House Prices in Southern California need to Rest now (reposted from Forbes).

From my Forbes blog:

DataQuick today reported that house prices in Southern California have risen 28 percent from the last year.  A year ago, people who were buying houses in this part of the world were getting a good deal.  Now, the deal is so-so.

Take a look at the table below (it is something I constructed for my class on mortgages and mortgage backed securities).  The numbers on the vertical axis (.03,.05,.05..)are cost of capital numbers–the financing costs of owning a house.  Generally speaking, the cost of capital for owning a house is the mortgage rate plus one percent, which reflects that the cost of the equity in the house (the down-payment) is higher than the cost of the mortgage.  The numbers across the horizontal axis (10, 15,20…) are rent-to-price ratios.  Suppose you can own a condo for $360,000; the rent on the same unit is $1500 per month or $18,000 per year.  The price to rent ratio is then 20.

In the example given here, we are looking at a household that pays a federal marginal tax rate of 25 percent, a state marginal tax rate of 7.9 percent, faces closing costs of 3 percent, annual maintenance cost of 2.5 percent, a property tax rate of one percent, a Realtor commission of 5 percent, and expects to hold the property for five years (feel free to email me at richarkg@usc.edu if you wish to put your own assumptions in the spreadsheet that produced the numbers listed below).

As it happens, I have been looking at costs and rents in Westwood, a neighborhood just west of Beverly Hills and on the other side of the 405 from Brentwood.  Rents on 2 bedroom units run around $28 per year per square foot; prices are around $650 per square foot, so the price to rent ratio is around 23.  With current mortgage rates at 4.5 percent, the cost of capital is 5.5 percent.  So lets look at the cells that are bolded: a price to rent ratio of 23 and a cost of capital of 5.5 lies in the middle of them.  The numbers in the cell is the amount of appreciation that is required each year that one holds a property for renting and owning to break even with each other.

So right now, for owning to be a better financial deal than renting, prices must rise around 4 percent each year.  Is this feasible in the long run for Los Angeles?  Yes, because over the long term, prices in LA tend to rise by about the rate of inflation plus one percent, so if we think 3 percent steady state inflation is in our future, we should be fine.  But will it rise much more than inflation plus one percent for a long time?  I doubt it.  And of course, CPI growth is less than two percent right now.  House prices are about where fundamentals say they should be, but it is time for increases to slow down.

				Price to Rent Ratio
		10	15	20	25	30
	0.03	-0.031	0.003	0.020	0.030	0.036
	0.04	-0.024	0.010	0.027	0.037	0.044
	0.05	-0.017	0.017	0.034	0.044	0.051
Cost of Capital	0.06	-0.009	0.024	0.041	0.051	0.058
	0.07	-0.002	0.031	0.048	0.058	0.065
	0.08	0.005	0.039	0.055	0.066	0.072
	0.09	0.012	0.046	0.063	0.073	0.079
	0.1	0.019	0.053	0.070	0.080	0.087

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