“Nothing is a buy at any price; almost anything is a buy at some price.”

How often do we wonder what a house is worth? All the time. How often do we consider what another housing crash would do to it? Hmmmm…not so much.   

Most people care only about comparable prices (“comps”) and the monthly payment. But like gold or a painting, a house has no intrinsic value. It’s worth what people say it is. However, if you were to rent it out, it would have real value based on the amount of its net rental income. It becomes an investment with income, expenses, and profit or loss.  

This is the only protection there is. If the price of any income-producing asset declines, someone will buy it when the potential income net of expenses is great enough to justify the price. This is exactly what happened in the housing crash. Buyers from individuals to large real estate investment trusts snapped up hundreds of thousands of houses from desperate sellers. To know whether they would earn a sufficient return on their investment, they used the real estate concept called capitalization or “cap” rate. If we don’t ever want to be desperate sellers—who does?—we should do the same. (Note that this does not apply to unique properties and gazillionaires, which have no such restraints.)   

Cap rate is income minus expenses, divided by sales price, expressed as a percentage. For a home that could produce $12,000 a year net of expenses, a sales price of $150,000 results in a cap rate of 8% (8% percent of $150,000 is $12,000). The chart uses this example to show the relationship between cap rate and sales price:   

The chart is not dependent on the example. For any given sales price, cap rate, or net income, the relationship between sales price and cap rate is the same.  As the cap rate (dashed line) declines, the implied sales price (solid line) rises. As the cap rate rises, the implied sales price declines. Buyers want a higher cap rate—to pay less for more. And sellers want to receive more money for less—a lower cap rate. Pay or own at a high cap rate and you have a greater margin of safety. It’s that easy. 

“But Tom, seriously, does anyone really think this way?” Yes!. During the boom and bubble, economist Dean Baker wrote an article explaining why he sold his Washington, DC home and became a renter. He used data showing that over time house prices are closely correlated to rental income. Certainly they may get out of whack and for a long time—just as stock valuations do—but in the end they revert to the average.  Baker applied real estate finance to a situation that “felt” crazy, found he was far too exposed to wealth-destroying downside risk, and made a rational choice.     

For such an important asset, why take unnecessary risk of catastrophic loss as occurred to many in 2007-08? We can look around the area to estimate rental income as if we had to rent our house. Deduct expenses and apply a rough cap rate range, say 8% to 12%. Compare the results to price paid, what we owe and would need to clear if we had to sell in a pinch—even if we can’t imagine ever selling. The higher the results, the greater our margin of safety, the more our peace of mind. Which is a good thing.