them as a long-term investment, most people at least break even on their home's purchase price, so buy not calculating the amount people pay into principal, you're eliminating one of the primary reasons for buying a home rather than renting.





"In practice, the effective rate is almost always less than people figure. The marginal tax rate on the amount of the deduction is rarely entirely in the highest bracket, and you are giving up a $10,000 deduction for your personal exemption in order to itemize."





This is only partially true, and is something that I already accounted for in my calculations. I actually used a lower tax bracket (25%) in my calculations to account for the marginal tax rate (couples filing together with 150k income are in the 28% bracket). From my experience, anyone with the ability to buy a decent home in OC nowadays will realize tax benefits from itemizing and unless they hit the AMT (which would take much more income than 150k/yr) the mortgage deduction is almost always their largest tax deduction. Again, I think when you're making long-term financial planning decisions, tax planning is too important to leave out of any calculations.





"Plus, in an amortized mortgage, the deduction decreases each year because you a paying off principal and paying less interest. All of these factors impact the calculation."





I did account for this as well in my calculations and again, the change actually only favors purchasing a home. True, your tax deduction drops slowly, but the reason is *you're owning more and more of your home* and throwing away less and less money to the bank. In other words, you have a consistently dropping rental rate. The way I took this into consideration in my calculation is that the amount I've listed as interest payment ($2130) actually is an average of the amount you would pay over the first 3 years of home ownership (obviously, the amount going to interest changes in an amortized loan). The length of 3 years of chosen only as a comparison to what you'd pay by renting for 3 years while waiting for the market to drop enough to buy (in 2010). If you extend the length, the calculation, as I explained above, only *favors* purchasing more and more.





Obviously, all of this is predicated on the buyer being able to hold onto the home long enough that if they needed to sell, they could sell at their original purchase price and any additional fees/costs etc. If you don't believe you can stay in a home long enough to do that, you shouldn't be buying in a depreciating market.
 
"When I think of the breakeven price, I like to think of it in terms of how much is coming out of a paycheck and going toward housing. The principal you are paying down on a 30 year note is a forced savings account as you have noted, but it is part of your monthly payment coming out of your paycheck, so I would prefer to count it."





"I just don't see that as being financially sound. In fact, that's the kind of thinking that leads to people leasing cars based entirely on monthly payment instead of comparing leasing rates to purchasing a car, where part of your monthly payment goes towards finally owning the car (obviously not a complete analogy as cars do not usually have the ability to appreciate in value, but you get the idea). Unless you're flipping homes and not buying them as a long-term investment, most people at least break even on their home's purchase price, so buy not calculating the amount people pay into principal, you're eliminating one of the primary reasons for buying a home rather than renting."





I am not sure what you are saying here. In your first analysis, you did not figure in the principal payment as part of your "cost" because it was a forced savings. I was saying I prefer to look at it as a cost because it comes out of your monthly cashflow. This forced savings is one of the benefits of ownership and amortizing a loan instead of going interest-only. Perhaps we are arguing the same point.





Your number of 200 may be more accurate in calculating the absolute breakeven point with the interest rates in today's market. Personally, I will not buy at that level, particularly given that prices will likely drop much lower given the conditions that exist today.





Also, I think most people take a less complicated approach to figuring their breakeven point. Each month they write a single check for rent. They know how much that is. If they buy a house, they will write checks for their mortgage (which probably has the taxes withheld), the HOA, insurance and maintenance. If the total of the last group of checks is equal to their rent check, they are at breakeven. The GRM for this simple method is around 160.





Many buyers will not take the time to calculate tax benefits accurately or figure in the loss of interest income as you have done. When trying to guess where a bottom may start to form, I try to look at the simple calculations people can easily understand to see where buyers might enter the market.
 
Just curious, what is the logic behind home market valuation based on "net rent cost = net home ownership cost"? There are many many intengibles benefits that renting will not have. Also, for MOST people, the quality of rentals are not even close to the quality of ownership: ie. appliances, backyards, spaces, flooring, etc. This is like saying a fully load car should be the same cost as the same brand base model car. This logic makes no sense to my pea brain.
 
Irvine123,





The logic is actually very simple: rental is a direct proxy for ownership because you can possess and use real estate through either method. Why pay more?





Your contention that rentals are not as nice as owned property is not true. I rent a very desirable property. It is very large, updated inside with granite tops, etc. If I owned this property, I would have no desire to change it. That being said, I rent it for about 20% of my income. If I were to buy it, it would cost 40% of my income. Same property, same use, half the price. Without the appreciation, there is no reason to pay double for the same property.


There are intangibles to ownership that make it more desirable, <em>all other things being equal</em>. Right now, costs are not equal. Is there a premium for ownership? Perhaps, but not as high as today's market would lead you to believe.
 
I agree with you 100% that in general it makes more sense to rent than buy, especially in high price area, and bubble area like here. I am just saying one SHOULD expect to pay a little more when it comes to home owneship. Thanks for the reply as always.
 
<p>Wow, lots of people like to start their handle with 'irvine'....</p>

<p>Anyways... I think it is foolhardy for anyone to try to derive what the right ratio "should" be by coming up with complex calculations where you try to account for all the variables. Just too hard to do. Too many variables to keep track of, and a lot of those variables differ greatly from person to person (tax deductions, perceived benefit of owning vs renting) or in time (investment returns, inflation). This isn't something you can reason out no matter how carefully you try.</p>

<p>That being said, it is handy to have a rule of thumb, but the only reasonable way to get one is by looking at history. At several points in the last few decades it has not been uncommon to see typical ratios well below 160. I wasn't pricing properties myself in the 90's, but I have heard that typical ratios got to be around 120-130 in So-Cal. Given that history has shown such ratios to be typical of a normal market, claims that ratios above 160 can be sustained long term just don't ring true.</p>
 
<p>irvine123, the idea that people should pay more to own than rent is not well supported by either history or economic reasoning.</p>

<p>Throughout most of the 90's (except possibly 1990, 1991, and 1999) it was almost always cheaper to own a home as opposed to renting a comparable home provided you did not move for several years)</p>

<p>In a market economy, long term, stuff ends up being priced according to what it costs to supply not according to the utility it provides. Since there are many units that are owned by investors and rented out there is good evidence that the marginal cost of the "pride of ownership" benefit is near zero.</p>
 
<p>Well said, Bigmoney. </p>

<p>Now, I do see validity in what the doctor says and don't have a problem with the 200 multiplier, so I revised my NPV calculations to include the impact of money saved and reinvested (at earnings - tax) and principle payment "forced savings". What I get is around 190 factor. Meaning, a home that would rent for $2500 should be priced at around $475K. This assumes a 3.5% inflation (& rent increase), 3-4 year time horizon, 5% savings rate, 6.5%, 30-yr fixed loan with $250 HOA. I'm sticking with the $250 HOA since any homes around $500K in Irvine will be a condo/th with high HOAs. </p>

<p>If we compare this to what a comparable $2500 rent condos/ths are going for these days, at anywhere between $550-$650K (avg seems to be around $570K), we have about 10-25% overpricing. If these homes that are renting for $2500 comes down to high $400's, I think we would have equilibrium at the current rent prices. Of course if rent goes down, that would not be factored in to this. I don't see this happening though, and I think a 3.5% annual increase is a reasonable expectation.</p>
 
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