South Florida Real Estate Bubble and Effective Payment with Ownership

Should an individual purchase a home in South Florida given the current state of the real estate
market? Well, this depends upon a number of key factors: market rents for comparable
properties, loan rates, lost interest income from down payment, property maintenance, tax-break
from homeownership (loan interest deduction and deduction of property taxes) and, perhaps,
most importantly property appreciation. In fact, this is simply an extension of the age old
question of owning verses renting that potential purchasers have faced for years.

This brief write-up addresses this very question in an effective payment scenario. Effective
payment is calculated by adjusting a potential home owner’s monthly mortgage payment for: (1)
Opportunity cost of their down payment on a monthly basis, i.e., lost interest income from down
payment, (2) Expected monthly property maintenance, insurance and property taxes, (3)
Expected monthly tax-break from ownership (deduction of loan interest from Federal income tax
and deduction of property taxes), and (4) Expected monthly gain in appreciation. Items 1 and 2
obviously add to the cost of ownership while items 3 and 4 decrease effective payment with
ownership. In short, we have traditionally compared the effective monthly cost of
homeownership with that of comparable monthly rents and recommended ownership if effective
monthly payment with ownership was lower than rents on comparable properties.

Assuming realistic numbers for Miami, Florida (circa Fall, 2005) and using a little algebra, we
can solve for the amount of property appreciation necessary to make a potential buyer indifferent
between owning and renting a property. Clearly, future property appreciation levels above this
break-even appreciation rate encourage home ownership.

Let’s assume a $600,000 property that will rent for $2,200 per month, property maintenance and
Homeowner Association fees equal $450 per month, 20% down payment, 30 year fixed rate
financing at 6.125%, 3.25% per year for property taxes and insurance (with 2.25% of value
representing annual property taxes and 1.0% for annual property insurance), and the potential
home owner is in the 33% marginal tax bracket. We will now compare the effective payment on
this typical South Florida home with rent on comparable properties.

Monthly Mortgage Payment (PITI) $4,541.53

Plus:
Expected Monthly Lost Interest $612.50
Income from Down Payment –
assume 6.125% per annum return
Expected Monthly Maintenance $450.00
Less:
Expected Monthly Tax-break $804.10
Interest Write-off
Expected Monthly Write-off from $371.25
Property Taxes
 Expected Monthly Appreciation ?
Effective Monthly Payment $2,200
Less:
Monthly Rent on Comparable $2,200
Property
Indifferent between Owning and 0
Renting

Solving for Expected Monthly appreciation, we see that monthly property appreciation with an
average of $2,228.68 per month (or $26,744.16 per year), which amounts to 4.46%
($26,744.16/$600,000) per year, is needed to make potential purchasers indifferent between
owning and renting. Therefore, if property in the coming years actually averages more/less than
4.46%, then potential purchasers will be better/worse off from purchasing verses renting, roughly
speaking.

Let:

Monthly Mortgage Payment (PITI) ≡ PITI Payment

Expected Monthly Lost Interest Income from Down Payment ≡ EMLIIDP
Expected Monthly Maintenance ≡ EMM
Expected Monthly Tax-break Interest Write-off ≡ EMTBIWO
Expected Monthly Write-off from Property Taxes ≡ EMWOPT
Expected Monthly Appreciation ≡ EMA
Effective Monthly Payment ≡ EMP
Monthly Rent on Comparable Property ≡ MRCP

PITI Payment + (EMLIIDP + EMM) – (EMTBIWO + EMWOPT + EMA) = EMP

Then:

If MRCP = EMP, then buyer is indifferent between owning vs. renting.

If MRCP > EMP, then potential buyer will prefer to buy.
If MRCP < EMP, then potential buyer will prefer to rent.

A brief word about the assumptions used in this analysis is worth noting. Estimates of all factors
(median home price, comparable rents, loan rates, property maintenance, etc.) are based on
casual experience and conversations with local Realtors working in the Coral Gables area in
circa 2005. In addition, all cash outflow estimates are slightly overestimated, while all inflows
are underestimated. This process ensures a slightly overestimated annual appreciation rate
needed to make potential purchasers indifferent between owning and renting. Finally, the
analysis was conducted on a one-year basis with an opportunity cost on the down payment of
6.125%. Alternative scenarios with varying realistic estimates of the factors influencing
effective payment from ownership were run resulting in needed annual appreciations between
4% and 7% for indifference between owning and renting.
So, was there a housing bubble in South Florida or were prices simply adjusting to market rents?
The above analysis does not categorically answer this question. However, it does clearly point
out that annual property appreciation levels below 10% should be sufficient to support ownership
versus renting.

The same analysis can be employed for varying locations and should prove helpful in the buy or
rent decision. Information that you will need for your area includes: (1) local interest rate, (2)
escrow calculations for taxes, insurance, and association fee (if any), (3) monthly maintenance
estimate, (4) rent on comparable property, (5) Property price, (6) Down payment, and (7)
Marginal Tax bracket.

So, what happened?