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Do the Math. For Investors, Housing Bottom is 20% Away.

Posted May 4th, 2012 No Comments

Spring time is here, and so is the annual discussion of whether or not the US housing market has bottomed. Have you ever wondered if there were a way to calculate the bottom of the housing market? There is! The housing bottom could be as low as the point where housing is priced solely as an investment, and that is 20% lower than current prices.

Investment Requirements

A rational investor wants to maintain positive cash flow after accounting for all expenses and debt service. Furthermore, a rational investor would want to borrow a majority of the capital from a bank and achieve positive leverage on the debt, while borrowing at a fixed interest rate. An investor would also expect a levered total return in the teens, at least, given the alternative investment opportunities.

While still cautious, banks will now lend on rental homes. Investors can get a 15-year fixed-rate loan at a 4% interest rate and 80% loan-to-value. While this example assumes a 1.2x debt service coverage ratio, most banks require a more conservative ratio and underwrite the loan considering the investor’s personal financial profile along with the property’s fundamentals.

Calculation Assumptions and Results

For this example, I used the March 2012 median house price of $176,500 and median rental price of $1,350 per month. I obtained both figures from Zillow. I budgeted $4,000 per year for vacancy, maintenance, insurance, and property taxes; which might be insufficient.

The result is that the median house does not pencil as a rental investment. The cash flow is simply too low to meet the investment requirements listed above. In fact, borrowing at 80% loan-to-value creates an investment that bleeds cash and suffers from negative leverage. Reducing the leverage helps with cash flow, but the overall return is only in the single-digits, which is too low for the risk associated with a levered, undiversified investment.

To make the median house pencil as a worthwhile investment, either the rent must increase, the interest rate must decrease, the price must fall, or some combination of all three. Individually, the rent would need to increase 22% from $1,350 to about $1,650, which is steep given flat wage growth. The interest rate would need to fall from 4% to 0.98%, which would have disastrous implications for the banks. The median price would need to fall 19.97% from $176,500 to $141,237, which seems the most realistic of the three.

Other Factors and Conclusion

While it has some limitations, this model is a useful attempt to gauge the possible depth of the housing bottom using math and reason. It is not my prediction of near-term housing prices. Historically, home price appreciation comprised the majority of the return associated with rental housing. Home prices are more a function of available credit and rent/mortgage payment differences, rather than rental cash flows. After all, when was the last time any asset class traded on the cash flows.

Despite its recent stabilization, the housing market remains draped in uncertainty. Shadow inventory, food and energy prices, stagnant wages, student loan debt, unfavorable demographics, and other issues are poised to affect housing prices over the next decade.

Joe Buczkowski is CEO of Joe has significant experience as a tech attorney, real estate investor, and finance instructor at the University of Colorado Leeds School of Business. Connect with Joe on LinkedIn.

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