Among those making anguished protests against the Tavares administration’s decision to enforce county laws on unpermitted vacation rental businesses outside the hotel districts, house owners have declared that they cannot afford the properties unless they can operate a vacation rental.
That raises a question of how did they afford the properties before they initiated their vacation rental business, and suggests they purchased the property based on expectation that they could conduct the business.
It’s one of the issues that Maui Realtors skirt with their defense of the vacation rental industry — the suggestion that real estate agents may have advised buyers that they could generate income by utilizing a part of a high-value property as a vacation rental.
It’s not uncommon for real estate advertisements to declare that a property can be used for income. But it is one thing to generate revenues from long-term home rentals, another to generate income from short-term vacation rentals that require special permits and conditional permits. Well-kept properties with scenic views can generate a higher income stream as short-term rentals, but if they are in a residential district they need a county conditional permit.
Long-term rentals don’t need permits, but the rents will be limited in the marketplace.
That difference can be evaluated through a real estate pricing theory forwarded by two economics professors from Pomona College a few years ago. In a paper presented in March 2006, Gary and Margaret Hwang Smith posited an opinion that housing values should be judged by what a house could generate in rental income.
Traditional pricing theory bases values on what the market is willing to pay, with issues raised over the potential for “bubble” markets to form. A bubble is created when excessively zealous buyers are driven by speculative demands, bidding prices over value in expectation that there will be another buyer willing to pay even more.
It is generally accepted that real estate value is not based on cost but on market demand. An acre of sand in the Sahara has no value because there is no market demand for it, but an acre of sand alongside Wailea Beach has a high value because there is a strong, continuing demand for it. By the same pricing process, a builder could spend $500,000 on labor and materials to put up a house in the Sahara and it still would have no value, but the same house at Wailea would be valued at three to five times the cost of construction.
Since market pricing for real estate is subject to significant variability based on factors such as location, the Smiths in “Bubble, Bubble, Where’s the Housing Bubble?” (Brookings Panel on Economic Activity, March 31, 2006) offered that a realistic “fundamental value” can be based on rental value since that would reflect what the surrounding community (including the would-be buyer) can afford or is willing to pay. It has nothing to do with what’s fair in pricing. In a community in which there is a high demand for housing — as is the case around Hawaii — renters may share the unit to be able to afford it, but if they pay the rent, that establishes value.
A buyer can calculate rental charges — which will be based on factors of location and rental market need — weigh it against costs for mortgage payments, taxes and insurance, and gauge “fundamental value.”
The Smiths suggested that pricing based on market value versus pricing based on rental costs is like comparing apples with oranges, and that rental income analysis provides a better basis for determining whether the price of a piece of real estate in a specific neighborhood is justified.
“The ratio of a house price index to a rent index can rise because the prices of houses in desirable neighborhoods increased more than did rents of apartment buildings in less desirable neighborhoods,” they wrote.
They held that savings on rental costs are a central factor in determining the fundamental value of a property for a buyer who will be an owner-occupant.
The transient vacation rental situation on Maui turns the Smiths’ theory on its head. Now fundamental value of a property is being based on potential for high rental income of a business operation within what is otherwise a residential (or rural or agricultural) neighborhood. The effect is to raise values, and prices, which satisfies sellers. Buyers would need to be convinced that they can afford what they buy. That difference also spawned the unconventional mortgages that are now skewing real estate values downward after first allowing them to rise well beyond fundamental value.
The Realtor will argue that market values were established when the less-wealthy buyer needed options to be able to afford the property. In some cases, buyers may have been persuaded by interest-only, no-downpayment or other unconventional loans to stretch their limited income. In others, apparently, buyers believed they need not adhere to county zoning laws to increase their incomes.
• Edwin Tanji can be reached at citydesk@mauinews.com'>citydesk@mauinews.com. “Haku Mo‘olelo,” referring to a story writer, appears every Friday.
