How can rental/purchase prices be so incredibly inefficient?

DanS · #1 10-15-2006, 07:54 PM

The recent thread about benefits of owning vs. renting a house have reminded me of an issue that I can't quite wrap my fingers around.

Until recently, I rented a house (with roommates) for $2600 that has a fair market value of at least $800,000, maybe $900,000. The corresponding mortgage on this house would be approximately $4,000-4,500/mo. How can the rental price be 60% of the mortgage cost? Obviously I'm missing something here, because it seems to me that buying the house at market value with intent to rent it out would be a horrible investment. What am I missing?

-Dan

P.S. The house is in the SF Bay Area, where it could be argued that the rental and/or purchase market is horribly inefficient.

john voight · #2 10-15-2006, 08:41 PM

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P.S. The house is in the SF Bay Area, where it could be argued that the rental and/or purchase market is horribly inefficient.

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That is the reason.

You need to realize that the investment is long term; after 30 years, you have a property that will prolly be valued around 2.5 million.

This is not a cashflow. If you want cashflow, you need prolly duplex (minimum) in a good market like texas etc..

I live in bay area. I ppl who are renting building are prolly paying low mortgage b/c they purchased 20 years ago when prices were fraction of current home value.

DesertCat · #3 10-16-2006, 01:19 AM

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You need to realize that the investment is long term; after 30 years, you have a property that will prolly be valued around 2.5 million.

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That's the key (IMHO) to why the market is inefficient. Over very long periods you are almost guaranteed to have substantial appreciation. A change of 2% a year in appreciation over 30 years will make a big difference in the end value of your home. This means it's almost impossible for a homeowner to use DCF (discounted cash flow analysis) to get an accurate value on owning the home today. Change the inputs slightly and you get a hugely different answer.

So instead homeowners tend to get carried away with paying up nowadays, because the market has been strong for twenty years due to falling interest rates. Lower interest rates make homes more valuable. Over the last two decades, that extra boost from falling rates has made it appear you never make a mistake buying a home since appreciation has made almost any purchase price reasonable given enough time.

If interest rates rose for 5 years, appreciation would be so miserable (probably negative) that opinions would switch and we'd soon think only an idiot would own a home.

And today no one thinks about trade-offs. In the example given, it might be $3k per month in savings by renting (no property tax, maintenance, etc). That's $36k per year, and over $1M in 30 years, without earning any interest on it. Invest it at 6-7%, and the result might be worth much more than the house. Of course if most people rent, who is really going to invest the difference?

haakee · #4 10-16-2006, 01:36 AM

In addition, many buyers are unaware of the true cost of their loans because they get exotic loans which makes the loans appear to cost less than they actually will over the full 30-year period. Lenders seem to care less than ever before about the ability of their lendees to pay as well.

dc_publius · #5 10-16-2006, 02:06 AM

I am willing to bet that your landlord didn't pay $900,000 to buy the place to rent it out to you for half the price. Chances are good that he bought it 10 years ago for $300K and he's banking much cash from your rent (and can sell the property eventually for additional gain)

In general, in stable nonappreciating markets rents are more likely to be cash flow positive. In fast appreciating markets, the money is in appreciation so investors are willing to give up positive cash flow in exchange for possibly huge gains in property value. Individual area markets tend to switch between these two scenarios. If you're really good (or lucky) you get the property as a cheap cash flow property right before the local market takes off.

pig4bill · #6 10-16-2006, 11:23 AM

Supply and demand. People are not going to rent a house for $4000 a month when they can rent an apartment for $1500-$2000. By contrast, a few years ago you could buy a house in Vegas for $1000 a month in payments and rent it out for $1000. Apartment were $700, so people would pay an extra $300 a month to rent a house.

DanS · #7 10-16-2006, 02:15 PM

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I am willing to bet that your landlord didn't pay $900,000 to buy the place to rent it out to you for half the price. Chances are good that he bought it 10 years ago for $300K and he's banking much cash from your rent (and can sell the property eventually for additional gain)

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I agree with you and everyone else. The landlord had owned the property for at least 20 years, so the purchase price was probably <$200k and even with a refi, she probably has a $1200-1500 mortgage. My concern was more geared towards someone who would buy a property like that today, with an eye towards renting it out.

Dan

maxtower · #8 10-16-2006, 03:09 PM

I don't think it would be a smart move for anyone to buy the house today (in the area in question) with the intent to rent it out. You will lose on that deal. Having to compete with cheaper apartments and other rental homes whose owners bought 20 years ago would make it impossible to compete.
There are areas of the country where people have a lot more money than average. They also place a high value on home ownership, and so the home prices get inflated compared to the areas of the country where people in general make less. Those areas where people make less (rural areas and southern states) are probably a lot more efficient in terms of rental prices vs. ownership costs. This is because the majority of buyers/renters are more price sensitive.

Let the real estate market see a couple of consecutive years of interest rate increases, and then you'll see these inflated home prices fall. A lot of investors are going to want to cash out at the same time that a lot of people realize they can't afford the new payments on the ARMs they got 3-5 years before.

Derek123 · #9 10-16-2006, 03:28 PM

say I find a property now that has positive cash flow from renting it out. If the total rent payments are more than my mortgage, insurance, upkeep etc. Are there downsides to purchasing this? will the threat of future interest rate increases affect me? I am considering doing this but want to know the possible risks.

haakee · #10 10-16-2006, 04:38 PM

If you get a fixed-rate loan then the movement of interest rates won't affect your cash flow, although it would likely affect the resale value of your property. Vacancies will cost you money, don't forget to figure that in. If you want somebody to manage it for you that will also cost you money.