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Housing Market Reports Understanding and interpreting OCHN monthly housing market reports HOUSING MARKET FORECAST

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949.769.1599. OC Housing News market reports information on housing market valuation and price trends essential to homebuyers and home sellers.

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Page 1: Housing market  forecast

Housing Market

Reports

Understanding and interpreting OCHN

monthly housing market reports

HOUSING MARKET FORECAST

Page 2: Housing market  forecast
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    Housing  Market  Reports    

[email protected]     949.769.1599      

OC  Housing  News  Monthly  Market  Report  .....................................................................................................................  3  Using  the  OCHN  Monthly  Report  ........................................................................................................................................  3  Interpreting  an  OCHN  Monthly  Market  Report  ............................................................................................................  4  

News  Overview  ..........................................................................................................................................................................................  4  Median  Home  Price  and  Rental  Parity  Trailing  Twelve  Months  ..........................................................................................  4  Resale  $/SF  and  Year-­‐Over-­‐Year  Percentage  Change  Trailing  Twelve  Months  ............................................................  6  Rental  Rate  and  Year-­‐Over-­‐Year  Percentage  Change  Trailing  Twelve  Months  .............................................................  7  Historic  Market  Data  Charts  ................................................................................................................................................................  8  Percentage  Change  Charts  .................................................................................................................................................................  10  Historic  Valuation  ..................................................................................................................................................................................  12  OCHN  Rating  System  Chart  ...............................................................................................................................................................  13  Investor  Analysis  ...................................................................................................................................................................................  14  Market  Performance  and  Trends  Table  .......................................................................................................................................  15  Market  Timing  Rating  and  Valuations  Table  .............................................................................................................................  17  

The  importance  of  rental  parity  .....................................................................................................................................  18  Rental  Parity  as  basis  of  value  .........................................................................................................................................................  18  

Premiums  or  discounts  to  rental  parity  ..........................................................................................................  19  Benchmark  value  of  stable  market  ....................................................................................................................  19  

How  rental  parity  is  calculated  ........................................................................................................................................................  20  Conventional  financing  ...........................................................................................................................................  20  

Year-­‐over-­‐year  percentage  change  ................................................................................................................................................  21  Per-­‐Square-­‐Foot  Basis  .............................................................................................................................................  21  Sales  prices  on  a  per-­‐square-­‐foot  basis  ...........................................................................................................  21  Rents  on  a  per-­‐square-­‐foot  basis  ........................................................................................................................  22  

OCHN  Rating  ..........................................................................................................................................................................  22  System  Criteria  .......................................................................................................................................................................................  22  

Valuation  rating  .........................................................................................................................................................  23  Resale  momentum  rating  .......................................................................................................................................  23  Rental  momentum  rating  .......................................................................................................................................  24  What  would  a  typical  market  look  like?  ..........................................................................................................  26  What  would  be  a  perfect  world?  .........................................................................................................................  26  

 

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OC  Housing  News  Monthly  Market  Report  

OC  Housing  News  monthly  market  report  and  newsletter  provides  a  clear  picture  of  the  health  of  the  housing  

market.  Both  buyers  and  sellers  find  the  information  on  location,  valuation,  and  price  trends,  timely  and  relevant  

to  their  decision  to  buy  or  sell  a  home.  The  OC  Housing  News  report  answers  the  most  important  questions  to  

buyers  and  sellers:  (1)  Where  should  I  look  for  bargains,  (2)  Are  current  prices  over  or  under  valued  in  my  area,  and  

(3)  what  direction  are  prices  headed,  up  or  down  in  my  area?  Armed  with  better  information,  people  make  better  

decisions.  

There  is  too  much  information  about  housing  floating  around  the  Internet,  and  most  of  it  is  bad.  It  is  easy  to  take  

data  and  create  pretty  charts  and  graphs  that  don't  provide  any  useful  information  someone  might  use  to  make  a  

good  decision.  The  OC  Housing  News  has  eliminated  the  useless  information  and  distilled  the  market  down  to  

three  key  pieces  of  information:  (1)  resale  value  relative  to  rent,  (2)  yearly  change  in  resale  prices,  and  (3)  yearly  

changes  in  rents.  

For  those  who  are  very  technical  and  analytical,  the  information  on  the  theory  and  the  calculations  behind  the  

report,  the  later  sections  of  this  work  starting  with  The  importance  of  rental  parity  on  page  18,  provides  more  

detail.  For  those  more  interested  in  using  this  information  to  find  a  home,  keep  reading.  

Using  the  OCHN  Monthly  Report  

When  most  people  are  considering  renting  or  buying  a  home,  they  already  have  narrowed  their  choices  for  

location.  Most  want  to  be  near  work,  but  they  may  also  want  to  be  near  family,  friends,  or  a  particular  school  

district.  The  table  of  contents  on  the  front  page  of  the  OCHN  monthly  report  organizes  the  reports  by  county  so  

people  can  narrow  their  search  to  the  area  they  are  most  interested  in.  I  suggest  searchers  start  with  the  overview  

of  the  county  as  this  provides  important  data  on  the  broader  real  estate  market.  

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Interpreting  an  OCHN  Monthly  Market  Report  

The  first  page  of  a  county  report  breaks  down  into  four  parts:  The  news  overview,  Median  Home  Price  and  Rental  

Parity  trailing  twelve  months,  Resale  $/SF  and  year-­‐over-­‐year  percentage  change  trailing  twelve  months,  Rental  

rate  and  year-­‐over-­‐year  percentage  change  trailing  twelve  months.    

NEWS  OVERVIEW  

 

The  news  overview  provides  concise  descriptions  of  the  facts  and  conditions  in  the  market.  It  states  whether  the  

market  trades  at  a  premium  or  a  discount  to  rental  parity  and  provides  a  measure  of  it.  A  market  trading  at  a  

premium  to  rental  parity  is  more  desirable,  so  buyers  are  willing  to  pay  more  than  rental  parity  to  live  there.  A  

market  trading  at  a  discount  is  less  desirable,  and  people  must  be  motivated  to  live  there  by  saving  versus  renting.  

The  news  overview  measures  the  current  premium  or  discount,  compares  it  to  the  historic  premium  or  discount,  

and  states  whether  the  market  is  currently  overvalued  or  undervalued.  This  is  an  important  measure  of  future  

financial  performance.  

MEDIAN  HOME  PRICE  AND  RENTAL  PARITY  TRAILING  TWELVE  MONTHS  

For  those  who  want  the  bottom  line  without  all  the  analysis  and  detail,  the  market  rating  is  the  first  row  of  the  first  

section  of  data.  The  rating  encapsulates  all  the  conditions  of  the  market  into  one  figure.  For  more  information  on  

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how  this  is  calculated,  see  OCHN  Rating    on  page  22.  Suffice  to  say  that  a  rating  of  10  is  good  and  a  rating  of  1  is  

bad.  Buyers  can  rest  assured  that  a  highly  rated  property  or  market  is  a  good  financial  buy.  

 

The  chart  displays  three  lines  that  reveal  much  about  the  market.  The  first  two  lines  to  note  are  the  parallel  green  

and  orange  lines,  rental  parity  (green)  and  historic  value  (orange).  As  mentioned  previously,  some  markets  trade  at  

a  discount  and  some  at  a  premium  to  rental  parity.  If  the  orange  line  (historic  value)  is  above  the  green  line  (rental  

parity),  the  market  is  a  premium  market.  If  the  orange  line  (historic  value)  is  below  the  green  line  (rental  parity),  

the  market  is  a  discount  market.  The  larger  the  gap,  the  greater  the  premium  or  discount  is.  

The  third  line  plotted  against  these  two  parallel  lines  is  the  median  resale  price  for  the  area.  This  line  reveals  

whether  the  market  is  currently  trading  at  a  premium  or  discount  to  rental  parity  and  historic  value.  The  more  

important  of  these  relationships  is  between  median  resale  price  and  historic  value.  Over  time,  the  market  has  

shown  a  tendency  toward  trading  at  historic  value.  If  it  trades  above  for  a  while,  over  time  it  will  revert  back  to  this  

value.  That  may  happen  either  by  an  extended  period  of  little  or  no  appreciation  or  an  outright  decline  in  prices.  If  

the  market  trades  below  its  historic  value,  it’s  likely  to  see  a  rebound  back  to  this  value  in  the  future.  The  best  

markets  are  those  trading  at  a  steep  discount  to  its  historic  value.  

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RESALE  $/SF  AND  YEAR-­‐OVER-­‐YEAR  PERCENTAGE  CHANGE  TRAILING  TWELVE  MONTHS  

Since  the  historic  value  is  so  important,  the  first  column  in  next  section  displays  the  premium  or  discount  from  

historic  value  over  the  last  year.  The  second  column  and  the  chart  shows  the  dollars-­‐per-­‐square-­‐foot  resale  price  in  

the  market.  The  line  on  the  chart  visually  shows  the  general  direction  of  prices,  and  the  third  column  shows  the  

actual  percentage  change.    

 

It’s  important  to  note  that  the  percentage  change  in  resale  prices  can  be  misleading.  Most  buyers  foolishly  

extrapolate  short-­‐term  movements  in  market  prices  will  continue  forever,  motivating  them  to  buy  at  what  is  often  

the  worst  possible  time.  In  reality,  buying  in  a  declining  market  when  valuations  are  low  is  generally  the  best  time  

to  buy  because  sellers  are  motivated  and  supply  is  abundant.  Buying  in  an  appreciating  market  may  not  be  wise,  

particularly  if  valuation  signals  a  bubble.  In  short,  valuation  is  much  more  important  that  price  movement.  

   

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RENTAL  RATE  AND  YEAR-­‐OVER-­‐YEAR  PERCENTAGE  CHANGE  TRAILING  TWELVE  MONTHS  

The  final  table  and  chart  on  the  page  is  similar  to  the  first  grouping;  it  displays  three  lines,  two  of  which  are  parallel  

and  show  current  rent  and  the  historic  cost  of  ownership  relative  to  rent,  and  the  third  line  is  the  current  cost  of  

ownership.  The  relationships  are  similar,  the  charts  will  look  similar,  and  the  interpretations  are  the  same.  

 

This  method  of  looking  at  the  data  is  more  revealing  to  those  who  like  to  focus  on  monthly  costs  rather  than  

purchase  price.  It  reveals  how  affordable  properties  are  relative  to  monthly  rent,  which  is  what  rental  parity  

analysis  is  all  about.  The  first  column  of  data  shows  the  rate  of  rent  growth  over  the  last  year,  and  the  next  two  

columns  show  the  cost  of  renting  and  the  cost  of  owning  during  the  same  period.  

   

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HISTORIC  MARKET  DATA  CHARTS  

The  next  page  of  the  report  shows  two  charts:  County  median  home  price  since  January  1988,  and  County  median  

rent  and  monthly  cost  of  ownership  since  January  1988.  These  charts  are  designed  to  put  current  circumstances  in  

historic  context.  They  answer  questions  like,  “How  volatile  are  prices?”  and  “How  does  today’s  pricing  compare  to  

the  fluctuations  of  the  past?”  and  “How  much  danger  is  there  in  buying  today?”  

 

The  chart  above  displays  LA  County  through  early  2014,  but  the  pattern  is  similar  across  California.  With  the  green  

line  for  rental  parity  and  the  orange  line  for  historic  value,  it’s  easy  to  tell  when  the  market  is  fairly  valued,  over  

valued,  or  under  valued.  

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The  chart  above  shows  rent  and  monthly  cost  of  ownership.  It  looks  similar  to  the  rental  parity  and  resale  home  

price  chart,  as  it  merely  converts  that  information  to  a  monthly  format.  For  those  who  have  difficulty  relating  to  

the  large  numbers  of  purchase  price,  viewing  the  data  in  terms  of  monthly  expenses  is  easier  to  put  into  context.  

 

   

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PERCENTAGE  CHANGE  CHARTS  

The  follow  page  in  the  report  contains  two  more  charts  displaying  historic  information.  This  time,  the  data  shows  

percentage  changes  over  time.  This  is  important  because  many  people  believe  more  is  always  better.  That’s  not  

the  case.  When  house  prices  or  rents  go  up  quickly,  it’s  often  a  sign  of  some  underlying  distortion  in  the  market,  

and  buyers  should  be  cautious.  As  mentioned  previously,  most  people  erroneously  extrapolate  recent  past  price  

behavior  as  a  permanent  trend,  motivating  them  to  buy  at  the  worst  possible  time  –  as  many  who  purchased  in  

2004  and  2005  found  out  painfully.  

 

Throughout  2013,  house  prices  rose  very  rapidly  causing  some  analysts  to  proclaim  a  new  housing  bubble.  Though  

such  price  action  is  certainly  a  cause  for  concern,  it  must  be  placed  in  context;  prices  rose  from  an  extremely  

undervalued  condition.  The  price  rally  was  abrupt,  but  it  does  not  represent  a  new  bubble  until  valuations  soar  

above  historic  norms.  

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When  prices  go  up  very  quickly  and  rents  do  not,  affordability  plummets,  like  it  did  in  2013.  When  both  go  up  

together,  it  may  be  a  sign  of  an  overheating  economy,  and  when  both  go  down  together,  it’s  a  sign  of  a  weak  

economy.  

   

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HISTORIC  VALUATION  

The  next  page  in  the  report  shows  two  charts:  Historic  Median  Home  Price  Relative  to  Rental  Parity:  County  since  

January  1988,  and  OCHN  Market  Timing  System  Rating:  Los  Angeles  County  since  January  1988.  

 

The  chart  above  shows,  at  a  glance,  how  close  the  market  trades  to  its  historic  norm.  The  benchmark  period  is  

shown  in  green,  and  the  degree  of  market  volatility  can  be  inferred  from  the  scale  to  the  left.  For  example,  LA  

County  traded  for  as  much  as  42%  below  rental  parity  and  84%  above  it  during  the  26-­‐year  period  shown.  Needless  

to  say,  that  is  very  volatile,  and  people  who  bought  during  the  overvalued  periods  endured  painful  price  

corrections  when  their  houses  were  worth  far  less  than  they  paid.  

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OCHN  RATING  SYSTEM  CHART  

 

The  market  timing  rating  system  mechanically  identifies  both  good  and  buy  dimes  to  buy  based  on  valuation,  

resale  price  change,  and  rental  rate  change.  Since  1988,  in  LA  County,  it  was  wrong  in  its  recommendation  in  only  a  

single  two-­‐year  period  from  late  1999  to  mid  2001  as  the  local  economy  tipped  into  a  recession.  The  system  

correctly  identified  the  housing  bubbles  from  the  late  80s  and  the  mid  00s  as  well  as  the  buying  opportunities  in  

the  mid  90s  and  early  10s.  

   

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INVESTOR  ANALYSIS  

The  final  page  of  the  county  market  analysis  contains  two  charts  focusing  on  investment  opportunities:  Cash  

Investor  Capitalization  Rate:  County  since  January  1988,  and  Financed  Investor  Cash-­‐on-­‐Cash  Return:  County  since  

January  1988.  This  page  can  be  ignored  by  family  home  shoppers.  

 

The  chart  on  capitalization  rate  (shown  above)  displays  the  mortgage  interest  rate  (yellow)  and  the  capitalization  

rate  (purple).  The  capitalization  rate  is  the  net  rent  divided  by  the  purchase  price.  It  goes  up  when  rents  go  up  or  

house  prices  go  down;  and  it  goes  down  when  rents  go  down  or  house  prices  go  up.  Most  of  the  volatility  in  

capitalization  rate  is  caused  by  changing  home  prices.  

When  the  capitalization  rate  is  greater  than  the  mortgage  interest  rate,  properties  become  cashflow  positive  to  

financed  investors.  This  usually  brings  many  buyers  to  the  market  and  helps  a  housing  market  stabilize  after  a  price  

crash.  

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The  cash-­‐on-­‐cash  return  for  financed  investors  is  based  on  the  relationship  between  capitalization  rate  and  

mortgage  interest  rates.  The  cash-­‐on-­‐cash  return  is  positive  when  the  capitalization  rate  is  greater  than  the  

mortgage  interest  rate  and  visa  versa.  

MARKET  PERFORMANCE  AND  TRENDS  TABLE  

The  market  performance  trends  table  provides  a  tabular  summary  of  the  current  market  conditions  by  city  and  zip  

within  the  county.  It  displays  the  same  performance  metrics  detailed  in  previous  sections  including:  median  resale  

price,  resale  percentage  change  year-­‐over-­‐year,  resale  dollars-­‐per-­‐square-­‐foot,  rent  percentage  change  year-­‐over-­‐

year,  median  rent,  monthly  cost  of  ownership,  the  ownership  premium  or  discount  based  on  rent,  and  the  

capitalization  rate.  For  how  to  interpret  these  numbers  see  previous  sections  for  more  detail.  

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To  use  these  tables  effectively,  users  should  have  a  short  list  of  potential  cities  they  would  consider  living  in.  These  

tables  allow  the  user  to  search  alphabetically  for  city  data.  It’s  suggested  to  consult  both  the  city  data  and  the  zip  

code  data  that  often  provides  more  detail,  particularly  in  larger  cities  that  may  have  significant  neighborhood  

variability.  For  example,  in  Canyon  Country,  the  two  zip  codes  demonstrate  that  91387  is  more  desirable  than  

91351  because  the  former  costs  more  to  own  than  to  rent  whereas  the  later  costs  more  to  rent  than  to  own.  

By  compiling  and  comparing  data  from  the  various  cities  in  a  users  search  area,  they  can  determine  how  much  they  

would  have  to  spend  to  either  own  or  rent  in  each  area,  suggesting  how  desirable  and  affordable  each  area  is.  This  

will  also  allow  users  to  eliminate  areas  they  may  not  be  able  to  afford.  

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MARKET  TIMING  RATING  AND  VALUATIONS  TABLE  

The  next  table  shows  the  ratings  and  valuations  for  each  city  and  zip  within  the  county.  This  information  is  most  

valuable  for  those  hunting  for  bargain  properties  or  fearful  of  overpaying  in  an  overvalued  market.  

 

 

In  the  example  above  Artesia  is  a  prime  market  for  buying  a  home.  The  market  usually  trades  at  a  12.9%  premium  

to  rental  parity,  but  at  the  time  of  this  report,  it  was  trading  at  a  16.9%  discount,  making  it  29.6%  undervalued!  A  

buyer  in  this  market  should  experience  above  average  appreciation  as  the  market  rebounds  to  its  historic  norm.  

This  table  helps  buyers  spot  those  markets  where  the  best  deals  are  to  be  found.  Helping  buyers  target  their  

search  to  where  deals  are  best  is  the  primary  value  of  this  report.  

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The  importance  of  rental  parity  

Rental  parity  is  important  because  it  represents  the  threshold  of  affordability.  When  prices  are  above  rental  parity,  

it  costs  more  to  own  than  to  rent,  so  owning  is  often  not  a  wise  financial  decision.  Owning  may  still  be  right  for  

people,  and  many  are  willing  to  pay  the  premium  to  own  to  obtain  the  emotional  benefits  of  ownership;  however,  

on  a  purely  financial  basis,  paying  more  than  rental  parity  is  generally  not  wise  because  prices  will  inevitably  return  

to  this  price  level  in  time.  

When  prices  are  below  rental  parity,  it  costs  less  to  own  than  to  rent,  so  owning  under  these  circumstances  is  

generally  a  wise  choice.  Since  a  buyer  who  pays  less  than  rental  parity  for  a  house  is  saving  money,  there  is  a  clear  

financial  benefit  obtained  irrespective  of  fluctuations  in  resale  price.  

When  the  cost  of  ownership  is  less  than  rental  parity,  an  owner  is  far  less  likely  to  be  forced  to  sell  at  a  loss.  The  

property  can  always  be  rented  to  cover  costs  rather  than  sell  for  a  loss.  Further,  this  ability  to  rent  and  at  least  

break  even  provides  the  owner  with  flexibility  to  move  if  necessary.  Mobility  to  take  a  new  job  or  buy  a  different  

house  is  denied  to  those  who  overpaid  and  who  are  stuck  paying  more  in  the  cost  of  ownership  than  they  can  

obtain  in  rent.  

With  these  advantages,  buying  at  a  price  below  rental  parity  using  fixed-­‐rate  financing  is  critical.  Every  buyer  

should  consider  rental  parity  in  their  buying  decision.  

RENTAL  PARITY  AS  BASIS  OF  VALUE  

Valuation  is  the  least  understood,  yet  most  important,  aspect  of  a  housing  market.  Economists  look  at  various  

ratios  including  price-­‐to-­‐income,  price-­‐to-­‐rent,  and  other  aggregate  measures  to  attempt  to  establish  valuation  

metrics.  Each  of  these  has  strengths  and  weaknesses,  but  each  of  them  fails  because  they  don’t  directly  connect  

the  actions  of  an  individual  buyer  to  the  activity  in  the  broader  market.  For  this  reason,  I  strongly  favor  rental  

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parity  as  the  best  measure  of  valuation.  Rental  parity  ties  together  income,  rent,  interest  rates,  and  financing  

terms  in  a  way  that  matches  the  activities  of  individual  buyers  to  the  overall  price  activity  in  the  market.  

Premiums  or  discounts  to  rental  parity  

Rental  parity  does  not  capture  the  complete  picture.  Some  neighborhoods  are  very  desirable,  so  move-­‐up  buyers  

take  the  profits  from  previous  sales  and  bid  up  prices,  and  motivated  buyers  often  stretch  to  the  limit  of  their  

borrowing  power  to  acquire  homes  in  these  neighborhoods;  therefore,  the  most  desirable  neighborhoods  often  

carry  a  premium  to  rental  parity.  The  inverse  is  also  true.  Some  neighborhoods  are  not  as  desirable,  or  may  contain  

high  concentrations  of  condos  and  other  first-­‐time  homebuyer  products.  These  neighborhoods  generally  trade  at  a  

discount  to  rental  parity.    

Benchmark  value  of  stable  market  

To  value  of  any  asset  or  market,  it’s  necessary  to  establish  a  standard  of  measure  considered  “normal”  for  the  

asset.  To  achieve  this  end,  historic  data  must  be  obtained  and  analyzed  to  establish  a  period  of  time  within  the  

specified  geographic  area  when  the  asset  was  considered  fairly  valued  under  normal  market  conditions.  

Real  estate  markets  generally  exhibit  long  periods  of  stability  and  normalcy;  however,  there  have  been  a  number  

of  distortions  to  market  value  over  the  last  forty  years.  It  is  imperative  for  accuracy  to  identify  and  exclude  periods  

when  the  data  is  distorted  and  does  not  represent  a  normal  condition.  There  were  a  real  estate  bubbles  in  

California  from  1976  to  1982,  from  1987  to  1992,  and  from  2003  to  2009.  Further,  from  2010  to  2013  prices  were  

undervalued  as  prices  crashed  below  stable  levels.    

For  these  calculations,  I  am  using  the  period  from  1993  to  1999  (the  last  period  of  stable  prices  with  good  available  

data)  to  measure  the  neighborhood  premiums  and  discounts.  I  adjust  the  rental  parity  valuations  accordingly  to  

establish  the  baseline  valuation  for  each  neighborhood.  When  my  report  shows  a  neighborhood  is  overvalued  or  

undervalued,  it  is  not  simply  measuring  against  rental  parity,  it  is  adjusting  for  historical  differences  in  

valuations  those  markets  typically  experience.  

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House  prices  typically  rise  about  3.5%  per  year  to  match  wage  inflation.  If  someone  pays  10%  more  than  rental  

parity,  they  must  wait  3  years  for  appreciation  to  catch  up  with  their  purchase  price.  Overpaying  may  not  cost  

them  nominal  dollars,  but  it  may  cost  them  time,  which  is  costly  when  considering  inflation-­‐adjusted  dollars.  

Underpaying  is  also  a  significant  advantage  because  this  creates  an  opportunity  for  rebound  appreciation  back  to  

historic  norms.  Valuation  is  critical  in  identifying  the  best  opportunities  for  financial  gain.  

HOW  RENTAL  PARITY  IS  CALCULATED  

Each  month  I  calculate  rental  parity  using  aggregate  data  from  the  MLS.  It  requires  two  data  points  to  make  the  

calculation:  

(1) Average  rental  rate        

(2) Current  mortgage  interest  rate  on  30-­‐year  fixed-­‐rate  loans.  

I  assume  a  30-­‐year  fixed-­‐rate  mortgage.  It's  the  only  mortgage  product  that  provides  sufficient  payment  stability  to  

ensure  the  property  will  always  be  affordable.  The  payment  is  generally  about  6%  smaller  than  the  actual  cost  of  

ownership.  The  cost  of  ownership  usually  includes  other  costs  like  HOA  dues,  Mello  Roos,  maintenance  expenses,  

and  insurance.  These  costs  erode  the  buying  power  of  the  rental  payment.  There  are  offsets  with  tax  breaks  and  

loan  amortization,  but  generally,  the  cost  of  ownership  is  bigger  than  the  payment.  

Conventional  financing  

There  are  two  assumptions  which  change  depending  on  the  type  of  financing  used.  A  buyer  using  conventional  

financing  does  not  pay  private  mortgage  insurance  or  FHA  insurance  premiums.  This  means  the  cost  of  ownership  

is  much  closer  to  the  actual  payment.  Or  looked  at  another  way,  the  rent  which  would  be  applied  to  the  payment  

would  be  higher.  When  I  make  these  calculations,  I  assume  94%  of  the  rent  could  go  toward  making  a  loan  

payment.  In  areas  with  no  HOAs  or  Mello  Roos  (like  today's  featured  property)  that  assumption  is  too  low,  but  in  

areas  where  the  HOA  and  Mello  Roos  is  high,  the  assumption  is  too  high.    

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I  take  the  aggregate  rent  as  a  potential  loan  payment.  I  calculate  the  mortgage  balance  such  a  payment  would  

service  at  today's  interest  rate.  The  result  is  the  loan  component  of  rental  parity.  To  the  loan  balance,  I  add  an  

appropriate  down  payment.  For  conventional  buyers,  the  down  payment  applied  is  20%.  

YEAR-­‐OVER-­‐YEAR  PERCENTAGE  CHANGE  

Real  estate  market  exhibit  strong  seasonal  patterns  and  a  strong  tendency  to  trend  for  long  periods.  The  only  way  

to  gain  an  accurate  understanding  of  what's  happening  in  the  market  is  to  ignore  the  month-­‐to-­‐month  fluctuations  

and  focus  on  year-­‐over-­‐year  changes.  The  financial  media  often  shows  the  monthly  changes  that  fluctuate  wildly.  

This  information  is  often  useless  or  outright  misleading  as  to  the  real  direction  of  prices.  These  fluctuations  make  

for  interesting  headlines,  but  they  don't  provide  any  meaningful  information  to  help  buyers  or  sellers  make  an  

informed  decision.  

Per-­‐Square-­‐Foot  Basis  

Further,  I  prefer  to  look  at  data  on  a  per-­‐square-­‐foot  basis.  The  median  is  too  susceptible  to  fluctuations  based  on  

the  change  of  mix  to  be  reliable.  Looking  at  per-­‐square-­‐foot  costs  provides  a  more  accurate  picture  of  what  buyers  

are  obtaining  for  their  money.  When  prices  are  volatile,  the  mix  of  sales  may  change  causing  wild  swings  in  the  

median  sales  price  which  is  not  representative  of  the  prices  of  individual  properties  in  the  market.  Looking  at  per-­‐

square-­‐foot  data  eliminates  much  of  the  data  distortion  caused  by  a  change  in  sales  mix.  

Sales  prices  on  a  per-­‐square-­‐foot  basis  

Sales  prices  on  a  per-­‐square-­‐foot  basis  reveal  much  about  what  people  are  actually  obtaining  for  their  money.  If  

buyers  in  a  market  are  able  to  pay  $500,000  for  properties,  the  median  may  stay  at  $500,000,  but  if  high-­‐end  

properties  are  competing  for  buyers,  they  may  be  lowering  their  prices  to  attract  buyers.  When  these  buyers  

purchase,  they  still  spend  $500,000,  but  they  get  a  better  home  for  the  money.  Median  sales  prices  reveal  what  

people  are  spending,  but  only  price  per-­‐square-­‐foot  reveals  the  value  buyers  are  getting  for  their  money.  

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Rents  on  a  per-­‐square-­‐foot  basis  

Rental  parity  is  a  comparison  of  the  cost  of  ownership  to  the  cost  of  rent.  Therefore,  the  direction  of  rental  rates  is  

important  to  the  health  of  the  housing  market.  Rising  rents  will  eventually  put  pressure  on  prices  as  people  will  

chose  to  buy  to  save  money.  Falling  rents  will  have  the  opposite  effect.  If  prices  are  rising  and  rents  are  falling,  a  

bubble  is  forming.  If  rents  are  rising  and  prices  are  falling,  a  bottom  is  forming.  

If  you  know  the  value  relative  to  rental  parity,  the  yearly  resale  price  momentum,  and  the  yearly  change  in  rents,  

you  can  evaluate  the  risk  of  short-­‐term  and  long-­‐term  price  declines.  This  is  valuable  information  for  making  an  

informed  decision  regarding  buying  or  selling  real  estate.  

OCHN  Rating    

When  I  first  contemplated  a  rating  system,  I  considered  an  A  to  F  grading  system  like  the  HELOC  abuse  grading  

system.  As  I  worked  this  this  system,  I  found  the  nuances  were  lost  with  only  five  potential  grades.  The  next  most  

logical  choice  was  a  rating  scale  from  10  to  1.  It’s  intuitively  easy  to  understand,  and  it  provides  enough  gradation  

to  capture  the  subtle  differences  between  markets  under  varying  market  conditions.  

SYSTEM  CRITERIA  

When  considering  the  financial  implications  of  buying  a  home,  the  non-­‐kool-­‐aid  intoxicated  want  to  know  if  now  is  

a  good  time  and  if  the  location  they  are  considering  is  a  good  buy.  The  rating  system  provides  an  accurate  and  

unbiased  method  of  evaluating  the  market.  It  is  purely  mechanical  and  ignores  the  narrative  spun  by  market  

pundits.  At  times  this  narrative  is  important,  such  as  in  2009  and  2010  when  the  artificial  market  props  delivered  a  

false  buy  signal,  but  much  of  the  time  the  narrative  is  better  off  ignored  because  it  is  polluted  by  the  manipulations  

of  realtors.  

I  wanted  the  system  to  produce  results  consistent  with  my  view  of  the  housing  market.  It  should  have  said  not  to  

buy  during  the  bubble,  but  it  should  have  given  positive  signals  beforehand.  A  permanently  bearish  system  is  as  

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useless  as  the  realtor’s  permanently  bullish  ones.  The  system  should  produce  relatively  consistent  results  from  

month  to  month  with  few  abrupt  changes.  Housing  markets  don’t  change  quickly,  so  the  results  should  not  be  so  

volatile  as  to  suggest  buying  one  month  and  catastrophe  the  next.  

The  system  also  needed  to  respond  to  the  relative  importance  of  changes  in  the  market.  The  system  uses  the  three  

key  variables  I  tract:  valuation,  resale  price  change,  and  rental  price  change.  By  far  the  most  important  of  these  

variables  is  valuation.  It  is  also  the  least  understood  and  most  widely  ignored  fundamental  by  most  homebuyers.  

Valuation  rating  

The  valuation  rating  is  the  most  important,  and  most  volatile,  measure  in  the  rating  system,  mostly  because  house  

prices  are  so  volatile.  The  rating  system  ignores  any  market  within  6%  up  or  down  from  its  historic  norms.  The  

concept  is  simple:  negotiation  skills  and  motivations  of  the  parties  involved  introduces  at  least  7%  potential  

variability  in  resale  pricing,  so  a  market  within  7%  up  or  down  of  rental  parity  is  within  the  margin  of  typical  

variability.  For  each  increment  of  7%,  the  rating  is  either  increased  or  decreased  by  one.  For  example,  a  market  

that  is  between  35%  and  42%  undervalued  would  score  5  valuation  points.  And  markets  overvalued  by  35%  to  42%  

would  lose  5  valuation  points.  

This  point  system  based  on  7%  increments  makes  the  system  very  sensitive  to  changes  in  valuation,  and  it  does  

reflect  the  real-­‐world.  People  who  bought  at  inflated  prices  even  as  early  as  2003  when  prices  were  about  14%  

overvalued  are  living  in  properties  currently  trading  at  what  they  paid  nine  years  later.  Overpaying,  even  by  small  

amounts,  is  nearly  always  a  bad  financial  decision.    

Resale  momentum  rating  

Most  homebuyers  look  at  short-­‐term  changes  in  house  price  and  extrapolate  those  gains  forever.  Resale  price  

change  is  exactly  the  wrong  reason  to  buy  a  house.  In  my  rating  system,  resale  price  momentum  is  given  the  least  

weight  of  the  three  factors,  and  I  only  look  at  year-­‐over-­‐year  changes  rather  than  the  monthly  noise  subject  to  

seasonal  variations.  

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When  rating  the  rate  of  price  change,  I  have  four  categories:        

(1) greater  than  7%  =  2,        

(2) between  2%  and  7%  =  3,        

(3) between  2%  and  -­‐5%  =  1,  and        

(4) less  than  -­‐5%  =  0.  

A  stable  rate  of  appreciation  is  between  2%  and  7%,  and  markets  in  this  range  get  three  rating  points.  This  

provides  some  room  for  minor  fluctuations  and  recognizes  that  slow,  sustained  price  increases  are  a  normal  

function  of  healthy  real  estate  markets.  

Prices  rising  more  than  7%  per  year  are  not  sustainable.  Rather  than  being  considered  a  good  thing,  this  receives  

two  rating  points  rather  than  three.  Most  people  see  7%  per  year  appreciation  and  get  excited.  Most  often,  this  

means  they  are  buying  into  a  frenzy  and  overpaying.  

Prices  that  are  either  rising  slowly  or  falling  slowly  (between  2%  and  -­‐5%)  represent  a  weak  market  and  receive  one  

rating  point.  Some  might  argue  that  falling  prices  should  not  receive  any  points,  but  markets  with  gently  falling  

prices  often  have  more  motivated  sellers  and  better  bargains  on  individual  properties.  Such  markets  should  not  be  

shunned  just  because  prices  are  falling.  Bargains  can  be  found.  However,  the  same  is  not  true  of  markets  where  

prices  are  falling  more  steeply.  

Real  estate  markets  typically  display  strong  price  momentum,  a  market  falling  in  price  by  more  than  5%  per  year  is  

likely  to  continue  to  fall  for  the  foreseeable  future.  Such  markets  may  present  good  opportunities  today,  but  the  

opportunities  will  be  even  better  tomorrow.  For  that  reason,  these  markets  score  no  rating  points.  

Rental  momentum  rating  

Next  to  valuation,  momentum  in  rents  is  the  most  important  determinant  of  good  timing  in  a  real  estate  market.  

Shevy  recently  closed  a  sale  with  a  client  employed  by  a  major  bond  trading  company  in  Orange  County.  When  

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asked  why  he  was  buying  now,  he  stated  that  with  rising  rents,  locking  in  a  stable  cost  of  ownership  with  fixed-­‐rate  

financing  was  going  to  provide  him  a  return  on  his  investment  irrespective  of  any  changes  in  resale  price.  This  was  

not  a  man  looking  to  sell  for  a  profit  on  appreciation,  although  he  did  believe  appreciation  was  due  to  follow  in  

time.  He  recognized  the  importance  of  avoiding  the  rising  cost  of  housing  by  locking  in  his  housing  costs.  This  is  a  

valid  reason  to  buy  a  home  —  assuming  the  buyer  doesn’t  overpay  and  negate  the  savings.  

Rents  are  the  basis  of  all  value.  Falling  rents  are  a  huge  detriment  to  a  housing  market.  In  a  market  with  falling  

rents,  it  makes  little  sense  to  buy  and  lock  in  a  fixed  cost  of  ownership  unless  the  discount  is  very  attractive.  For  

example,  if  a  tenant  is  paying  $2,000  per  month  in  rent,  but  he  thinks  he  could  negotiate  a  $200  price  reduction,  

why  would  this  person  be  motivated  to  lock  in  a  $2,000  cost  of  ownership  to  buy  a  house?  There  is  money  to  be  

saved  by  renting,  and  in  all  likelihood,  resale  prices  of  houses  will  fall  to  match  the  new  level  of  rents.  

When  rating  the  year-­‐over-­‐year  rate  of  rental  rate  change,  I  have  five  categories:  

(1) greater  than  7%  =  3,        

(2) between  2%  and  7%  =  4,        

(3) between  2%  and  0%  =  2,        

(4) between  0%  and  -­‐2%  =  1,        

(5) less  than  -­‐2%  =  0.  

Note  that  all  rental  ratings  are  generally  higher  than  resale  price  momentum  ratings.  This  recognizes  their  greater  

relative  importance.  

Similar  to  resale  price  momentum,  rental  rates  increasing  between  2%  and  7%  are  normal  and  sustainable  yielding  

a  rating  of  four.  This  provides  room  for  minor  fluctuations.  Rents  increasing  more  than  7%  per  year  are  not  

sustainable  and  the  rating  drops  to  a  three.  Rising  rents  are  always  better  than  falling  rents,  so  increases  between  

0%  and  2%  are  given  two  ratings  points.  Slowly  falling  rents,  ranging  from  0%  to  -­‐2%,  are  given  one  point,  and  rents  

falling  more  than  2%  per  year  are  given  no  points.  

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What  would  a  typical  market  look  like?  

I  write  often  about  what  a  typical  or  healthy  market  would  look  like.  Based  on  this  rating  system,  such  a  market  

would  score  7  out  of  10  points.  It  would  have  resale  prices  and  rents  rising  between  2%  and  7%  scoring  three  

points  and  four  points  respectively.  Since  it  would  be  trading  at  rental  parity,  it  would  receive  no  valuation  points.  

For  a  market  to  get  a  boost  from  valuation  points,  it  needs  to  be  trading  at  a  discount  of  more  than  6%  from  its  

historic  norms.  To  get  points  subtracted,  it  needs  to  be  selling  at  valuations  more  than  6%  higher.  At  the  peak  in  

Irvine,  the  market  was  65%  overvalued  in  August  of  2006.  During  much  of  the  bubble  rally,  the  rating  system  gave  

five  to  seven  points  for  increases  in  resale  prices  and  rents,  then  routinely  subtracted  those  points  and  then  some  

for  excessive  valuations  —  which  is  what  a  good  market  rating  system  should  have  done  during  this  period.  In  the  

bear  rally  of  2009-­‐2010,  the  degree  of  market  inflation  was  less,  but  declining  rents  and  declining  prices  resulted  in  

no  points  scored.  The  system  would  have  largely  avoided  the  bear  rally.  By  mid  2011  with  falling  prices,  falling  

interest  rates  and  rising  rents  the  system  began  to  give  markets  favorable  ratings.  It  turned  bullish  about  6  months  

before  the  housing  bottom.  

What  would  be  a  perfect  world?  

So  what  market  conditions  would  give  ratings  of  eight,  nine,  or  ten?  It  takes  some  combination  of  low  valuations,  

rising  rents  and  rising  prices.  When  prices  were  still  falling,  many  markets  rated  high  because  relative  valuations  

became  very  low.  In  other  words,  it  was  so  inexpensive  relative  to  historic  norms,  the  price  discount  negated  the  

effect  of  falling  prices.  In  my  opinion,  that’s  how  it  should  be.  That’s  how  a  bottom  forms.  Value  buyers  purchase  

and  reverse  the  downward  price  momentum.  

This  system  is  not  perfect.  I  will  undoubtedly  revise  it  over  time.  Further,  it  is  not  without  its  own  drawbacks.  Right  

now  rental  parity  is  relatively  high  because  interest  rates  are  so  low.  Will  rising  interest  rates  cause  house  prices  to  

crash?  I  don’t  know,  but  it  is  certainly  a  possibility.  And  what  about  the  potential  for  future  REOs?  Won’t  that  

impact  market  pricing?  Probably.  That’s  part  of  the  narrative  worth  paying  attention  to.  

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No  strictly  mechanical  system  can  capture  the  unusual  circumstances  surrounding  any  financial  market.  Right  now,  

the  math  says  it’s  a  good  time  to  buy  in  many  cities  around  Southern  California,  and  many  buyers  are  active.  Will  

those  buyers  come  to  regret  their  decision?  If  they  are  locking  in  a  cost  of  ownership  less  than  rents,  and  if  they  

have  a  long  holding  time,  I  don’t  think  they  will.