Stop listening to the economists, it all comes down to the math
I generally do not heed the predictions of the well-paid, but financially compromised real estate economists, for they are all usually incorrect. Most of these market shills are not involved in the residential market they way we investors and property managers are on a daily basis. We active investors are better able to feel the pulse of the marketplace than any well-paid analyst. Savvy investors who directly own their properties will generally come out ahead over time.
As long-term investors, we only care about the numbers; specifically I prefer analyzing what’s behind the discounted cash flows of a particular real estate investment. The easiest way for me to determine if a property is overvalued/undervalued/fair market is by determining an investment’s capitalization rate (cap rate) and internal rate of return (IRR). I then attempt to compare these current values to its historic norms to see if the price is too expensive or still offers value to me. Thus, the current market value only tells us part of the story. We need to see how the rental market has performed over this time frame. While we may not be getting full market rent, other investors will price real estate off this potential amount.
A look behind the numbers of two of my single-family dwellings
I recently rented out one of my single-family houses, and the table directly below shows the specifics. I did not charge full market rent, but only have four people living in this 5 bed/3 bath house. However, I was easily able to increase my rent well over $1,200 a month. I received about 10 applications in the five days it was listed, and the phone was ringing non-stop.
Take a look at the change in the capitalization rate; it actually increased over the four-year time frame. Based on these numbers, the price of the house actually offers me a better value than that of four years ago!
Let’s take a look at another property I just rented out. In this instance, it is a 2 bed/2 bath condo. I initially advertised it last week on Zillow for $1,785/mo., but with renter competition, I am now going to recieve $1,900/mo. And this is not even full market rent of close to $2,000. The property was only listed for four days, I had 12-13 different parties come by during the open house, and received about 10 applications.
As we can see in the above example regarding this condo, while the capitalization rate has declined, this property still offers an investor an ample cash flow and rate of return. While the cap rate has declined over the past four years, it has not dropped to the lows observed in the real estate bubble of the mid- to late-aughts. During the height of that real estate bubble, the cap rate on this property fell to as low as 3.5%. As we can see, there is still a lot of room for prices to rise before we call it a day on this cycle. If the cap rate dropped to 3.5%, the condo’s price would have to double, while the rent stayed the same.
Please note that I did not address the concept of the IRR in this article, since it wasn’t necessary to illustrate the main thrust of my post; residential real estate in many parts of the United States still offers investors (and homeowners) some compelling value. This determination, of course, is based on the growth in market rents.
I predict that the capitalization rate on the single-family detached house could approach 4% if bond yields stay in their historically low range for the longer-term. The capitalization rate on the detached house in the mid-aughts RE mania was as low as 4%. Moreover, given the trajectory of rent rates, I look for more rental rate increases over the years as more immigrants pour into the local area.
If the cap rate on the house falls to 4%, this would imply a market value of $745,000. If the cap rate on the condo fell to the same level, this would imply a market price of $428,000.
Are we in a real estate bubble? Based on my experience I say we are not even close. If you live in Australia, New Zealand, Europe, or Canada, I say come to the states. The US still offers us opportunity. I have run numbers for many people around the world over the years and know the cap rates in your countries are less than half of what they are here in the States.