DataQuick today reported that house prices in Southern California have risen 28 percent from the last year. A year ago, people who were buying houses in this part of the world were getting a good deal. Now, the deal is so-so.
Take a look at the table below (it is something I constructed for my
class on mortgages and mortgage backed securities). The numbers on the
vertical axis (.03,.05,.05..)are cost of capital numbers–the financing
costs of owning a house. Generally speaking, the cost of capital for
owning a house is the mortgage rate plus one percent, which reflects
that the cost of the equity in the house (the down-payment) is higher
than the cost of the mortgage. The numbers across the horizontal axis
(10, 15,20…) are rent-to-price ratios. Suppose you can own a condo for
$360,000; the rent on the same unit is $1500 per month or $18,000 per
year. The price to rent ratio is then 20.
In the example given here, we are looking at a household that pays a
federal marginal tax rate of 25 percent, a state marginal tax rate of
7.9 percent, faces closing costs of 3 percent, annual maintenance cost
of 2.5 percent, a property tax rate of one percent, a Realtor commission
of 5 percent, and expects to hold the property for five years (feel
free to email me at richarkg@usc.edu if you wish to put your own
assumptions in the spreadsheet that produced the numbers listed below).
As it happens, I have been looking at costs and rents in Westwood, a
neighborhood just west of Beverly Hills and on the other side of the 405
from Brentwood. Rents on 2 bedroom units run around $28 per year per
square foot; prices are around $650 per square foot, so the price to
rent ratio is around 23. With current mortgage rates at 4.5 percent,
the cost of capital is 5.5 percent. So lets look at the cells that are
bolded: a price to rent ratio of 23 and a cost of capital of 5.5 lies in
the middle of them. The numbers in the cell is the amount of
appreciation that is required each year that one holds a property for
renting and owning to break even with each other.
So right now, for owning to be a better financial deal than renting,
prices must rise around 4 percent each year. Is this feasible in the
long run for Los Angeles? Yes, because over the long term, prices in LA
tend to rise by about the rate of inflation plus one percent, so if we
think 3 percent steady state inflation is in our future, we should be
fine. But will it rise much more than inflation plus one percent for a
long time? I doubt it. And of course, CPI growth is less than two percent right now. House prices are about where fundamentals say they should be, but it is time for increases to slow down.