Sunday, December 05, 2010

How Property Taxes Undermine Housing Prices

It snowed about 8 inches here in the Twin Cities this weekend. Normally this would upset people, but I enjoy it. And the reason I enjoy it is because when it snows like this I am happily reminded of the fact I no longer have to drive to Minneapolis to shovel my duplex.

It's the same feeling I get when it's late in fall and the leaves are on the ground. I no longer have to drive to my duplex in Minneapolis to rake the yard. I just mow over what few leaves fall on my new yard in the burbs.

Of course these are seasonal feelings. I get about a weekly dose of "post-partem-von-Minneapolis" happiness when I have to drive through the town and pass the Riverside exit knowing full well I never have to take that exit ever again to deal with my former rental property be it tenants, mice, or just general maintenance problems.

But the biggest smile on my face is when I look at my property tax bill and see that in my current abode (which is a nicer property and in a nicer neighborhood) I pay literally 1/4th the property taxes I did in Minneapolis. Not to mention I have much better schools, police, public services and plowing service (and I have yet to have my car stolen!).

Regardless, the snow this latest time around got me thinking about another aspect of my former place in Minneapolis and that was whether or not home prices were coming down enough to rationalize investing in my old neighborhood once again. To do this we need to take a look at that old standard classic ratio;

House price to rents.

There are varying measures or ways to do this, but they all measure the same thing - how much of a multiple of rents is the price of the house.

It is identical to the P/E ratio of stocks. The idea being a low ratio shows you, you are getting a lot of rent for a relatively low price. A high ratio shows you the rent is likely NOT worth the cost of the house.

I pulled figures from 2001 (most available) to the present using the "fair market rents" for a one bedroom apartment in the Twin Cities area and the median sales price from the Minneapolis Area Association of Realtors and came up with the blue line.

And what do you know, it looks like the bubble is finally over, hallelujah! Price to rents was originally about 26, reaching a peak of 32 and now because of the crash, back down all the way below 20! Certainly a deal!

But what has your old wise Captain been telling you about the biggest largest threat to the recovery of the housing sector, especially in big cities?

That's right, property taxes.

You see, charge all the rent you want, you don't get to keep all of it. You have to pay for insurance, interest and repairs. These things (bar having an ARM as a means of financing your house) stay relatively stable. But there is one thing that you pay every month and has a tendency to go up.

Property taxes.

I remember when I first bought my house my property taxes were just $1,100. Ten years later they were over $4,000. Certainly more than the rate of inflation.

Now I know property taxes figure in lastly when most people buy a house, but please listen to me.

Property is nothing more than an asset. Assets only have value if they have some means of feasible cash flow. This is why you compare a stock price versus it's earnings. Or a mutual fund against its dividends. And a house against its rents.

However, if you are going to buy any one of these assets, keep in mind you don't get to keep all the profits they generate. You have to pay taxes to various governments on various assets. And if the taxes on those cash flows goes up, it directly and negatively affects the value of that asset, driving asset prices down.

Thus, the red line.

The red line is much more representative of the true over/undervaluation of properties in the MInneapolis area. It takes out the average property taxes one pays (no historical data was at the Minneapolis city's web site so I used my own as a proxy) and then applies the price of the house to NET rents (rental income after property taxes).

The trend is a little bit different.

The ratio started at 30, went up to 50, and then back down to 30. Meaning housing is no more of a deal today than it was in 2001. Why? well prices are actually lower today than they were in 2001 (by about $30,000), so how did the ratio not drop as much as its gross rent counterpart?

Those wonderful property taxes.

When you account for property taxes, you're still buying into a bubble. A house isn't worth a ratio of 30 times annual net rental income. You can find a lot cheaper (and safer and better and lower taxes and etc. etc.) in the burbs.

But this also has ramifications for the appraisal and collateral based industries. REIT's heavily invested in major cities, banks with overexposed real estate portfolios in major cities (or any heavily taxed city) and hedge funds chomping at the bit to take positions in real estate hoping to buy at the bottom better pay close attention to net rental rates and not gross.

Of course if they have even the slightest bit savvy of models (or analysts) their calculations will account for net rent. However, it's not that as much as it is the perpetually increasing chunk property taxes take out of rents. Using my property taxes as a historical proxy against the FMR in Minneapolis, property taxes were originally just 14% the rent I could get from the available unit. Now it's 42%.

(technical note - this is for a duplex, so the above chart could be halved if one were to consider renting out the additional unit for rent, doubling the rent instead of living in it)

Regardless of whether the unit is rented or not, the issue is the perpetually increasing property taxes relative to the rents. As property taxes take more and more profit from the property, that property will continue to have less and less value. So the issue is not one of what property taxes are today. It's what they are going to be in the future. And given the ilk on the Minneapolis City council, you can expect all rents to be consumed by property taxes by ehhh, roughly 2030/2035ish or so.

Enjoy the decline!

1 comment:

Anonymous said...

Since commercial property is generally valued as a multiple of net operating income, property tax rates are taken into consideration when valuing it, and commercial leases always include rent escalators for property taxes. Of course, at some point the tenant will balk and the landlord's NOI gets hit, so in the long run unlimited tax increases steal value from commercial property owners.

Philly has a 3% real estate transfer tax and its own wage taxes, in addition to the state's, which very effectively keep businesses out of the city and residential property values low. Next-door Bucks county is very visibly more affluent.

The single-family landlords are getting hit hard because residential leases are gross leases and rental houses don't benefit from "homestead" property tax caps.

There is an interesting non-government parallel here: owners of mobile home parks steal value from their tenant's mobile homes every time they raise rents.