Friday, May 13, 2005

Rents vs. Mortgages

California is experiencing the greatest rise in real estate prices since the 1880's boom in Los Angeles. Real estate brokers, home owners, and mortgage bankers swear that the 25% annual price appreciation is completely sustainable, because of high demand and constrained supply. Economists and scholars are starting to see a bubble market even drawing comparisons to the NASDAQ crash in 2001.

The reality is that no one truly knows what is going to happen. California may go the way of Australia and see a price drop 40% in the next few years. It may muddle through as it did in the 90's after the heavy job losses in the period from 1989-1992. Or it may continue to appreciate, as supply of developable land is exhausted.

While no one can accurately forecast future home prices, I believe the tea leaves are very clear for the future direction of rents in California. Peering into my crystal ball I foresee a rent spike in the next 18-24 months of 8-12% in a single year.

Any way you slice it, rents have to rise. If interest rates stay low and home prices continue to go up, then the spread between rents and mortgages will increase, and rents will rise. If interest rates rise and home prices flatten out, the increased cost of a mortgage will deter new home buyers and force people to stay in apartments, and rents will rise.

But why a huge spike of 8-12%?

1. Condo conversions
Condo conversions are sucking ten of thousands of units out of California. In San Diego, 56% of the apartment units sold in the last 2 years have been converted to condos. In LA, OC, and SF the figure is more like 30%, but still a significant figure when you consider the record deal volume in the last 2 years.

2. Condo Development
Condo developers are currently paying anywhere from 2-3x more than apartment developers for land. Condos are essentially crowding out apartment development.

3. Mortgage to Rent Spread
It is common knowledge that people will pay more on a monthly basis to own rather than rent. Owning gives one the opportunity for appreciation, instills pride, a sense of permanency, community, etc. Therefore a moderate premium of 20-30% makes some sense. For instance if you can rent a 1800 sf home for $2000/month than a mortgage payment of $2400-2600 is sensible. However, in cities like Irvine (in The OC) an 1800 sf home costs about $750,000. With 20% down you need a loan of $600,000 on a 30-year fixed at current rates of 5.85% (as of May 13, 2005) that is a monthly mortgage payment of $3,539. After property taxes and the interest deduction the net is about $3,200/month. By comparison, an 1800 sf home in Irvine rents for about $2300/month. This equates to a premium of about 40% for owning versus renting. To narrow to a more normal range like a 25% premium, rents would increase from $2300 to $2560 or 11%.

Just food for thought.

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