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RENT TO VALUE RATIO: THE ECONOMICS OF RENTALPROPERTY

June6,2012

Lately there has beenmuch news regarding theGovernment SponsoredEnterprises (GSEs) and other privateREOtoRentalprograms.Withhousingpricesnowherenear thehighsofa fewyearsago, can investorsmakegoodreturnsrentingthesepropertiesuntilthemarketrecovers?

The simple answer is yes, but its not that easy to find a property that can provide enough rental income tocover all carrying costs while also being easy to convert into the owner occupied market once the housingmarkethasrecovered.InthismonthsLessonsfromtheDatawewill reviewsomeduediligenceconsiderationsthataffecttheriskinmakingsuchaninvestment.

RENT TO VALUE RATIO (RENTAL YIELD)

Theratioofrenttovaluecanbeavaluableguideandarequisitepartofathoroughinvestigationofaninvestmentopportunity.Thethoughtbehindthisratio(12monthsofrent/homeprice),calledrentalyield,isthatitisakintotheearningstopriceratiointhestockmarket:higherearnings,allelseequal,areassociatedwithmoreprofitableinvestmentsandarelessreliantuponfuturegrowthinthestockpricetogenerateexpectedreturns.

Thesamenotionappliestotherentalyield:higherrentsmakeit less important for theproperty toappreciate invalue inorder tomeetacertainexpectedreturn targetsetby the investor.However, rentalyieldalone, like theclassicearningstoprice ratio, isnotaguarantee forasuccessful investment. It isnecessary to lookcarefullyunderthehoodatotherconsiderations.

RENTAL YIELD DRIVERS

Much researchhasbeendone toevaluate thedriversand thevariabilityof rental yieldsamongmarkets.Suchresearchprovidessupportfortheroleofrentalyieldsininvestmentdecisions,butalsomakesclearthatthereisnosinglerentalyieldthatshouldguideallinvestmentdecisions.Herearesomefactorsthatleadtovariationsintherentalyieldsamongmarkets.

1.SupplyElasticityMatters

Historically,weobservethehighestcurrentyieldsinelasticmarketswhereitiseasytoaddnewhousingsupply.Becauseitiseasytoaddnewsupply,anysignificantrealincreasesinpricesresultinmoreunitsbeingaddedtothemarket.Rentswill tend to risewhile prices stay flat in these elasticmarkets as investors turn to rents inordertomakeareturnoninvestment,whilemanywouldbehomebuyersrentbecauseanonappreciatinghomepurchase isa lessattractive investmentand/or theycant obtain the financingwith todays tighterunderwritingguidelines.

Weseevariations ingross rental yieldsat theneighborhood levelmapsgeneratedbyProTecksHomeValueForecast.InsupplyconstrainedmarketslikeNewYork(Figure1)weseeratherlowyields.

Figure1:SingleFamily2011GrossRentalYieldsbyNeighborhoodinNewYork

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Thedarkest reddotsrepresentyieldsunder2percent,while thepinkdotsrangefrom2percent to5.9percent,the lightest pink dots range from 6 percent to 7.9 percent and the various shades of darker blue reach to 14percentandabove. It isapparent that in thesemarkets thecurrentgrossyieldsare rather low,and itwouldbedifficulttocarrysuchpropertiesasinvestmentswithoutinfusingcashduringtheholdingperiod.

Attheotherextreme,wehavemarketslikeLasVegas(Figure2),whereweseemanydarkbluedotsandgrossyields close to or above 14 percent. Granted, in such markets we also must consider the risk of having avacancyanddosomeresearchonthechancesoffindingtenants.

Figure2:SingleFamily2011GrossRentalYieldsbyNeighborhoodinLasVegas

2.SubprimeEffectsLinger

Thehigher current yields are also correlatedwith thedegreeof subprime lendingandhigh loan to value (LTV)mortgagesasthesemarketscontinuetobeimpactedbyahighdegreeofdistresssalesholdingpricesdown.We

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cansee this inmarkets likeAtlanta (Figure3),whereweobserveneighborhoodswithin the samemetropolitanarea where the rental yields are quite high (generally southern Atlanta, where prices have been held down byhigher ratioof distressedsales) andotherneighborhoodswhere the yieldsarequite low,andwheredistressedsalesarenotascommon.

Figure3:SingleFamily2011GrossRentalYieldsbyNeighborhoodinAtlanta

WealsoseethismixoflowandhighyieldsintheSanFranciscometro(Figure4)wheremarketslikeRichmondandSanPabloremaindistressedwithmuchhigherrentalyieldscomparedtoSanFrancisco.

Figure4:SingleFamily2011GrossRentalYieldsbyNeighborhoodinSanFrancisco

3.RisksAreCorrelatedwithCurrentYields

Thedilemmafor investorswhowishtotakeadvantageof thenewREOsalescomingonthemarket is that the

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Loanrateat4percentwith50percentloantovalueratio(2percentofthehomepricenet)

Propertytaxesat1.0percentofhomeprice

Propertyinsuranceat.75percentofthehomeprice

Utilitiestobepaidbytenant

Maintenanceat1.25percentofhomeprice

leastdistressedandmostsupplyconstrainedmarkets(whicharethosewherepricesaremoststableandlikelytoincreaseoverthenextfewyears)arethemostdifficulttocarryThereverseistrueinmarketslikeLasVegas,where yields are much higher but there is uncertainty when the excess supply will expire. There is alsouncertaintyhowmanyyearswillpassbeforepriceswillincreaseinsuchmarkets.

Eventually excess supply will dissipate, but by thenmortgage ratesmay be double, holding prices down. Soevenifthereisconfidencethatthesupplywillnormalize,asithasinmarketslikePhoenix,thereisnoguaranteeofpriceincreases.

An investor can look to market data and forecasts to help determine markets that have both strong currentfundamentalsandstrong longer termdrivers that indicatethehomesvalue is likely toappreciate,providingtheopportunity to sell the investment for aprofit in the future.Someof the current fundamentals an investormaylook at would be vacancy rates, rental rates,months of inventory on themarket, price trends and amount ofdistressed sales. Longer term drivers of future value appreciation are broader economic drivers likemortgagerates,household incomeandemploymentgrowth.Forecastingmodels that incorporatesuch longer termdriverscanbeusedtoestimatefutureappreciation.

CALCULATING OUT CARRYING COSTS

Wecancalculatehowmuchrentmustbecollectedinordertocarryaninvestmentrentalhomeusingahousingcostfactor(HCF).TheHCFexpressesthecostofcarryingahomeasapercentoftheoriginalpricethatneedstobepaidannually inordertocoverhomeexpenses.Itdoesnot includetherequiredreturnonequityandsoisvery sensitive to leverage (the amount borrowed as a percent of the original price). Lets use the followingassumptionstodemonstrate:

Theresultofaddingthesetogetherisexactly5percentofthehomeprice:r/v=.02+.01+.0075+.0125=.05.If youassumenovacancy, thennoadjustment isneeded,but if youassume10percentvacancy, theHCF isequal to 5 percent divided by the average occupancy rate, 90 percent, or 5.556 percent. We must also addsomethingformanagementwhichtendstorun10percentto20percentasapercentageoftherentcollectedforsinglefamilyhomes.Ifweuse10percentthenweneedtohit5.556percentagaindividedby90percentresultingin6.2percentastheaveragerequiredcurrentcashyieldnecessaryinordertocarrytheunitwithoutanyongoingsubsidy.

OnequestionishowmanydistressedREOsalesareouttherewheretherentisgoingtoaverage6.2percentormoreofthepriceofthehome?Lookingatthemapsinthisarticle,anyofthesubmarketswithlightpinktobluedotsmeetthiscriterionandarecandidatesforacquisitionwhenonemustholdforthreeyearsorlonger.

Suchisnotthecaseinthosemarketsdominatedbyredordarkerpinkdotsbecausetherentalincomesintheseareas make it difficult to carry these homes, even with 50 percent down. Even 100 percent down REOinvestmentsneedarounda4percentyieldperyearinordertocoverpropertytaxes,insurance,maintenanceandmanagement expenses and many markets do not provide yields that high. The conclusion is that holding aproperty for three years or more in a market where the rent may not even cover the carrying cost is notappealing.Theselowyieldmarketsremainmostappealingtoflipperswhowillcomein,repairthehomesandputthembackontheowneroccupiedmarketassoonaspossible.

In the table below we calculate the net appreciation required in order to hit a target internal rate of return(annualized yield) over three years, given the goingin rent to value ratio and carrying costs. The differencebetweenthesetwoisthedeficitthatmustbemetbyappreciationinthevalueofthepropertyinordertomeetthetargetinternalrateofreturn.

It isobviousthatmuchlessappreciationisneededtohit thesametargetreturnwhenhighergoinginyieldsarepossible,althoughonemightarguethatinsuchmarketsthereismuchmorerisk,requiringpremiumyields.

Note that an appreciation rate of ~80 percent over three years is the same as buying a REO property atapproximately45percent lessthantheeventualsalesprice.This isnotunusualonREOsalespurchasedfrom2008through2010(discountshavenarrowedsinceduetoincreasedcompetitionforproperties).

Belowwevarythecalculationstoshowtheeffectsofrequiringhigheryieldsinthosemarketswherethecurrentyieldsarehigher,buttherisksarealsohigherinseveralways.

Akeysourceofsuchriskisthesizeandultimatedispositionoftheinventoryofdistressedrealestatebeingheldby banks. For example, the rapid disposition of this distressed inventory may dampen prices and increasevacancyrates.

Onewaytocapturesuchriskistoincreasetherequiredyieldapercentinlinewiththeincreasedgoinginyield.Theresultisthatweneedslightlymorenetappreciation,aswestepupthecurrentyields,whichislesslikelyintheselesssupplyconstrainedmarkets.

CONCLUSIONS

Themoreconservative investorswhobuyREOsfromtheGSEs(FannieMaeandFreddieMac)will likelyseek

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out acquisitions in thosemarketswhere the current (gross) yields are significantly above6 percent andwherecurrentvacanciesarenotexcessive.Suchpropertiesarenotwithoutrisksbutareeasiertocarry.

Marketswhere thecurrentyieldsarevery lowarebettermatchedwith flipperswhowillwant to turn them inaslittletimeaspossible,sellingthembackintotheowneroccupiedmarketwithouteverrentingthemout.Buttheselower current yield properties do not accommodate significant financing leverage without periodic cash flowinfusions and if interest rates go up, the new buyer demand from owner occupierswill soften.Onemust alsokeepinmindthateagerbuyersoftendonotqualifyintodaysunderwritingenvironmentsothatalonerestrictsthedepthofdemand.

ThebiasofREOinvestorstowardshigheryieldpropertiesis, infactwhereweseethemostdemandforREOs.These investorswillneed tocarry theproperties forat leasta fewyearsor longerandbepatient inoffloadinginventoryatpacesthatthemarketcanabsorbwithoutsignificantlyaffectingcurrentprices.Thosemarketswheretheyieldsarenothighenoughtocarrynorlowenoughtobegoodflippercandidatesmayflounderforabitlongerastheyfallthroughthecracksofmarketappetites.

JamesR.Follain,Ph.D.JamesR.FollainLLCandAdvisortoFIConsulting

NormMiller,PhDProfessor,BurnhamMooresCenterforRealEstateUniversityofSanDiego

MichaelSklarz,Ph.D.PresidentCollateralAnalytics

AboutHomeValueForecast

Home Value Forecast was created from a strategic partnership between Pro Teck Valuation Services andCollateral Analytics. HVF provides insight into the current and future state of the U.S. housing market, anddelivers14marketsnapshotgraphs from the top30CBSAs.Eachmonth,HomeValueForecast.comdeliversamonthlybriefingalongwithLessonsfromtheData,anindeptharticlebasedontrendsunearthedinthedata.

HVF is built using numerous data sources including public records, local market MLS and general economicdata.Thetop750CBSAsaswellasdatadowntotheZIPcodelevelforapproximately18,000ZIPsareavailablewithacorporatesubscriptiontotheservice.

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