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The Inflation Premium for Residential Real Estate

Published by Lawrence Roberts | December 26th 2008 | Views:

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Residential housing does have a cash-saving value, if financed with a fixed rate mortgage. Over time, the growth in income and rents increases the cost of housing for renters. The inflation of housing costs for renters is greatly lessened for homeowners using a fixed-rate mortgage because their housing costs are effectively frozen at the rate of their ongoing mortgage payment. Other costs of home ownership, such as property taxes, insurance and maintenance do still rise with inflation, but since the mortgage payment is about two-thirds of the cost of ownership, fixing this amount provides a large benefit. Over time, the savings accruing to homeowners from a level housing payment can be quite substantial. Applying the technique of discounted cashflow analysis, this savings over time can be evaluated.

Since the savings grow every year, the value of the inflation premium grows as the term of ownership is extended, and this premium is not as sensitive to changes in the discount rate as is the appreciation premium. The premium accruing from the savings on rent can be substantial, but ownership periods vary, and the national average is less than 7 years; therefore, if a buyer pays this premium up front by paying more than the rental equivalent value, they do not reach breakeven for several years. In the early years of the mortgage, the owner who paid in excess of the rental equivalent value actually falls behind the renter in terms of out-of-pocther to replace them at market rates. The circumstance is a bit different for private landlords. Most private individuals that rent out investment properties are far more concerned with the loss of cashflow resulting from the property sitting vacant than they are about maximizing income through raising rents each year. Most long-term landlords have conventional, fixed-rate financing on their properties, and because their costs are not increasing, and because they do not want to endure vacancy loss, they seldom raise rents. When they do, they do not tend to raise them to market for fear of the tenant moving out. The result of this is that housing costs are somewhat fixed for long-term renters who rent from private individuals. These renters get to enjoy almost the same benefits of fixed housing costs as homeowners. The implication of this landlord behavior is that homeowners do not necessarily see the dramatic savings over renting suggested in the calculation of the inflation premium.

The investment value for home ownership is a combination of the appreciation value and the inflation value. Both accrue to homeowners for different reasons. The appreciation value is caused by the general tendency of house prices to increase over time with the inflation of income and rents. The inflation value is a cashflow savings accruing to owners as rental rates increase while their cost of ownership is fixed. There are many variables that influence the investment value, and much depends on the assumptions behind the variables selected. Based on a typical ownership period of 7 years, and an investment environment adhering to historic norms, residential real estate has an investment value of approximately 10% of the fundamental value of the property.

Buyers who pay this 10% premium will see a return on their investment if they stay in the property long enough. Buyers who pay premiums in excess of this amount or who own the property for shorter timeframes do not see a return on their investment. Buyers in the Great Housing Bubble paid well in excess of the fundamental and investment value of real estate primarily due to unrealistic expectations for appreciation. If a buyer believes properties are going to appreciate at a 15% rate every year forever, paying a 100% premium over fundamental value is justified; however, since house prices cannot rise at that rate in a sustained manner, such premiums are ill advised.
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