Using The ‘Rule Of 15’ To Identify Local Housing Bubbles
“All real estate is local.” A statement often repeated by those in the housing industry. Now, there might be a way to determine if housing bubbles are local too. CNBC contributor Carmen Wong Ulrich wrote on July 10:
Ever hear of the real estate Rule of 15? I mentioned it yesterday on a segment with Al Roker on the TODAY Show as we discussed a question tossing and turning through many American heads these days: “Should I buy or rent?”
Here’s how the rule goes: Let’s say you’re looking at a 2-bedroom house or apartment:
1) Find the going rent in the neighborhood or location you’re interested in—which you can track down through sites like Zillow.com and Trulia.com—and calculate how much you’d spend in rent a year. Say, $2,000 a month would mean an annual rent of $24,000.
2) Multiply that number—your annual rent—by 15. (in this case: $360,000)
3) Now look up and compare the going price of a comparable space in the same area, to buy.
4) If that number is much greater than your annual-rent-times-15, the location probably still has a way to go down in home value. The bubble here ain’t done burstin’ and you should rent for a while. The last thing you want to be is upside-down on a mortgage—owing more than your new home is worth.
Hmm. Time to whip out the old calculator and try the “Rule of 15” myself:
1) My girlfriend and I rent out a 2-bedroom, 2-bath apartment on the northwest side of Chicago. We pay $1,100 a month, or $550 each, which is more-or-less the going rate in the neighborhood. Therefore, annual rent is $13,200.
2) Multiplied by 15, this comes out to $198,000.
3) I took the average going price of comparable 2-bedroom, 2-bath condo units for sale in our neighborhood, and found that this number comes out to $223,444.
4) The difference between the numbers arrived at in step 3 versus 2 is $25,444. According to the “Rule of 15,” prices for comparable 2-bedroom, 2-bath units in the area are headed south. Judging by the number of “for sale” signs in front of some of these buildings (and in the neighborhood in general), there might be something to this Rule.
Just one thing I don’t understand though. Why the “15?” I’ve sent an e-mail to Ms. Wong Ulrich, hoping for an explanation…
Source:
“Buy or Rent? Learn the Rule of 15”
Carmen Wong Ulrich
CNBC, July 10, 2008
July 17th, 2008 at 8:10 pm
That’s a pretty rough (in my view high) ballpark ratio considering the amount of variability a range of interest rates, closing costs and property taxes in various locales could have on the overall carrying monthly costs. Not to mention insurance, repairs, etc., some of which is offset by the mortgage interest and property tax deduction from income tax.
Still, as a rough target it serves a useful purpose. By the logic of the above it should probably be a bit lower though, like 13. Especially if interest rates rise.
As to “why 15?” It’s probably because when you add the interest of a 30 year loan to the sale price of a house, the price approximately doubles, so 15 bought + 15 interest = ~ the monthly mortgage payment.
July 18th, 2008 at 12:25 pm
Thanks for the comment and input Steve. I’l have to check into that. It’ll be interesting to see if Ms. Wong Ulrich replies to my e-mail in the meantime.
August 4th, 2008 at 12:33 pm
Historically prices should reflect three times household income. So this 15 rule is twice that in LA. The average income there is 50k per year times three equals 150k price. Compare that to your calculation of 360k value and you are too high. Timberrrrrrr.
August 4th, 2008 at 10:09 pm
Thanks for the info Gary.