Tuesday, March 17, 2009

Owner’s Equivalent Rent

A question surfacing recently on local blogs and forums has been how to properly value owner-occupied housing. The concept of “owner’s equivalent rent”, the effective rent an owner-occupier pays to carry a property, can be used to justify a property’s value. Such a concept would require setting equivalent rent based upon what other owner-occupiers pay, a slightly unsatisfying exercise for the value investor. A more palatable method would be to find equivalent investment properties and see what rents they command but this is not always easy. It begs the question: how does one ground a property’s value when there is little in the way of equivalent local rentals to do so?

A recent article in the Vancouver Sun had three local pundits involved in the real estate industry give their comments about the local real estate market. While I cannot encourage you to read it fully, I did pick up on a few items Dr. Tsur Somerville from the University of British Columbia has said about his research in how real estate markets behave with a significant portion owned by owner-occupiers.

Q: You said the investment piece is gone: Does that mean that the froth is not going to happen again? (If people aren't buying as investment properties, what would happen with price?)

Tsur Somerville: A couple of issues: No. 1, we don't actually really understand what goes on with investment real estate. When you look at research and studies, it is because home owner/occupiers are such a big piece....

Q: How big?

Tsur Somerville: Since we don't actually 100 per cent know which unit is which. But if you take the Lower Mainland and [calculate] 2.5 million people, 2.6 people per household, that's 800,000 households, 60 per cent homeownership [so] 480,000 households.

The investment piece is still very small in the overall number. It's highly concentrated in certain product types, downtown condos, certain suburban high rise buildings. Overall, it's not a big story. Going forward, we have two things we don't really understand, which is what are those people going to do?

What Dr. Somerville is commenting on is that when owner-occupiers make up a significant portion of a housing pool, it becomes more difficult to determine motivations of marginal players when existing data lump investors and owner-occupiers in one pool, especially when the “investment piece is still very small,” say, 40% of total households.

Joking aside, what I believe is implied is many people place a monetary premium on ownership and motives for buying and selling are not always strictly financial, hence the difficulty in separating true “investors” from the rest. (this blog discussed the concept of the "ownership premium" here.) The “non-investment” focus of marginal owner-occupiers therefore adds uncertainty to the behaviour of the market. He states that there is segmentation between owner-occupied and rental housing, or at least that is the perception, meaning that valuing entire neighbourhoods based upon the whims of investors not heavily involved in the market is questionable.

From a value investment perspective, to determine the net present value, we sum a property’s expected discounted net cash flows. We should also remember that undensified detached housing can justifiably carry a premium over today's rent as the property could be redeveloped in the future so as to increase its utility (as discussed here) and possibly a "gentrification" premium AKA location-location-location in some circumstances (see m-'s great post for some interesting data and analysis). Determining net present value with many equivalent properties with known rents is simple; unfortunately it is more difficult when properties have few direct comparisons. It is possible that in certain neighbourhoods the one or two rentals offering true comparables do not provide enough of a sample to truly gauge what rents would be for other properties. This can even be true for a seemingly normal property with a high finish quality where the neighbourhood's rentals are not renovated to the same degree.

Buyers are therefore left looking at comparable sales in the same geographic location to determine value, in part because neighbourhoods and even adjacent blocks can significantly vary in price. I doubt very much rental data enters into most owner-occupiers’ heads when determining a fair price yet it is an important and almost necessary clue when determining a property’s value ex speculation. Perhaps it is a stigma associated with comparing “the renters” to “the owners”; an admission a property can be rented out at all goes against the concept of “achieving” ownership, or maybe it is just making the buying decision simple: find five comparable sales, offer about that, and Bob’s your uncle. Alas, this is not my idea of value investing.

Believe it or not, even “high quality” houses are rented out. A quick search of Craigslist turns up a few “high quality” rentals, as examples (not sure if they’re “real” or not; these props will likely disappear so maybe do your own search...):







You can calculate how much these properties would be worth as net present value and compare to their rough market values. There are not too many examples of higher quality rentals, however, and we are still left with the problem that a specific neighbourhood will likely reveal few, if any, equivalent rentals for a property for sale.

Yet even from the close to nonexistent comparables, we can still make some assumptions. In the absence of direct data we can look at high quality rentals across the entire region and compare them to lower quality rentals in their respective areas. This will give a rough indication of the premium higher quality demands in the rental market. From this we can look at a larger set of “high quality” compared to “lower quality” rentals and apply a factor to determine equivalent value for a certain “higher quality” property. The concept is simply that there are many neighbourhoods that are effectively comparable, even if separated geographically.

Using comparables from other neighbourhoods is roundabout method of determining value. The uncertainty is higher and my guess is Realtors won’t like the concept one bit; after all isn’t all real estate local? But we need something, even if it’s using deductive inference, or the market is not grounded on anything but sentiment and margins.

Many neighbourhoods have a large mix of both rental and owner-occupied properties so the problem of determining value for the value investor is less severe. For some neighbourhoods, say close to UBC for example, the concept of determining value for predominantly owner-occupied properties I am sure can seem daunting. Even in the face of such high noise, using a bit of deduction, an expanded "virtual" rental market provides us with enough of a tangible signal highlighting how much "high quality" properties are currently priced above what the rents say they are worth.

10 comments:

patriotz said...

One huge flaw in Somerville's argument regarding the signifance of the % of properties owned by investors is that pricing is determined at the margin. In other words, it's not the % of properties owned that's significant but the % of buyers and sellers. Since investment properties turn over more quickly than owner-occupied ones their impact on pricing is more than one would infer from their % of properties owned.

Indeed I would argue that for condos in particular investors are the prime movers of the market. Owner-occupiers are incidental.

jesse said...

"Since investment properties turn over more quickly than owner-occupied ones their impact on pricing is more than one would infer from their % of properties owned."

I think the argument is that there are effectively two markets, the investment market and the non-investment market and in some classes of dwellings the non-investment class dominates.

I agree that investors will set general price levels in the aggregate statistics and for markets in which they produce a significant fraction of transactions (such as condos). That doesn't help solve how to value properties in higher end "non-investment" neighbourhoods. We are left trying to infer rent that is a function of purchase price! Unless we can reference to something more tangible...

Alan said...

On a side note, I was recently given this link from CMHC about the effect different ways to count home ownership cost might affect CPI.

http://www.statcan.gc.ca/pub/62f0014m/62f0014m2003016-eng.pdf

patriotz said...

I think the argument is that there are effectively two markets, the investment market and the non-investment market

Which is patently incorrect. All properties are sold on the same market. A buyer does not care whether the seller is an owner-occupier or an investor, nor does a seller care about the buyer.

yaa said...

Which is patently incorrect. All properties are sold on the same market. A buyer does not care whether the seller is an owner-occupier or an investor, nor does a seller care about the buyer.

i wonder if given two similar condos, one owner-occupied, and one being rented out (i.e. investor owned), which the majority would choose.

patriotz said...

Clearly an owner-occupier would prefer a non-tenanted property given the same condition and the same price. Getting rid of a sitting tenant incurs cost and risk. But that does not mean a segregation into two different markets, just a price adjustment.

But an investor always has the option of incenting a tenant to leave prior to marketing the property. Also of course, a great many investor owned properties are vacant anyway. Just look at the MLS. Such a property would usually be preferred by an owner-occupier over one which is currently occupied by the seller.

jesse said...

"i wonder if given two similar condos, one owner-occupied, and one being rented out (i.e. investor owned), which the majority would choose."

Rents must cover the cost of wear and tear and other forms of depreciation. If a landlord decides to use the income from rents for other purposes and not properly provision for depreciation or perform adequate maintenance, this is nothing more than a cash advance.

Agree with patriotz it's the same market. It may seem different but I would be very hesitant to gloss over the fact there are perceived differences between market segments, seemingly manifested through the owner-occupier versus investor ratio, when the two are very similar when all costs are accounted for.

JimTan said...

Congratulations! This series is thought provoking and adds value. This is an improvement over people- bashing which doesn't add economic value, though bashing can be gratifying at times.

That said, I would advise against analysis paralysis. This is a fuzzy world. Be market-focused. Markets are dynamic. Can you capture the nature of that dynamism? You're got to pound the pavement and talk to people.

buff_butler said...

I have to admit this is by far my favorite blog. Thanks!

LC David said...

This rent is to justify value of property only....
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