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EDITORIAL COMMITTEE

RENT TO VALUE RATIO: THE ECONOMICS OF RENTAL

PROPERTY

HVF UPDATES

June6,2012

ABOUT HVF

HVF LESSONS FROM THE DATA

Lately there has been much news regarding the Government Sponsored Enterprises (GSEs) and other private
REOtoRental programs. With housing prices nowhere near the highs of a few years ago, can investors make

HVF INSIGHTS

goodreturnsrentingthesepropertiesuntilthemarketrecovers?

CBSAs

The simple answer is yes, but its not that easy to find a property that can provide enough rental income to
cover all carrying costs while also being easy to convert into the owner occupied market once the housing
markethasrecovered.InthismonthsLessonsfromtheData we will review some due diligence considerations
thataffecttheriskinmakingsuchaninvestment.

RENT TO VALUE RATIO (RENTAL YIELD)

Theratioofrenttovaluecanbeavaluableguideandarequisitepartofathoroughinvestigationofaninvestment
opportunity.Thethoughtbehindthisratio(12monthsofrent/homeprice),calledrentalyield,isthatitisakinto
theearningstopriceratiointhestockmarket:higherearnings,allelseequal,areassociatedwithmoreprofitable
investmentsandarelessreliantuponfuturegrowthinthestockpricetogenerateexpectedreturns.
Thesamenotionappliestotherentalyield:higherrentsmakeitlessimportantforthepropertytoappreciatein
value in order to meet a certain expected return target set by the investor. However, rental yield alone, like the
classic earningstoprice ratio, is not a guarantee for a successful investment. It is necessary to look carefully
underthehoodatotherconsiderations.

RENTAL YIELD DRIVERS

Much research has been done to evaluate the drivers and the variability of rental yields among markets. Such
researchprovidessupportfortheroleofrentalyieldsininvestmentdecisions,butalsomakesclearthatthereis
nosinglerentalyieldthatshouldguideallinvestmentdecisions.Herearesomefactorsthatleadtovariationsin
therentalyieldsamongmarkets.
1.SupplyElasticityMatters
Historically,weobservethehighestcurrentyieldsinelasticmarketswhereitiseasytoaddnewhousingsupply.
Becauseitiseasytoaddnewsupply,anysignificantrealincreasesinpricesresultinmoreunitsbeingaddedto
the market. Rents will tend to rise while prices stay flat in these elastic markets as investors turn to rents in
ordertomakeareturnoninvestment,whilemanywouldbehomebuyersrentbecauseanonappreciatinghome
purchase is a less attractive investment and/or they cant obtain the financing with todays tighter underwriting
guidelines.
We see variations in gross rental yields at the neighborhood level maps generated by Pro Tecks Home Value
Forecast.InsupplyconstrainedmarketslikeNewYork(Figure1)weseeratherlowyields.
Figure1:SingleFamily2011GrossRentalYieldsbyNeighborhoodinNewYork

The darkest red dots represent yields under 2 percent, while the pink dots range from 2 percent to 5.9 percent,
the lightest pink dots range from 6 percent to 7.9 percent and the various shades of darker blue reach to 14
percent and above. It is apparent that in these markets the current gross yields are rather low, and it would be
difficulttocarrysuchpropertiesasinvestmentswithoutinfusingcashduringtheholdingperiod.
Attheotherextreme,wehavemarketslikeLasVegas(Figure2),whereweseemanydarkbluedotsandgross
yields close to or above 14 percent. Granted, in such markets we also must consider the risk of having a
vacancyanddosomeresearchonthechancesoffindingtenants.
Figure2:SingleFamily2011GrossRentalYieldsbyNeighborhoodinLasVegas

2.SubprimeEffectsLinger
The higher current yields are also correlated with the degree of subprime lending and high loan to value (LTV)
mortgagesasthesemarketscontinuetobeimpactedbyahighdegreeofdistresssalesholdingpricesdown.We

can see this in markets like Atlanta (Figure 3), where we observe neighborhoods within the same metropolitan
area where the rental yields are quite high (generally southern Atlanta, where prices have been held down by
higher ratio of distressed sales) and other neighborhoods where the yields are quite low, and where distressed
salesarenotascommon.
Figure3:SingleFamily2011GrossRentalYieldsbyNeighborhoodinAtlanta

WealsoseethismixoflowandhighyieldsintheSanFranciscometro(Figure4)wheremarketslikeRichmond
andSanPabloremaindistressedwithmuchhigherrentalyieldscomparedtoSanFrancisco.
Figure4:SingleFamily2011GrossRentalYieldsbyNeighborhoodinSanFrancisco

3.RisksAreCorrelatedwithCurrentYields
ThedilemmaforinvestorswhowishtotakeadvantageofthenewREOsalescomingonthemarketisthatthe

leastdistressedandmostsupplyconstrainedmarkets(whicharethosewherepricesaremoststableandlikely
toincreaseoverthenextfewyears)arethemostdifficulttocarryThereverseistrueinmarketslikeLasVegas,
where yields are much higher but there is uncertainty when the excess supply will expire. There is also
uncertaintyhowmanyyearswillpassbeforepriceswillincreaseinsuchmarkets.
Eventually excess supply will dissipate, but by then mortgage rates may be double, holding prices down. So
evenifthereisconfidencethatthesupplywillnormalize,asithasinmarketslikePhoenix,thereisnoguarantee
ofpriceincreases.
An investor can look to market data and forecasts to help determine markets that have both strong current
fundamentalsandstronglongertermdriversthatindicatethehomesvalueislikelytoappreciate,providingthe
opportunity to sell the investment for a profit in the future. Some of the current fundamentals an investor may
look at would be vacancy rates, rental rates, months of inventory on the market, price trends and amount of
distressed sales. Longer term drivers of future value appreciation are broader economic drivers like mortgage
rates, household income and employment growth. Forecasting models that incorporate such longer term drivers
canbeusedtoestimatefutureappreciation.

CALCULATING OUT CARRYING COSTS

Wecancalculatehowmuchrentmustbecollectedinordertocarryaninvestmentrentalhomeusingahousing
costfactor(HCF).TheHCFexpressesthecostofcarryingahomeasapercentoftheoriginalpricethatneeds
tobepaidannuallyinordertocoverhomeexpenses.Itdoesnotincludetherequiredreturnonequityandsois
very sensitive to leverage (the amount borrowed as a percent of the original price). Lets use the following
assumptionstodemonstrate:
Loanrateat4percentwith50percentloantovalueratio(2percentofthehomepricenet)
Propertytaxesat1.0percentofhomeprice
Propertyinsuranceat.75percentofthehomeprice
Utilitiestobepaidbytenant
Maintenanceat1.25percentofhomeprice
Theresultofaddingthesetogetherisexactly5percentofthehomeprice:r/v=.02+.01+.0075+.0125=.05.
If you assume no vacancy, then no adjustment is needed, but if you assume 10 percent vacancy, the HCF is
equal to 5 percent divided by the average occupancy rate, 90 percent, or 5.556 percent. We must also add
somethingformanagementwhichtendstorun10percentto20percentasapercentageoftherentcollectedfor
singlefamilyhomes.Ifweuse10percentthenweneedtohit5.556percentagaindividedby90percentresulting
in6.2percentastheaveragerequiredcurrentcashyieldnecessaryinordertocarrytheunitwithoutanyongoing
subsidy.
OnequestionishowmanydistressedREOsalesareouttherewheretherentisgoingtoaverage6.2percentor
moreofthepriceofthehome?Lookingatthemapsinthisarticle,anyofthesubmarketswithlightpinktoblue
dotsmeetthiscriterionandarecandidatesforacquisitionwhenonemustholdforthreeyearsorlonger.
Suchisnotthecaseinthosemarketsdominatedbyredordarkerpinkdotsbecausetherentalincomesinthese
areas make it difficult to carry these homes, even with 50 percent down. Even 100 percent down REO
investmentsneedarounda4percentyieldperyearinordertocoverpropertytaxes,insurance,maintenanceand
management expenses and many markets do not provide yields that high. The conclusion is that holding a
property for three years or more in a market where the rent may not even cover the carrying cost is not
appealing.Theselowyieldmarketsremainmostappealingtoflipperswhowillcomein,repairthehomesandput
thembackontheowneroccupiedmarketassoonaspossible.
In the table below we calculate the net appreciation required in order to hit a target internal rate of return
(annualized yield) over three years, given the goingin rent to value ratio and carrying costs. The difference
betweenthesetwoisthedeficitthatmustbemetbyappreciationinthevalueofthepropertyinordertomeetthe
targetinternalrateofreturn.
Itisobviousthatmuchlessappreciationisneededtohitthesametargetreturnwhenhighergoinginyieldsare
possible,althoughonemightarguethatinsuchmarketsthereismuchmorerisk,requiringpremiumyields.
Note that an appreciation rate of ~80 percent over three years is the same as buying a REO property at
approximately45percentlessthantheeventualsalesprice.ThisisnotunusualonREOsalespurchasedfrom
2008through2010(discountshavenarrowedsinceduetoincreasedcompetitionforproperties).

Belowwevarythecalculationstoshowtheeffectsofrequiringhigheryieldsinthosemarketswherethecurrent
yieldsarehigher,buttherisksarealsohigherinseveralways.
Akeysourceofsuchriskisthesizeandultimatedispositionoftheinventoryofdistressedrealestatebeingheld
by banks. For example, the rapid disposition of this distressed inventory may dampen prices and increase
vacancyrates.
Onewaytocapturesuchriskistoincreasetherequiredyieldapercentinlinewiththeincreasedgoinginyield.
Theresultisthatweneedslightlymorenetappreciation,aswestepupthecurrentyields,whichislesslikelyin
theselesssupplyconstrainedmarkets.

CONCLUSIONS
ThemoreconservativeinvestorswhobuyREOsfromtheGSEs(FannieMaeandFreddieMac)willlikelyseek

out acquisitions in those markets where the current (gross) yields are significantly above 6 percent and where
currentvacanciesarenotexcessive.Suchpropertiesarenotwithoutrisksbutareeasiertocarry.
Markets where the current yields are very low are better matched with flippers who will want to turn them in as
littletimeaspossible,sellingthembackintotheowneroccupiedmarketwithouteverrentingthemout.Butthese
lower current yield properties do not accommodate significant financing leverage without periodic cash flow
infusions and if interest rates go up, the new buyer demand from owner occupiers will soften. One must also
keepinmindthateagerbuyersoftendonotqualifyintodaysunderwritingenvironmentsothatalonerestrictsthe
depthofdemand.
ThebiasofREOinvestorstowardshigheryieldpropertiesis,infactwhereweseethemostdemandforREOs.
These investors will need to carry the properties for at least a few years or longer and be patient in offloading
inventoryatpacesthatthemarketcanabsorbwithoutsignificantlyaffectingcurrentprices.Thosemarketswhere
theyieldsarenothighenoughtocarrynorlowenoughtobegoodflippercandidatesmayflounderforabitlonger
astheyfallthroughthecracksofmarketappetites.
JamesR.Follain,Ph.D.
JamesR.FollainLLCandAdvisortoFIConsulting
NormMiller,PhD
Professor,BurnhamMooresCenterforRealEstate
UniversityofSanDiego
MichaelSklarz,Ph.D.
President
CollateralAnalytics
AboutHomeValueForecast
Home Value Forecast was created from a strategic partnership between Pro Teck Valuation Services and
Collateral Analytics. HVF provides insight into the current and future state of the U.S. housing market, and
delivers 14 market snapshot graphs from the top 30 CBSAs. Each month, HomeValueForecast.com delivers a
monthlybriefingalongwithLessonsfromtheData,anindeptharticlebasedontrendsunearthedinthedata.
HVF is built using numerous data sources including public records, local market MLS and general economic
data.Thetop750CBSAsaswellasdatadowntotheZIPcodelevelforapproximately18,000ZIPsareavailable
withacorporatesubscriptiontotheservice.

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