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Rental Parity Establishes The Value Of Residential Real Estate
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The importance of rental parity
Rental parity represents a crossover point where renting and owning have an equal monthly cost. When prices are above rental parity, it costs more to own than to rent, so owning is often not a wise financial decision. Owning may still be right for people, and many are willing to pay the premium to own to obtain the emotional benefits of ownership; however, on a purely financial basis, paying more than rental parity creates a negative cashflow situation where owners pay more to enjoy a house than they have to. Over time fixed-rate financing and rising rents may tip the balance the other way, but depending on how much more than rental parity an owner paid, it may take many years to realize this benefit.
When prices are below rental parity, it costs less to own than to rent, so owning under these circumstances is generally a wise choice. Since a buyer who pays less than rental parity for a house is saving money, there is a clear financial benefit obtained irrespective of fluctuations in resale price.
When the cost of ownership is less than rental parity, an owner is far less likely to be forced to sell at a loss. The property can always be rented to cover costs rather than sell for a loss. Further, this ability to rent and at least break even provides the owner with flexibility to move if necessary. Mobility to take a new job or buy a different house is denied to those who overpaid and who are stuck paying more in the cost of ownership than they can obtain in rent.
With these advantages, buying at a price below rental parity using fixed-rate financing is critical. Every buyer should consider rental parity in their buying decision, which is why the new upgrade to the OC Housing News shows the cost of ownership and the cost of a comparable rental for every property on the MLS.
Rental parity as the basis of value
When considering housing market valuation, I use rental parity as a basis. Valuation is the least understood, yet most important, aspect of a housing market. Economists look at various ratios including price-to-income, price-to-rent, and other aggregate measures to attempt to establish valuation metrics. Each of these has strengths and weaknesses, but each of them fails because they don’t directly connect the actions of an individual buyer to the activity in the broader market. For this reason, I strongly favor rental parity as the best measure of valuation. Rental parity ties together income, rent, interest rates, and financing terms in a way that matches the activities of individual buyers to the overall price activity in the market.
Premiums or discounts to rental parity
Rental parity does not capture the complete picture. Some neighborhoods are very desirable, so move-up buyers take the profits from previous sales and bid up prices, and motivated buyers often stretch to the limit of their borrowing power to acquire homes in these neighborhoods; therefore, the most desirable neighborhoods often carry a premium to rental parity. The inverse is also true. Some neighborhoods are not as desirable, or may contain high concentrations of condos and other first-time homebuyer products. These neighborhoods generally trade at a discount to rental parity.
Benchmark value of stable market
To value of any asset or market, it’s necessary to establish a standard of measure considered “normal” for the asset. To achieve this end, historic data must be obtained and analyzed to establish a period of time within the specified geographic area when the asset was considered fairly valued under normal market conditions.
Real estate markets generally exhibit long periods of stability and normalcy; however, there have been a number of distortions to market value over the last forty years. It is imperative for accuracy to identify and exclude periods when the data is distorted and does not represent a normal condition. There were a real estate bubbles in California from 1976 to 1982, from 1987 to 1992, and from 2003 to 2009.
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