Is Real Estate the New Dot-Com?

Morningstar.com – Real Estate Is the New Dot-Com

Like many people we know in Watertown who own homes and have children about to enter kindergarten, we have been struggling with the question of whether we should move to a town with a more highly regarded school system. Struggling is probably not the best description, better to call it paralyzed.

We bought our two-family five years ago and have seen its market value more than double (based on what other houses on our street have sold for recently). But even if we dumped all the equity into a downpayment and took on a monthly mortgage payment more than twice what we have now, according to SmartMoney’s “How Much House Can You Afford” worksheet the most we can afford is still considerably less than the starting price of decently located four-bedroom homes in, say, Belmont – and those are homes without any more square footage or land than we have now – defeating another major reason for moving.

So what are our options? As I read more about whether we are experiencing a housing bubble some people are writing that they are selling now and renting until prices drop dramatically. It’s hard to imagine moving a family with two children twice so that’s really not an option for us. But it did make me wonder just how inflated the prices around here really are and whether it’s likely that they’ll come down.

I found this article on Morningstar that tells how to calculate the NAV of your home

In its simplest form, the NAV requires just four major inputs: annual rent over the past year, average maintenance costs per year, an average long-term growth rate in rent or property value, and a discount rate (called the cap rate in real estate). Without getting into the guts of the theory behind this model (plenty of explanations exist in finance texts and on the Internet), the NAV formula looks like this:

NAV = ((Rent – Maintenance Costs) * (1 + Growth)) / Cap Rate

If you're dealing with your own home–owner-occupied real estate–you can simply estimate the rent component by comparing your house to comparable rental homes in your area.

Next, to estimate the average annual costs required to maintain the property in its present state–no better and no worse–consider the two major costs: property taxes (net of the income tax benefit) and home maintenance such as periodically replacing appliances, fixing leaky roofs, and so on. For reference, most apartment REITs have costs equal to about 30%-40% of the rental income, and this seems a reasonable proxy for single-family homes as well. Next, you need a long-term growth rate estimate. This is a bit subjective–and will vary by region–but can be arrived at via CPI estimates (4.2% per annum going back to 1980) or by using home price data (which averaged 4.4% annually since 1980 if you ignore the past 5 anomalous years). Finally, the cap rate. Because real estate is a low-risk asset class, the cap rate can be derived by adding a couple of percentage points to the current long-term Treasury rate. Historically, apartment real estate has carried a cap rate of about 7%, and, given the current interest-rate environment, professional investors have been able to justify a cap rate of about 6%-6.5% in some recent cases.

Once this calculation is done, investors will also probably need to tack on a control premium. This is the value assessed for the net benefit of controlling the residence rather than being at the mercy of a landlord. Similar methodology has commonly been employed in the stock market, most frequently during merger analysis, and the premium has typically averaged about 20%-30%.

 If the price you can sell for is much higher than the NAV then it’s time to sell. And if the price/rent multiple is very high then it’s not worth the asking price. The article says “a reasonable range of price/rent multiples–no matter where the property is located–ranges from about 9 at the low end to 23 on the absolute high end.”

So now I have to do some calculations.