I live in Southern California, an area of the country where by almost universal agreement, housing prices are completely out of touch with reality. But what does this actually mean? What "should" a house be worth? Of course the first answer is that something is worth whatever a willing buyer will pay that a willing seller will accept. Thus, my house was "worth" what I paid for it when I bought it. But no willing buyer at that price could now be found and economists say that housing values are retreating to a "more normal" level. But what does this mean?
Let me start by saying that I'm no real estate expert, nor am I an economist. I'm merely a curious person who likes to read and analyze, particularly with numbers. Now I recall reading, many years ago, an expert's opinion that a house should ultimately be valued at the net present value of the cash flows that would be available by renting the house. I can use this as a starting point and see where it gets me.
So then, what "should" be the value of a house based on the rent assumption? As is usually the case in my blog posts, I have to make some assumptions and estimates Let's assume that a household has an income of $70,000/year and can devote 35% (as is often recommended) of the 65% left after taxes, or $15,925 per year to housing. Let's further assume that this household occupies a house of 1500 ft^2 (neither excessively small nor large). Further, let's assume that the house requires about 4% of its value in maintenance each year and 2% in taxes and insurance. I'll assume that a real rate of return (net of inflation) of 7% is the minimum requirement. Finally, I'll assume that, over the "period of interest," inflation as applicable to the home purchaser is at 4%.
All right, then what amount of money would allow the receipt of $15,925/year less the taxes, insurance and maintenance to result in a return of 11%? Simplistically, the equation is 15925-.06*x=.11*x. Solving yields a house value of $93,676.47, or $62.45/ft^2. I purchased my house for dramatically more than that so, by this criterion, I overpaid. Ah, but our household income exceeds $70,000/year so it's reasonable to assume I'll rent a nicer home with my income. Adjusting the rent by the income ratio (probably a pretty bad assumption) I can estimate that I overpaid by a factor of about 1.8.
Of course, I also purchased the property my house is on, the safety of the neighborhood in which I live, the school system my children attend, etc. It's hard to put a monetary value on these things, but I could rent them as well. This isn't making me feel good, so what about the replacement value? Well, evaluating building a home with the materials in my house, together with the landscaping, hardscaping, etc. might cost about 3/4 of what I paid for the house. Adding the land value gets me somewhat closer to the actual price paid.
So what can be concluded? Well, to start, the fact that the replacement value of my property isn't that far off of what I paid for it combined with the fact that using the rental value evaluation yields a much lower number shows that Southern California housing is out of the price range of "average" incomes even without regard to the "asset bubble" aspects of it. Duh. It also may portend a continuing secular downward trend in residential real estate values. $70,000/year is not poverty level income, even in California, so I think I'd best be prepared for lower valuations.