In Greg Ip’s WSJ article Home Prices Must Fall Far To Be In Sync With Rents he covers a study on the relationship between sales prices and rents in a report by fed economists although it doesn’t necessarily reflect the views of the fed.

>The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6,600 a year) and the average home price was about $134,000.

>But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%.

>That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade.

This concept has been discussed for the past five years in the Economist magazine as they warned of the imbalance in the ratio of rental rates and sales prices.

I have always liked the logic of this concept but it doesn’t seem to cover the entire value picture.

I tend to see property value in this context:

[rental stream converted to income value] + [owner/use value impacted by highest and best use] = [property value]

In a market where the use value is 0 then this logic does apply, but how much is the owner/user element? For example, in my market, buyers for the past 20 years have paid more for a 3-family than the rents would support. Thats because they are paying for the potential upside for conversion to single family at some point in the future. The rental stream doesn’t justify the price.

But I think the concern expressed in this article is the idea that the spread between these two values is expanding. Here are some other thoughts.Viagra

  • Teardowns — Another common example has been teardowns in many suburban markets. An undersized property relative to its land is worth more because the land size allows for the development of a larger property. The rental rate of the existing property doesn’t convert readily to value because the price of the property reflects its potential value with a larger improvemement built on it and the rent/sale price ratio is therefore not reflective of the property. It seems to me that there has been a tremendous amount of this activity over the past decade.

  • National rental stats — There is no national housing market in the purest sense. That being said, I get angina thinking about this concept when the consumer patterns have changed significantly towards housing since 1960 which is the beginning of this rental study. Demand for larger houses and the idea that the higher price points of those markets tend not to reflect the same level of rental demand is apples and oranges because larger sized houses are much less likely to be built for rental use because the upper income demographic segment is less transient and less likely to rent.

  • Percentage of home ownership — The percentage of home ownership has been rising since 1980. Rising demand for housing, has changed at the expense of the rental market. A change in orientation of housing. If ownership demand is rising, that must come at the expense of rentals. Therefore it is likely that the ratio would expand. I am not sure why this long term change wouldn’t soften the argument the ratios getting out of balance although I would agree with the idea that the last 3 years, the looseness of underwriting guidelines promoted home ownership at the expense of rental. This difference will be exaggerated greatly in the coming years as investors are forced to rent to remain solvent because they are unable to flip out of their mortgage trouble and the wave of investor units coming to market as rentals will further depress the rental market.

  • Currency exchange rates — Foreign ownership fostered by periods of exchange rate swings is much more of a factor in the purchase decision of residential property in coastal locations (CA, FL and NYC for example) further eroding the “national housing market concept.”

After working through these concepts, it suggests to me that a portion of the widening spread between ownership and rental is due to a change in the perception of housing as an investment. However, the exaggerated difference over the recent several years is still of significant concern.

12 Responses to “Rent This: Home Prices Must Fall To Sync”

  1. Minimum Wage says:

    The price/rent ratio hasa been trending upward for decades.

    In the ’60s there was a casual rule of thumb that a home’s price should be roughly 70 times its monthly rental value.

    Over time, I’ve also seen ballpark ratios of 100 and 120. Today, of course, the ratios are even considerably higher.

  2. John K says:

    I can understand the whole rent vs. own analysis. You have to live somewhere, either rent or own, so there should be a direct correlation between the cost of one and the cost of the other.

    I understand that.

    I’ve just never seen it as clearly as some analysts.

    As you mention, Jonathan, there may be other factors involved.

    I guess I’d make the analogy to cars. Gasoline prices have risen, what, 300%, over three years? Yet the number of people switching to hybrids or to economy cars specifically due to the cost of gasoline is probably small.

    Driving isn’t just about cost, obviously. I want to be comfortable when coming home at rush hour, so I want to be in an Escalade, not a Prius. I’m willing to pay for the extra gas. (Actually, I don’t own a car.)

    Perhaps housing isn’t just about cost, either?

  3. avorob says:

    The “teardown” rentals are usually short term, while the builder obtians his or her building/demo permits. It could take up to a year depending on the municipality. In most cases builders don’t bother renting out those properties.

  4. Jonathan J. Miller says:

    great comments. The point I am trying to make is that the motivation that drives the demand to purchase is driven by more than what a tenant is willing to pay. An undersized tired house on an oversized lot may not rent for a premium with the additional land because the tenant doesn’t care as much or be willing to pay for the land as a purchaser might, who sees the future up side of the property.

    That’s highest and best use and has more to do with the future potential of the property.

    This also is a primary reason that CPI is flawed because it relies on large part to the “rental equivalent”.

  5. John Mason says:

    Not to be argumentative, but I think there is a direct connection between the cost of owning and renting. But like Jonathan said, there is no national housing market. As such, the ratio fluctuates based on location, economic conditions, social trends, etc. As an example, in areas with strong local economies and high housing costs, the cost to own far exceeds the cost to rent (and vice-versa). Some even claim this creates a legal form of exclusivity in wealthy communities, where zoning greatly restricts viable rental options, which exacerbates the own vs. rent cost ratio, thereby creating a high hurdle entry level (economically speaking). The ratio also changes from year to year, even within each market. And yes it might also change from one era to another. But just because it’s a moving target doesn’t mean you can’t or shouldn’t track it.

    It’s similar to capitalization rates. You wouldn’t use the same cap-rate for all products in all markets. Owners/investors of class A office buildings expect a different rate of return from those with industrial properties, retail space, residential rentals, and so forth. Also, the cap-rates deemed reasonable just 6 or 12 months ago might need to be revised (i.e. due to the current credit crunch, etc.).

    So as some have suggested, the motivations are clearly different for the different participants. But the motivations of these participants also change over time, from one market/product to another, and for a whole host of other reasons. Even the participants themselves are constantly changing (i.e. more foreign buyers are showing interest in US real estate with the declining value of the dollar).

    So in the end the cost to own/rent ratio could simply be another potential tool to help us see where the market is vs. where we think it could/should be, (and dare I say it) give us the gall to predict where it might be headed.

  6. Jonathan J. Miller says:

    Thanks John – yes I completely agree there is a relationship, but I think there is often a gap between the straight rental value and the value as an owner/user and its misleading to rely on it in a formulaic fashion. Like you said, motivations vary and change. I think of a builder considering a new residential apartment building and whether it is to be a rental or a condo. Would the configurations be the same? I would think that in most urban markets, the unit sizes for rentals would be smaller than condos. Why? Because they represent different markets.

  7. Phil says:

    I’ll probably regret wading into the deep waters of your blog, but I’m an avid reader of your’s and other blogs on the general topic. This does not mean I’m a keen thinker.

    The rent/ home purchase price ratio is out of wack, this much is clear. I am not smitten by the factors you cite. They are NY-centric, and remind me of what I read about why the stock market is up or down today, or this week. Mostly correlative issues. Under historical economic circumstances, the desire for a nicer cave would not have gotten so far out of whack.

    I think about a few broader factors that influenced the trend, which may now well be reversing:

    • Psychological factor. Let’s buy a nicer cave, and make some money on it. When people feel wealthy for long enough, they think about moving into a nicer/bigger/etc. home. People have made a lot of money in the last 10-15 years, particularly the boomers. When you consider the recent economic history – the longest economic expansion under Bill Clinton/ Rubin, followed by a brief recession, then continued expansion under Bush — most people have forgotten what hard times really are. So people have money, and they don;t (or didn;t) hesitate to take on risk (debt). This is also a cross-cutting factor, because macroeconomic factors and monetary policies contributed to “net worth inflation”.

    • Macroeconomic factors: Establishment of the global financial architecture has been underway for some time, but money flows really increased with Asia’s participation. So there;s been a lot more money to fund the developed world’s debt, which has contributed to unusually low and sustained mortgage interest rates.

    • Monetary policies: Mortgage lenders took advantage of growing demand and low regulation to offer loan products that lowered front end borrowing costs, which helped sustain the price/rent imbalance. Unregulated lending increased the flows to all borrowers, but importantly, the lower-than-median borrowers helped sustain the above-median borrowers.

    So, monetary policy helped build wealth(and reduce poverty), followed by laissez faire policies for regulating mortgage lending, which together collided with human nature – the desire for a nicer cave.

    It’s pretty obvious I’m not an economist.

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  9. Russ says:

    My experience with these sorts of metrics is that you have to compare to the mortgage payment, not the home price. While interest rates are off their 2003-04 lows, they’re still far below the levels they were at for most of the last 30 or so years. If I recall correctly, the mortgage payment to rent payment ratio was fairly stable for a long time (but did deteriorate during the 2005-2006 timeframe).

    has some short-term metro-level stats. And while it’s a few years out of date (and predates the last few years of the housing run-up when you can make an argument that bubble really did get out of control), has some useful charts and graphs that look at mortgage to rent ratios (e.g., Chart 6).

  10. Russ says:

    I mangled my links — here are the raw URLs:

  11. John Hunter says:

    Nice post and discussion. In addition to your conversion upside I believe owners were expecting (unrealistically but none-the-less expecting) capital gains on appreciation and therefore accepting lower rental rates. I would expect the % to increase toward long term rates due to rising rents and falling prices. For more see:

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