bostonbubble.com

[Guest]

This is an issue I've been thinking a lot about recently and I wondered what people think...

For commercial RE, the accepted means of valuing an asset basically looks at the current NOI (net operating income) and future growth of that NOI and then discounts those cash flows according to a certain discount rate. As a shorthand, one can take the current year's cash flows and apply a cap rate to get the value.

I don't see why owner occupied real estate should be much different. This is the analysis I did when I recently purchased a condo. I took the imputed rent (what I would pay to rent this place) and subtracted the HOA fees, RE taxes and some cost for maintainence, repairs, etc... These numbers are basically 1800 rent, 100 HOA fees, 60 RE taxes, and 50 for other. This leaves me with about 1600 per month in NOI.

Now the question becomes, what sort of cap rates does this get? As I understand it, multifamily cap rates in the Boston area are currently running around 5-6%. This would imply a value of $324-384k. But what if the cap rate were 8%? Then the value would be $240k.

What should the cap rate be? I think this calculation above ignores the value of the interest deduction. One could add this to NOI or use it as a discount to the cap rate. In my situation, the interest deduction reduces by interest payments by about 20% as some is not realized. I might say that this would decrease the cap rate by 10% off of what one gets for multifamily because there are economies of scale.

Another approach would be to take the effective borrowing rate factoring in the interest deduction. Say you borrow at 6%, after taxes, this is really like borrowing at 4.8% because of the interest rate deduction. Does this seems like a reasonable cap rate? Perhaps one adds 100 basis points as a risk premium and comes up with 5.8%?

A couple things to bear in mind. Looking at a cap rate of 5.8% one might think this is a really bad yield. But if you can factor in (normal) 3% appreciation, then one is getting a yield of 8.8% on an investment. This seems about right in terms of the total return one would expect from having a vacancy free real estate investment (perhaps a little high).

Now, at this point I'm sure someone is screaming about the historically low cap rates. Yes, they are low across all property sectors. But why? If one says cap rates used to be 8% and they are now 5% that might imply that we are in a bubble. But what impact would a reduction in financing costs have? Looking back 10-15 years, the assumptions at the time would have been that interest rates would fluctuate wildly and go pretty high (as they had in the previous 10-15 years). The average mortgage interest rate over that period was like 9% (this is an estimate but I actually did the calculations once). Looking back over the past 10 years, mortgage interest rate haves been much lower and much less volatile. To the extent, financing remains cheaper and less variable over the long term, I think this would imply a significant reduction in cap rates. I would argue that this reduction in finacning costs is tied to the taming of inflation over the past 20 years as well.

If one were to accept the reduction of cap rates from 8% to 5% (based on sound fundamental reasons) what would this imply? This would imply an increase in prices of 60%. I personally think cap rates are low and that they should be more like 6%. So let's say you get a 33% increase in prices tied to this fundamental rebalancing of the market to reflect revised long-term thinking about interest rates, inflation, etc... If one imagines this to have been priced into the market sometime since 2000, then this would imply that the inflation adjusted (est. 2.5% per year) case schiller index should be about 158. Boston is somewhere in the low 160s right now. Thus, perhaps we're close to where we should be now (a year of two of inflation would take away this difference).

So, here are my questions for y'all:

(1) what should the cap rate for owner occupied housing be?
(2) how should you deal with the mortgage interest deduction?
(3) what explanation is there for cap rate compression across all sectors of real estate? We aren't really talking about a housing bubble so much as a general real estate bubble.
(4) what is wrong with my macro-economic story suporting housing prices near their current level in Boston?

[john p]

I think that if you look at rental cash flows as a basis for valuation you'd have to consider these things:

The alternative investments other than real estate and how they are doing (in the early 2000's real estate was attractive as compared to equities).

The demographics to determine who might be able to take advantage of such type investment.

A typical financial plan of a person buying or renting and why that unit may be attractive to fit into that financial plan.

The interest deduction's value would depend on the type of buyer.

Further, think about the nature of the investment:

Is the investment a growth investment i.e. appreciation

Is the investment an income investment i.e. positive cash flow

Is the investment a necessity: shelter

I think that this past boom was a perfect storm in that buying worked for those in their early professional careers because a condo was a "growth" appreciation investment that could either be sold or turned into an "income" investment which they could rent when they moved out and bought a single family. Further, people with single families were buying condos for investments.

Over time, the purchase for condos for investment became only profitable for those with the long term view and for those who could put a sizeable amount down and weren't paying much with respect to interest. So, a certain segment invest in real estate to diversify and potentially shelter assets from taxes.

Essentially, I'm saying look at the profiles of the entire portfolio and assess which segments are waning and which are growing.

[admin]

That's an interesting way of looking at a purchasing decision. I don't have a good answer for what a reasonable cap rate would be since I'm not used to looking through that lense, but I do have a few thoughts on your fourth question and your model in general. The area of your reasoning that I am most reluctant to accept is this:

[john p]

http://www.nolo.com/article.cfm/objectID/822A5B90-F9E8-4BA5-BA8518731B79F920/213/243/282/ART/

[Guest]

I would have two points of response:

(1) I'm quite skeptical of Schiller's historical housing data. I'd like to know more about how this was constructed because I would think it would be very difficult to do this. Where is he getting the transaction data and how does he account for shifts from urban to suburban and back to urban?

(2) Doesn't Schiller show a similar trend for equity prices? I guess I don't really understand his thesis unless it is to say that every asset class is currently a bubble. Perhaps there is something else going on. I really don't understand how the entire economy could be simulatenously a bubble. The only reasonable explanation I can see is that this is the result of irrational exhubrance on the part of foreign investors in putting their money into the US. But this doesn't really make sense in that many (if not most) international property markets (and equity markets) have boomed as much or more than the US over the last 20 years. I guess what I'd be interested to know is what assets Schiller thinks are undervalued.

[admin]

[Guest]

I would like to know more about how Case Schiller compiles this historical data-not all states require registry of deeds to report consideration and there are many reasons why this will often differ from market value. I'm more inclined to trust the recent data than stuff from 100 years ago. I understand the basic methodology but I'm not sure how this would work in practice given how existing housing stock gets replaced over time, different phases of time tend to yield different quality of stock, locational values shift, etc... For example, as the desirability of central locations decreased after WWII, I would expect this to deflate the index from where it would otherwise be because the repeat sales would be less likely to occur in the growing, more desirable areas... Not saying I'm sure this data is wrong, I'm just saying I'm skeptical of it.

Regaring asset bubbles across the globe, I guess I still don't get it. I can see the argument for how money gets shifted from hard assets to speculative ones but this implies a devaluation of hard assets simulatenously with the inflation of speculative assets. I'm wondering what those hard assets would be. Traditionally, real estate has been one of the paradigmatic hard assets. There is a inherent value in real estate that is relatively fixed and constant, baring wars, natural disasters, etc... I guess commodities are another. Just wondering.

[admin]