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Rent This: Home Prices Must Fall To Sync

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 [1]

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.