Looking at the latest posted mortgage rates, a 5 year fixed rate mortgage is between 4% and 5.25%. If you are a long-time reader, you remember the back-of-the-envelope NPV formula used by mohican (I derived it here), used to calculate a “fair” value for a property, given the net rental income and the 5 year mortgage rate:
NPV = (RENT – EXPENSES)/(5 YEAR MORTGAGE RATE)
If the mortgage rates are approaching 4%, does that mean that many of today’s prices are fairly valued? Is this formula valid in today's environment?
What low long term rates are saying, translated into mortgage rates, is that the market does not expect inflation to be a concern for the next while. That means two things for real estate investors: incomes and rents are unlikely to increase in aggregate and could even fall in the short term. The above NPV calculation, if derived from discounted cash flows, accounts for rental inflation by offsetting the denominator against inflation. We are left with a denominator that should contain the discount rate minus inflation. With mortgage rates low, what are banks saying, and should we really be using the 5 year rate in the denominator?