What is Rental Parity? What features or characteristics create value above rental cashflow value?

Asking Price: $1,425,000

Address: 34 Coldbrook Irvine, CA 92604

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I’m solid gold
I’ve got the goods
They stand when I walk
Through the neighborhoods

Makin’ It — David Naughton

The concept of Rental Parity is often discussed on this blog, but to date, I have never devoted a post to defining it and explaining it before today.

I first discussed Rental Parity in How Inflated are House Prices?, and later I added Rent Versus Own to explore the cost of ownership and relate it to the cost of rental. Finally, I added a subjective refinement to the rental parity basis in I Will Not Call a Bottom.

What is Rental Parity?

Rental Parity is a mathematical relationship between rental rates and property values where rent is equal to the monthly cost of ownership. There are many assumptions and variables that impact Rental Parity — so many that it takes a spreadsheet to try to explain it. (We have a calculator that provides the total cost of ownership on a monthly basis to compare
to the cost of renting. What is perhaps more useful to buyers is the
ability to run the calculation in reverse — If you know what you spend
on rent, you can estimate how much house you can afford.)

The fluid relationship between rents and prices provides a conceptual understanding of value. Rental rates establish where property values should be. Rental Parity is a balance point where there is no financial advantage to choosing renting or owning; a point of theoretical indifference.

If we had a group of theoretically indifferent people who always acted rationally based on perfect information, prices would always be at Rental Parity; any price below rental parity would be perceived a bargain and bid upward, and any price above rental parity would be perceived as too high, and there would be no bid interest. Of course, we all know that people are not indifferent; in fact, they can become very emotional about buying and selling real estate. When they participate in a market, they get caught up with the herd and move prices without regard to fundamentals; short-term price movements become accepted as the market’s long-term trajectory. Trees really can grow to the sky.

Rental parity becomes a baseline — a fundamental. Prices are loosely tethered and may depart for long periods, but prices always manage to return to rental parity in time because as a logical point of indifference; it is the natural resting point for a market purged of kool aid intoxication.

Rents Capture Premiums

Rental Parity provides a useful measure of desirability and premium. When people are deciding between renting and owning and comparing costs (you all do that now, right?), some will chose to rent and some will chose to buy. Both parties are going to take a portion of their income and go obtain housing in their own way. Neighborhoods with high rents will have high home prices, and neighborhoods with high home prices will have high rents. The intrinsic desirability will be mirrored in the rental and for sale markets.

Applying Rental Parity

Rental Parity is a guideline for value, but this number can be refined to adjust for some of the intangibles of ownership — good and bad.

Each property is evaluated to determine its
desirability as a long-term residence — this is an opinion; it is not a mathematically provable. If
the best properties in the entire market would rank a 1, and if the
very worst would rank as a 5.
The little green dot represents a subjective evaluation of a property.

The black dots represent different important price points every
buyer should be aware of. The first is the “value,” if you want to call
it that, of comparable sales in the market. This has nothing to do with
cashflow, and it is based totally on what people are currently paying
for similar properties in the market. The
Comparable Sales Value floats up and down this chart based on whatever
people are currently paying.

The next black dot on the list is the asking price. This can also be
just about anywhere. The frequent WTF listing prices I profile here
would be off the top of the chart. Some short sales are priced well below comps to attract attention.

The next black dot on the list is the Maximum Cashflow value of the property. Do you remember the post, Investment Value of Residential Real Estate?
As I described in that post, there is a legitimate
financial reason to pay more than rental parity for blue-chip
properties a buyer plans to own for 10 years or more. This is not a
large premium over rental parity. The calculations in that post
demonstrate you can pay up to 10% more than rental parity on a
long-term hold because you obtain the benefit of the inflation hedge.
This is not a price point for homes you know you will want to move up
and out of in a few years.

The next black dot on the list is Rental Parity.

The zone between rental parity and cashflow investor levels is the
gray area where all the less desirable properties fall. This would
include most condos, any two-bedroom properties and what are commonly
known as “starter homes.”

The final black dot is the cashflow investor level. This is the
price point where an investor can acquire a property, rent it out, and
turn a monthly profit from owning the property. This is the bottom of
the line for Irvine properties, and it is usually about 25% below
rental parity.

The final number on the chart would be those properties nobody wants
to live in. Does everyone remember Dr. Housing Bubble’s series Real Homes of Genius? Those are the properties I am talking about. What they really need is a bulldozer.

Moving Beyond Rental Parity

Are their influences on the prices of homes beyond income and rent? Are there properties, neighborhoods or communities where money is stored like a reservoir, and values are sustained at levels not justified by incomes?

I have been contemplating the disparity between home prices and incomes in areas like Malibu to see if there really is something that makes certain neighborhoods or certain properties conform to a different set of rules.

In areas like Malibu where there are many cash buyers, prices are determined more by the wealth of a few than the income of the many. Any times you get truly unique properties of very high quality, and the people competing to own them are not wage earners, they are people of great wealth who see something they want. They are bidding on percentages of their net worth rather than percentages of wage income.

When the disparity of wealth sees a shift toward wealth concentration (our recent governmental policies have favored wealth concentration), special properties in a place like Malibu get bid up to very high prices. The prices go so high because the people bidding have very large fortunes. For some of these people, a $20,000,000 house is a small fraction of their holdings.

The implication is that real estate in places like Malibu will be subject to fluctuations in the general pool of wealth in society. Since deflation has ravaged people’s investments, real estate will likely fall in equal measure.

That is all very interesting for Malibu, but Irvine is a working-class city where property values are largely determined by income. Is there any stored wealth in real estate here?

Uniqueness and Quality

There are only two things that creates the capacity to hold wealth beyond cashflow value in real estate; uniqueness and quality. To illustrate the value-adding feature of uniqueness, I thought I would share with you a great scene from an episode of Star Trek The Next Generation. Commander Data, a one-of-a-kind android, has been taken hostage by a wealthy collector who is obsessed with unique objects.

Clip is 5:00 in the video, or click the link below; it is at the right starting point.

The Most Toys — Star Trek The Next Generation

Uniqueness adds value. Wealthy people will compete with one another to obtain unique items, and they are not subject to pressures of financing. When you enter the realm of unique properties, you abandon ideas of Rental Parity.

If something is unique, substitutes are limited. An architect designed mansion on the beach is completely unique, and there is a limited number of comparable properties. When you see properties like the Hearst Castle, there simply are no comparables. In Irvine, there are few unique properties; most properties have many close comparables. Many floorplans are duplicated around town, and properties with comparable sizes and configurations are everywhere. Most of Irvine is an undifferentiated mass.

Quality adds value. Donald Trump, whatever you may think of the man, always strived to create the highest possible quality in his product, even if the pricetag was beyond ridiculous. Most people think pergraniteel is adding quality; it isn’t. Pergo wood flooring is imitation wood, and nothing of quality stands in imitation. Quality is not cheap. Most attempts at quality end up as over-improvements and return less value than cost. There are some very high quality, unique properties in Irvine, mostly in Shady Canyon because it is the only neighborhood where lots are big enough to create unique estates.

Reservoir of Value

Real estate can be a reservoir of value. When properties are unique and of very high quality, the wealthy become interested in possessing them, and prices become based on wealth rather than income. These properties are few and far between. Irvine is not a community where homes will be a tool of the wealthy. Our real estate is simply not that unique, and it is generally not at exceptional levels of quality. That doesn’t mean individuals in Irvine do not store wealth in real estate. Anyone who pays down their mortgage and enjoys appreciation from wage growth can accrue a substantial nestegg. The value of that nestegg in Irvine will always be determined by local wages not by the buying and selling of the very wealthy.

Asking Price: $1,425,000

Income Requirement: $356,250

Downpayment Needed: $285,000

Purchase Price: $875,000

Purchase Date: 7/14/2000

Address: 34 Coldbrook Irvine, CA 92604

Picture yourself hosting friends and family in this beautiful, large
home with views of the Woodbridge North Lake from almost every room.
Entertainer’s back yard with pool, spa and expansive wood and concrete
decks. Roomy master suite with vaulted ceilings, sitting area and
balcony overlooking the pool. Beautifully appointed formal living and
dining rooms with hardwood floors and fireplace with custom mantle.
Expanded kitchen with breakfast nook and counter. Huge upstairs bonus
room with brick fireplace. Downstairs bedroom/office with adjacent 3/4
bathroom. Large laundry room with sink. Crown molding, updated doors,
windows and baseboards. Intercoms in most rooms. Many parts of home are
wired for audio from the entertainment center. Inside the loop location
just steps from lake, tennis club and swimming lagoon. Walking distance
to elementary, middle and high schools. *** No Mello Roos / Low HOA
dues ***

This must be the most entertaining property in Irvine.

Today’s featured property is very desirable. Finishes have been upgraded to the pergraniteel level, it has a private pool, and there is a view of the lake — albeit sideways. There are fewer substitutes for this property because of some unique features, but there are also some substitute houses that are superior (how about the homes right on the water?) It’s cashflow value is probably around $1,000,000. Is there $425,000 in uniqueness and quality here? Is the $1,425,000 price justified?

In The Great Housing Bubble, I outlined both a A Free-Market Solution to Prevent Housing Bubbles and a regulatory solution to do the same. Today, we will explore a potential regulatory solution.

Asking Price: $600,000

Address: 62 Fringe Tree, Irvine, CA 92606

An eye for an eye;
Well before you go under…
Can you feel the resistance?
Can you feel the thunder?

Lunatic Fringe — Red Rider

Regulatory Solutions

The regulatory solution proposed herein is simple, yet far
reaching. It comes in two parts, the first is to limit the amount lenders can
loan to borrowers with a rather unique enforcement mechanism, and the second is
to increase the penalties for borrowers who commit mortgage fraud. The
following is not in legalese, but it contains the conceptual framework of
potential legislation that could be enacted on the state and/or federal level.
A detailed discussion of the text follows:

Loans for the purchase or
refinance of residential real estate secured by a mortgage and recorded in the
public record are limited by the following parameters based on the borrower’s
documented income and general indebtedness and the appraised value of the
property at the time of sale or refinance:

1. All payments must be calculated based on a 30-year
fixed-rate conventionally-amortizing mortgage regardless of the loan program
used. Negative amortization is not permitted.

2. The total debt-to-income ratio for
the mortgage loan payment, taxes and insurance cannot exceed 28% of a
borrower’s gross income.

3. The total debt-to-income of all debt obligations cannot
exceed 36% of a borrower’s gross income.

4. The combined-loan-to-value of mortgage indebtedness cannot
exceed 90% of the appraised value of the property or the purchase price,
whichever value is smaller except in specially sanctioned government programs.

Any sums loaned in excess of
these parameters do not need to be repaid by the borrower and no contractual provision
is permitted that can be interpreted as limiting the borrower’s right to
exercise this right, make the loan callable or otherwise abridge the mortgage
agreement.

This
last statement is the most critical. This is how the enforcement problem can be
overcome. Regulators are pressured not to enforce laws when times are good, and
decried for their lack of oversight when times are bad. If the oversight
function becomes a potential civil matter policed by the borrowers themselves,
the lenders know exactly what their risks and potential damages are. Any lender
foolish enough to make a loan outside of the parameters would not need to fear
the wrath of regulators, they would need to fear the civil lawsuits brought by
borrowers eager to get out of their contractual obligations. If any borrower
could obtain debt forgiveness by simply proving their lender exceeded these
guidelines based on the loan documents, no lender would do this, and regulatory
oversight would be practically unnecessary. One key to making this work is to
prohibit lenders from introducing a “poison pill” to the loan documents that would make borrowers hesitant
to bring suit, otherwise lenders would make their loan callable in the event of
a legal challenge forcing the borrower to refinance or sell the property.
Basically, if the borrower brought suit and won, they would see principal
reduction equal to the deviation from the standards, if they brought suit and
lost, they would have no penalty. Most of these cases would be decided by
summary judgment based on a review of the loan documents thus minimizing court
costs.

Another
pillar to the system is the documentation of income as part of the loan
document package – the “borrower’s
documented income” from the proposed legislation. One of the most egregious
practices of the Great Housing Bubble was the fabrication of income by
borrowers that was facilitated and promoted by originating lenders. Stated-income
loan programs were widespread, and they were the cause of much of the
uncertainty in the secondary mortgage market during the initial stages of the credit crunch in the deflation of the bubble.
Basically, investors had no idea if the borrowers to whom they had lent
billions of dollars were capable of paying them back. Without proper documentation
of income, investors lost all confidence in the secondary mortgage market. Stated-income
loan programs were one of the first casualties of the credit crunch. These
programs should be eliminated totally due to the inherent potential for fraud
and the undermining of confidence in the secondary mortgage market
stated-income loans create. If
lenders can be sued based on the content of the loan documents, and if
borrowers can be fined or go to jail for committing fraud or misrepresentation
on loan documents, both parties have strong incentive to prepare these documents
completely and correctly. Originating lenders will argue this adds to their
costs and will result in higher application fees. The amount in question is
very small, particularly relative to the dollar amount of the transaction. A
small amount of additional expense here will provide huge benefits by assuring
investors the borrowers to whom they are loaning money really have the income
to pay them back. The benefit far outweighs the cost.

If such
a law were passed, agency interpretation and court case precedents will end up
defining adequacy in loan documentation. A single W2 does not establish a work
history, but 2 years worth is probably excessive documentation. One of the most
contentious areas will likely be documenting the income of the self-employed. In
theory, the self employed must document their incomes to the US government
either through Schedule C reports or corporate K-1s. The argument the
self-employed have traditionally made is that these documents understate their
income. Since many self employed take questionable tax deductions, there is
probably some truth to the claim that tax records understate their income;
however, why should the self-employed get to have both benefits? If the
self-employed had to use their tax returns as loan documentation, they probably
would not be quite so aggressive in taking deductions. A new business without a
tax return or with only one year of taxable receipts probably is not stable
enough to meet standards of income necessary to assume a long-term debt.

The
poor quality of loan documentation during the bubble was a mistake of
originating lenders; therefore, in this proposal much of the burden of
paperwork and liability for mistakes falls on the lenders. During the deflation of the bubble, lenders
paid an enormous price for some of their lax paperwork standards, but much of
the problem was also due to borrowers misrepresenting themselves in the loan
documents. There were instances where lenders encouraged this behavior, but in
the majority of cases, the document fraud was perpetrated by the borrowers. The
only recourse available to a lender is a civil suit as there are few criminal
penalties associated with loan documentation and almost no enforcement. It can
be very difficult and costly for lenders to pursue civil damages, and few
lenders attempt it even when they have a strong case. To create a more balanced
set of responsibilities, the borrowers must face criminal penalties for fraud
and misrepresentation on loan documents. If borrowers know the lender can turn
documents over to a prosecutor who will charge the borrower with a crime if
they make false material statements, borrowers will be much less likely to
commit these acts.

The
parameters of the forming limitations on the debt-to-income ratio and combined-loan-to-value are essential to
prevent bubbles in the housing market and to prevent the banking system from
becoming imperiled in the future. People will commit large percentages of their
income to house payments when prices are rising quickly; however, they do this
out of fear of being “priced out” and greed to make a windfall from
appreciation. These are the beliefs that inflate a bubble. Borrowers
cannot sustain payments above the traditional parameters for debt service
without either defaulting or causing a severe decline in discretionary
spending. The former is bad for the banks, and the latter is bad for the entire
economy. This must be prevented in the future. There are a number of reasons
why high combined-loan-to-value lending is a bad
idea: it promotes speculation by shifting the risk to the lender, it encourages
predatory borrowing where borrowers “put” the property to a lender, it promotes
a high default rate because borrowers are not personally invested in the
property, it discourages saving as it becomes unnecessary, and it artificially
inflates prices as it eliminates a barrier to market entry. This last reason is
one of the arguments used to get rid of downpayment requirements. The
consequences of this folly became readily apparent once prices started to fall.

The
payment must be measured against “30-year
fixed-rate conventionally-amortizing mortgage regardless of the loan program
used.” One of the worst loan programs of the Great Housing Bubble was the
2/28 ARM sold to large numbers of subprime
borrowers. These borrowers were often qualified only on their ability to make
the initial payment, and these borrowers were generally not capable of making
the fully amortized payment when the loan reset after 2 years. Regulations like
this would prevent a recurrence of the foreclosure tsunami triggered by
the use of this loan program. It is also important to ban negative amortization because it would allow the loan balance to
grow beyond the parameters of qualification, and it invites property
speculation. Perhaps borrowers would not be concerned because they would
receive debt forgiveness of the expanding balance. Lenders should be wary of
these loans after their dismal performance in the deflation of the bubble, but
institutional memory is short, and these loan programs could make a comeback if
they are not specifically outlawed. This provision is careful to allow
interest-only loans. They are still a high-risk product, but an argument can be
made that these loans have a place, and there is no need to completely ban
them. They will not have a future as an affordability product capable of
driving up prices if the borrower must still qualify for the fully amortized
payment.

For the
lending provisions to have real impact, they must apply to both purchases and
to refinances, thus the clause, “Loans
for the purchase or refinance of residential real estate.” If the rules
only applied to purchases, there would be a tremendous volume in refinances to
circumvent the regulations. The caps on debt-to-income ratios, mortgage
terms and combined-loan-to-value only have meaning if
they are universally applied. The combined-loan-to-value standard is based on
the “appraised value of the property at
the time of sale or refinance.” The new appraisal methods will have impact
here. It is important that the records need only be accurate as of the time of
the transaction. If a borrower experiences a decline in their income or if the
property declines in value to where they no longer meet the loan standard, it
does not mean they can go petition for debt relief.

The
regulations would only need to apply to loans “secured by a mortgage and recorded in the public record.” People
can still borrow money from any source they wished as long as the lender knows
they will not have any claim on residential real estate. If a lender wanted to
issue a loan secured by real estate outside of the outlined standards, the
borrower would not have to pay back that money. If a borrower has non-recorded
debts which create a totally indebtedness requiring more than 36% of their
gross income, they would not be eligible for a home equity loan even if they met
the other qualifications. In such circumstances, it is better to limit
borrowing than increase the probability of foreclosure.

Many
states have non-recourse laws on their books. These
laws serve to protect the borrower from predatory lending because the lender
cannot go after other assets of the borrower in the event of default. In theory
this should make lenders more conservative in their underwriting; however, the
behavior of lenders in California, a non-recourse state, during the Great
Housing Bubble was not conservative. These laws do serve to protect borrowers,
and they should be enacted for purchase-money mortgages in all 50 states.

Since
one of the goals of regulatory reform is to inhibit the behavior of irrational
exuberance, the sales tactics of the
National Association of Realtors should be examined and potentially come under
the same restrictions as securities brokers through the Securities and Exchange
Commission. After the stock market crash which helped precipitate the Great
Depression, Congress created the
Securities and Exchange Commission to regulate the sales activities of securities
brokers. There are strict regulations in place governing the representations
made concerning the future performance of investment opportunities. These
protections were put in place to protect the general public from the false
promises made by stockbrokers in the 1920s which many naïve investors believed.
The same analogy holds true for Realtors. The National Association of Realtors has launched numerous
advertising campaigns suggesting erroneously that residential real estate is a
great investment and appreciation will make home buyers
wealthy. The mantra of all realtors is that house prices always go up. There are
currently no limits to the distortions and outright lies realtors can tell
prospective buyers with regards to the investment potential of residential real
estate. Buyers are already prone to believe the fallacies of unlimited riches
in real estate, and these fallacious beliefs lead to housing bubbles. Realtors
should be prevented from making representations concerning the investment
potential of real estate. Since the regulatory framework for this kind of
regulation and oversight is already in place under the auspices of the
Securities and Exchange Commission, Congress would merely need to make Realtors
subject to these regulations in order to solve the problem.

The
result of these restrictions will be that all homeowners will have at least 10%
equity in their properties unless they have borrowed
from a government program like the FHA where the combined-loan-to-value can exceed the
limits. This equity cushion would buffer lenders from predatory borrowing and a
huge increase in foreclosures if prices were to decline. Home equity in the
United States has been declining since the mid 1980s, and it actually declined
while prices rose during the Great Housing Bubble due to the rampant equity
extraction. The lack of an equity cushion exacerbated the foreclosure problem as many
homeowners who owed more on their mortgage than the house was worth simply stopped
making payments and allowed the house to fall into foreclosure.

Asking Price: $600,000

Income Requirement: $150,000

Downpayment Needed: $120,000

Purchase Price: $671,000

Purchase Date: 1/19/2007

Address: 62 Fringe Tree, Irvine, CA 92606

This property was purchased on 1/19/2007 for $671,000. The owner used a $536,750 Option ARM first mortgage and a $134,250 downpayment. Basically, she cannot afford the place.

If this property sells for its asking price, and if a 6% commission is paid, the total loss will be $107,000. The owner’s credit will be saved, but most of her downpayment is lost.