2008 November 01 — Greater Fool – The Troubled Future of Real Estate

It’s the yield, dude

November 1st, 2008 — Book Updates — E-mail this blog post to a friend

Where are real estate prices headed? If you agree with me, down. In fact, price reductions across Canada over the last six months represent just a taste of what’s to come.

That’s my opinion, and I’ve expressed my reasons for this belief many times over.

But, maybe I’m full of it. Wouldn’t be the only time. So what this country really needs is a tool real estate junkies can use on their own to determine if a property’s over-valued.

Fortunately, it exists, at least in rough form: The P/R ratio.

This is the Price-to-Rent ratio, which has been used for some time to figure out if a piece of real estate is fairly valued relative to its ability to earn income in the marketplace. It operates on the same principle as a stock’s P/E ratio (no, that does not mean how much you wet your shorts when opening your latest mutual fund statement).

With stocks, investors can judge if the price being asked is worth paying based on what a single share yields. If the price is expensive and the earnings low, then the P/E is high – not a good thing for short-term capital gains.

With a house, same thing. If the asking price or current market valuation bears an unrealistic relationship to what it can be rented for, well, it’s probably not worth what the vendor is asking. Here’s how to determine that:

Simply take the annual rental income and divide it into the property’s price tag, and then measure it against an historic norm. One good benchmark, according to Moody’s Economy.com, is a P/R of 16 – which is a long-term average.

So, let’s take a subdivision home in a western suburb of Toronto built three years ago, sitting on a 36-foot-wide lot with a double car garage, and currently on the market for $460,000. You can rent that three-bedroom home today (or a mess of others just like it) for $1,800 a month.

So, that’s a yearly rental income of $21,600, divided into an asking price of $460,000, for a P/R ratio of 21.2. Ouch! This baby is overpriced, especially so because comparable houses can be leased for up to $300 a month less in the same general area.

So, let’s ask a final question: Is it better financially (i.e. cheaper) to buy or to rent this particular house?

Well, let’s do the math on 20% down (that’s $92,000) and a mortgage of $368,000, plus maintenance costs, insurance and property taxes (charges not incurred by a tenant).

Downpayment cost (what $92,000 a year would earn in a 3% GIC): $2,760

Mortgage payments ($368,000 at 5-yr rate of 7.2%, 25-year am): $31,477

Maintenance (new house, virtually nothing): $1,000

Insurance: $1,700

Property tax (in this area, average on 3-bedroom, 2,000 sq ft home): $5,400

Total annual ownership cost: $42,377

Rental cost for the same house: $21,600

Cost of being a Greater Fool: $20,737

This post: Priceless.