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Residential Real Estate Prices May Not Have Hit Bottom

It's Your Money

Posted: March 6, 2008 7:45 p.m.
Updated: May 7, 2008 5:02 a.m.
Residential real estate prices may still have a ways to go before reaching a bottom.

Let me shed some additional light on why this may be so, at least mathematically speaking. Back in July 2005, I wrote an article for The Signal titled "SCV Residential Real Estate May Be Overvalued by 23 to 40 Percent." I used a valuation tool called the net asset value model.

This model is commonly used to value commercial real estate. I can get back to the specifics of how this model works later, but for now, suffice it to say the results of that model pointed to a reasonable value for a single family residence here in Santa Clarita to be $352,800.

Looking at the underlying assumptions used, I don't see that result changing as of now. The average single family home price for homes sold in April 2005 was $552,200. I just pulled up a copy of the most recent Realtors Report for Santa Clarita on the Internet, which stated that the median price now for single family homes here is down to $460,000 from its peak in April 2006 of $643,000.

However, if the $352,800 estimated reasonable value for a home here is still valid, then that says that we still have another 20 percent decline to go from $460,000 before we reach a mathematical equilibrium. That is not a pleasant prospect.

By changing (tweaking) one of the assumptions of the NAV model, the reasonable value number would increase to $423,000. If this number were more accurate, then another 8 percent decline is all that is needed to reach reasonable value equilibrium.

Based upon the NAV model, single family homes in Santa Clarita may still fall another 8 to 20 percent before leveling off.

Having reached the above conclusion, I must throw in a caveat: No one can say for sure just how far residential real estate prices may fall. There are so many extenuating circumstances affecting home prices that prices could bottom now or not bottom for a long time. Interest rates, the economy, potential buyer reluctance (some would call "fear") all have an impact on home prices to one degree or another.
Now for those of you interested in the model, this is how it works:

The model requires just four major inputs: 1. annual rent over the past year; 2. average maintenance costs per year; 3. an average long-term growth rate in rent or property value; and 4. a discount rate (called the "cap rate" in real estate circles).

The NAV formula looks like this:
NAV = ((Rent - Maintenance Costs) * (1 + Growth Rate))/ Cap Rate

If you are dealing with your own home-owner occupied real estate, you can simply estimate the rent component by comparing your house to comparable rental homes in your area.

Now let's throw some numbers into this formula. These numbers are rough estimates as to what exists out in the real Santa Clarita world right now.
  • Rent = $2,400/month or $28,800/year.
  • Maintenance Costs = $720/per month or $8,640/year. (Property tax, insurance, repairs)
  • Growth Rate = 5 percent/year. Obviously this is not happening now, but this is a long term projected growth rate. May be a bit generous, but let's help our formula.
  • Cap Rate = 6 percent
Plugging in the above numbers we have:
NAV = (($28,800 - $8,640) * (1+.05))/.06 = $352,800

Plug in your own numbers and see what the results are for you.

In the meantime, hang on to your boot straps because it appears we are still in for a rough ride as it relates to residential real estate values.

D. Frank Norton CPA, MBA, CFP, is a money manager and financial planner in Santa Clarita. "It's Your Money" appears Thursdays and rotates between a handful of the valley's financial professionals. His column represents his own views, and not necessarily those of The Signal.



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