April 1, 2006, New York Times, By
DAMON DARLINHow do you know what to pay for a house?
You look at the "comps," of course. A real estate agent will tell you what comparable houses in the neighborhood sold for. Web sites like
Zillow.com or
HomeValues.com value homes the same way.
Is that not a little like thinking
Yahoo stock is a bargain at $32 a share because
Google is selling at $390 a share? With stocks, you would want to know how the price relates to the company's future earnings. Gary and Margaret Hwang Smith, Pomona College economics professors, argue that with housing you similarly want to know how the price relates to the future stream of rent from a home, whether you intend to rent or not.
It is not an unheard notion among investment professionals. Redbrick Partners, an investment fund that buys and rents single-family homes, evaluates a property's cash flow, as well as the economic prospects of the neighborhood and larger region, before buying it. "Just because you pay 5 percent less than somebody else doesn't mean it is a good price," said Thomas Skinner, a managing partner.
You will need some math skills and some software or a financial calculator to do this. The Smiths said they might offer a program on their Web site,
http://www.smithfinancialplace/.com, to automate the process, but until then, you'll have to read the formulas in their new research paper found there and work out the numbers using a spreadsheet.
To see how this would be useful to a buyer, take a look at a house on Silver Cloud Drive in Diamond Bar, Calif. It is an 1,812-square-foot four-bedroom two-bath split-level ranch built in 1964.
It sold last July for $560,000. First, you need to know how much the house could rent for. As it happens, just across the street is a nearly identical house that was renting at the that time for $2,295 a month.
Determining how much rent a house can fetch may turn out to be one of the more difficult tasks in this entire process, especially if you live in a single-family home in a neighborhood where few homes are rented. If you own a condominium or an apartment, it's easy because there are always comparable units renting.
Now you need to calculate the annual cash inflow, that is, the rent, and subtract it from the outflow, things like mortgage payments, taxes and maintenance. You'll have to make some assumptions of how much any of those factors will change over time. The cash flow may be negative in the first few years of ownership, but as rents increase and the mortgage payments don't, the returns flip positive.
Plug these numbers into a spreadsheet set up to calculate net present value — what the future payments are worth right now. You can find advice at
http://office.microsoft/.com/en-gb/assistance/HP052091991033.aspx. In our example provided by the Smiths, assuming (economists love to assume) the buyer makes a 20 percent down payment, secures a 30-year fixed mortgage at 5.7 percent, and spends about 2 percent of the price of the house each year on maintenance as rents rise 3 percent a year, you discover that with a 6 percent after-tax annual rate of return, the house price would be $696,000. That's about 24 percent more than the actual selling price and 18 percent above Zillow's estimate of $588,502.
The calculation doesn't mean that as a seller you'd necessarily get that much. Supply and demand — and the Greater Fool Theory — will still determine the price. It means as a buyer you could go that high and still be happy with the decision in years to come.
Given the price it did sell for, for someone in a 28 percent federal income tax bracket, the long-run after-tax annual rate of return will be 7.4 percent. (Use an internal rate of return, or I.R.R., function in a spreadsheet.) Given that a 30-year bond was yielding about 4.83 last week and some banks will give you 4.5 percent interest, 7.4 percent isn't a bad return.
What if the price drops? That's the risk in owning over renting. Certainly, if you had waited you would pay less and probably get an even better return. But that's the reason you analyze the fundamentals. If you computed a healthy return and are holding it for the long term, you minimize the danger of losing your investment.
At the risk of sounding like a real estate agent, Mr. Smith said there are two risks to consider when buying a house. One is that you buy and the price goes down. The other is that you don't buy and the price goes up. "The second is more scary," he said.
