Chapter 5 Residential Market Analysis 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 1 Major Topics Drivers of long and short term owner occupied housing market The dynamics of rental housing market The decision to buy or rent The leveraged return of housing investment Affordability calculations how big a house can I buy? Down payment constraint Income constraint User cost 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 2 1
Introduction Residential structures account for 24% of value of all assets owned in U.S. Value of owner-occupied housing including land is estimated to be approx. $6 Trillion Each generation desires bigger homes Average house is 25% bigger than 50 years ago Home ownership rate has been rising steadily 64% in 1990 to over 68% in 2004 Housing affordability has become more difficult for lower income households 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 3 Long Term Demand for Housing Demand for housing is a function of: Household growth (family formation) rate Population; Household sizes General economic productivity Long-term housing demand follows the general economy and GDP Regional demand for housing based on: Population growth; Migration Job growth in export sector of local economy 0.75 new household per new job 1.33 jobs to create the demand for a new house Overall quality of life in a region Climate, culture, cost of living, taxes 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 4 2
Short Term Demand for Housing Dominant factors for short term demand: Seasonality Climate, Schools, and holidays Typical Seasonal Pattern of Housing Sales By Month Monthly Index/Ave Sales 1.30 1.10 0.90 0.70 0.50 1 2 3 4 5 6 7 8 9 10 11 12 Month 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 5 Short Term Demand for Housing Mortgage interest rates People sometimes wait and hope that rates will fall While rates are falling people wait for it to hit bottom then react when they start to go back up On average mortgage rates are inversely proportional to sales volume 1% change in mort. rate 10-15% change in home sales Home Sales Index Typical Pattern of Homes Sales Index Versus Mortgage Rates 170 Sales Rate 150 130 Rates 110 90 70 50 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 Quarter 13 12 11 10 9 8 7 6 5 4 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 6 3
Patterns of Possible Rental Housing Market Changes Two general processes which bring a market back to long run equilibrium after a change in demand or supply: 1. Demand increases or supply is reduced 2. Demand is reduced or supply increases 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 7 Equilibrium after a Rise in Demand Vacancy rates decline, possibly to zero Rents increase; Rates of return increase. New construction occurs Eventually rates of return declines, which reduces the construction rates Rent D1 D2 S1 S2 Q1 Q2 Supply 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 8 4
Equilibrium after Supply Over-shoots Demand Vacancy rates increase Rents decline Rates of return decline Maintenance and repair may decline (increasing rate of deterioration) No new construction occurs Eventually, properties will deteriorate to lower submarket levels, reducing the supply of the affected submarket, until rents and rates of returns come back to equilibrium 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 9 Rent 1 st D1 S1 S2 2 nd 1 st 2 nd Q1 Q2 Supply Depreciation and lack of new construction will reduce supply over time 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 10 5
Economic Factors Buying Vs. Renting Capital constraints (equity vs. debt financing) Expected tenure Tax Mortgage interests and property tax deductions Capital gain exemptions Implicit rents not taxed for homeowners Mortgage rates & Financing programs Investment aspects (expected appreciation) Leverage Returns for alternative investment vehicles opportunity cost of capital 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 11 The Effects of Mortgage Leverage on Housing Investment Return Assume a mortgage rate of 5% and an implicit rental yield of 8%. What is the annual rate of return of a leverage housing investment at 80% LTV, when: A. House price appreciates by 10%; B. House price depreciates by 10% 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 12 6
Buying Vs. Renting Economic Factors (continued) Budgeting risk Big ticket item Less flexibility after mortgage/property tax commitment Psychological Factors Ego satisfaction; Self-control; Commitment 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 13 How Much Home can one Afford? Sources of capital Equity or Debt Young home owners depend mostly on their current income for down payment and future income to qualify and pay off mortgage debt The before tax costs of owning a home include: Mortgage payments (most significant) Property taxes Property insurance Utilities Maintenance 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 14 7
How Much Home can one Afford? Most lenders require that Monthly mortgage payments < 25-28% income Total housing expenses < 36-40% income Housing expenses + debt < 40-50% income To estimate of approximate affordable price based on: Calculate annual household income A proportion of monthly income can be used to support mortgage payment Mortgage amount supported by above payments at current rates Add the available down payment Make sure Down payment needs to be large enough to qualify for mortgage rate used for calculation 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 15 How Much Home can one Afford? After graduating from Baruch, you consider buying a house. You annual income is $48,000 and you have $25,000 for down payment. Assume that 25% of income can be used for monthly mortgage payment. What is the largest house you can buy if the following mortgage product is available on the market? i. A 6% 30-year fixed rate that requires < 80% ltv; ii. A 6.5% 30-year fixed rate that requires < 90% ltv; ii. A 5.0% 5-year adjustable that requires < 90% ltv. 9/27/2005 FIN4777 - Special Topics in Real Estate - Professor Rui Yao 16 8
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