Editor’s note: The Washington, D.C.-based Center for Economic and Policy Research is sponsoring an essay contest on “Why there is no housing bubble.” The winner will win $1,000. Send a copy of your entry to email@example.com for possible publication on Inman News.
I am a commercial real estate broker and an investor in multifamily and commercial properties. I am entering the Center for Economic and Policy Research’s contest, although I guess I won’t win because as I am not in disagreement with some aspects of the center’s position that there is a housing bubble.
I find the most room for argument in the statement: “No one has yet produced a remotely plausible explanation of how fundamental factors can lead to a run-up in home sale prices, but not in rental prices.” Actually this is simple. To start, let’s look at real estate market values as being composed of two components, one being functional value and the other being speculative value.
Functional value is what a property is worth today based solely on using it. Functional value can be derived directly from fair market rents and can be calculated as a function of net operating income and a reasonable capitalization rate.
Speculative value is what someone is willing to pay over today’s functional value based on the expectation that someone else will be willing to buy it for more tomorrow. This is how we inflate the bubble.
So in a given property there is a functional value, and if the actual market value is greater, a speculative value as well. (The speculative value could be a negative sum if the market value of the property were lower than the functional value.)
In single-family homes in many parts of the country today, rental rates have not kept pace with sales prices because of the speculative value component in the market value. This is part of the bubble.
There are several factors at work:
With interest rates low, many people who would otherwise rent can now afford to buy. All these new buyers add to demand, which pushes upward on prices. The same low interest rates also increase the prices existing owners can pay for their next home. As lower interest rates push home prices upward, the speculative value component keeps them moving upward. The thinking is that it’s okay to pay more if you know values will keep rising and that becomes a self-fulfilling prophecy. The same low interest rates that turn renters into buyers allow others to purchase second homes as rental investments, increasing the supply of rentals even more. Increasing the supply pushes rents, which are based on functional value, even lower.
Given this, buying quality rental properties that have little or no speculative value built in to the price, i.e., properties with cap rates of eight or more seems to make sense. When interest rates rise and the residential bubble bursts, a lot of people will be driven back into renting and the yields and functional values of rental properties will rise.
So, yes, there is a partial real-estate bubble, and when it bursts, that will benefit other types of real estate, namely multifamily and single-family residential rental properties.
Johann Robbins is a broker of Investment & Commercial Real Estate Preferred Properties in Bayfield, Colo.
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