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Price to rent ratios |
PreviewPrice to rent ratios are one way of measuring fundamental value in a housing market. For a prospective homeowner, the price of housing relative to rents is a major factor in the buy versus rent decision. For an investor in rental property, the price to rent ratio is a major determinant of the return on investment. Price to rent ratios also give us a sense for whether current home prices are within the range of historical norms. Rents provide a fundamental floor for home prices since investors will be willing to buy homes and rent them out if the price is low enough. But when the price to rent ratio rises too far above its sustainable level, it is likely to be corrected by falling prices and/or rising rents. Even after taking into account the most recent home price declines, nearly every U.S. city is above its long-term average price-to-rent ratio. Prices must come down (or rents must rise) another 20-40% in some cities just to achieve historically consistent levels. Price to Rent RatiosWhen people ask me whether home prices are too high, the first question that pops in my head is: relative to what? The most natural comparison is to the rent that would be collected from owning the home. Just as stocks are expensive when P/E ratios are too high, housing is expensive when the price is high relative to rents. Each city has a natural long-run price to rent ratio that depends on many factors, including the growth rate of rents, the rate of homeownership, mortgage rates, etc. We should not expect to see the same long-run price to rent ratio across cities. As a basic rule, the ratio should be higher in cities that are growing and lower in cities that are stable or declining (just like you would expect a higher P/E for Google than you would for Exxon-Mobile). In addition, the price to rent ratio does not summarize all of the relevant information for a real estate investment. The return on a housing investment also depends on maintenance, taxes, insurance, appreciation, etc., which can vary from property to property. But as a basic measure of value, the price to rent ratio is a good starting point. Fundamentally, real estate is a yield oriented investment. When prices are rising, people tend to discount the importance of yield because they make money on the price appreciation. But when prices are falling, it is rent yield that ultimately puts a floor on home prices. U.S. CitiesIn the long-run, we would expect that prices and rents grow at roughly the same rate within each city. If prices rise too fast relative to rents, then either prices will have to fall or rents will have to rise to correct the imbalance. By looking at the price to rent ratio over time, we can get a sense for whether housing is currently cheap or expensive (and how much so). Using the Case-Shiller and OFHEO home price indices and rent series from the Bureau of Labor Statistics, I can track historical prices and rents for many U.S. cities. In "bubble" cities like Los Angeles, we can see how a divergence of prices and rents leads to a correction in the years that follow:  Click on the chart above for a sharper image From 1982 to 1990, Los Angeles prices rose by 10.2% per year while rents rose by only 6.3% per year. From 1990 to 1997, prices corrected by an average of 3.5% per year while rents rose by only 1.2% per year. Most recently from 1997-2007, prices rose by 13.0% per year while rents rose by only 4.6% per year. The extreme divergence of prices and rents in cities like this one will likely lead to falling prices and rising rents for some time. It may be many years before the relationship is back to normal. The relationship between prices and rents can more easily be viewed as a ratio over time. Here is the chart for Los Angeles:  Click on the chart above for a sharper image Los Angeles reached a historical high near 30 in 2005-2006 and has now begun the corrective process. Miami is another example of a city that has started its corrective process (though it did not experience a similar divergence in the 1980s):  Click on the chart above for a sharper image Miami was in a long-run steady state for 14 years where prices and rents were increasing at roughly the same average rate over time. Then beginning in 1997 prices started to diverge as they did in Los Angeles. For the last 10 years, Miami home prices rose by 12.2% per year while rents rose by only 4.0% per year. The chart below displays the price to rent ratio over time:  Click on the chart above for a sharper image It seems that a price to rent ratio near 30 is going to be unsustainable for both Miami and Los Angeles. A quick numerical example should illustrate why this should be so. Imagine a prospective homeowner buying a house that rents for $2,000 a month. At a price to rent ratio near 30, this house would cost $720,000 ($2,000 x 12 x 30). Borrowing the money at the low rate of 5% would cost $36,000 per year in interest ($720,000 x 5%), not to mention taxes and maintenance. Compared to only $24,000 for renting, it's not a great deal. Alternatively, at a price to rent ratio of 12.5 (near Miami's 1980s level), the house would cost $300,000 ($2,000 x 12 x 12.5) and the financing expense would be $15,000 per year in interest ($300,000 x 5%). Adding taxes and maintenance makes this much more in line with the cost of renting. Not all cities experienced such a dramatic price and rent divergence, but nearly every city is above its long-term historical average. This means falling prices relative to rents for most of the country for the next few years. One crucial difference between the 1980s and today is that 30-year mortgage rates have declined from over 10% to under 6%. But my calculations suggest that this should increase price to rent ratios by at most 25-40% after adjusting for other expenses like taxes and maintenance. In any case, most of the price increases were well beyond this amount and occurred after 1997, when mortgage rates were already low. Finally, I don't want to exclude the possibility that mortgage rates will rise and that home prices will fall even further in response. The table below shows how much prices increased relative to rents since 1997 in all cities for which data are available, as well as how large a possible correction could be. Either prices must fall or rents must rise by these amounts to send the ratio back to historically consistent levels.  The historical pattern suggests that most cities will experience modest price declines and steadily rising rents (inflation) for many years to come until price to rent ratios reach more normal levels. Lower mortgage rates may raise the long-run averages above their 1990-1997 levels, but I think that people calling for a bottom in home prices are way too early. It will be many years before real estate once again becomes the most favorable asset class. The Bigger PictureThe $64 billion dollar question is to what extent declining home prices will impact the U.S. consumer and the broad economy. I have so far been impressed and surprised with the strength of U.S. corporate earnings amidst the housing decline. I am still expecting a substantial earnings slowdown, which could be quite negative for the U.S. stock market, but the evidence so far is mixed. More on this in months to come. ConclusionIn this issue, I have argued that prices and rents must grow at roughly the same rates over time for home prices to be sustainable. Currently, price-to-rent ratios in most cities are still well above historical norms, and I expect some combination of falling prices and rising rents to continue for many more years. I finish by providing brief descriptions of two key studies which offer similar analyses of the long-run relationships between prices and rents. My estimates suggest a weaker housing market than either of them, but in the interest of presenting some alternative viewpoints, here they are:
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