Deflating the Home Price Bubble: Where Might We Be?

A fairly simple way to assess the value of the housing market is to look at the price-to-rent ratio. This metric equates the median home price to what an equivalent property would yield in rent (known as owners’ equivalent rent). As is evident from calculations based on national and regional median prices and rents, this metric appears returned to levels last seen in the early 2000s, which means that in some markets buying is again looking like a reasonable option. A corollary to this, rental properties in select markets may have become attractive investment opportunities for some individuals with the capacity and means to invest and borrow inexpensively.

The run-up to the 2005/2006 peak certainly showed signs of a bubble in the making, as property values significantly outpaced rental prices during that period. In many markets prices were well higher than 20 times annual rent, a benchmark that many seem to see as an indication of overpricing.

Example: a home selling for $800,000 should have been renting for ~$3,500/month. This would have been a ratio of:

                           $800,000/$42,000 = 19

($3,500 x 12 months/year = $42,000 in annual rent)

We should also consider that the current wisdom finds 20 to 1 as the tipping point for the Buy vs. Rent decision.  While select factors can push this ratio they cannot do so for long, at least not forever. These may include:

·         Property tax rates

·         Interest rates

The higher they go (and this we must imagine is inevitable at some point) the more expensive will be buying and, as rents tend to lag, renting will enjoy a margin of advantage until either home prices come down, or rents catch up.

So, what can we expect for the long term return in housing stock investments?

When considering a home as an investment please consider: home prices, on average, track to inflation, as do rents. They do not grow any faster in the broad market.

“Wrong!” you say?

How can they grow faster I reply, when all we have at our disposal with which to buy these homes is our wages, which have, on average, struggled mightily to keep up with inflation.

This is to suggest that a portfolio of fully owned (not leveraged) average residential real estate will on average not grow wealth (increased purchasing power) over an extended period. History is littered with one off examples where this has not been the case. This is particularly true in many in the “hot” markets of California and others. And yet - maybe not.

As I said above, changes in Interest Rates are a lever that can throw off the equilibrium – but only for a while. A forty year period in which interest rates drop from ~14% to ~4% for home mortgages allows for a 150% market price increase for the same mortgage payment. This attributes 3% of the annual average real estate price growth. Add this to the ~4.3% average inflation from 1070 to today and we should have gotten a compounded ~7.3% price increase just to stay even with inflation

So…

That home one bought in 1981 for $25,000 with no upgrades made (only basic maintenance – find me that house!?!) could have appreciated to ~$530,000 today and yet only kept up with inflation and the interest rate decline “bonus”.

Well then… How were people making money investing in homes?

Appreciation of a leveraged asset.

Ok then… How might it work well going forward?

Charging more for rent than you pay in financing, lost opportunity cost, and tax, which may be do-able as the cost of financing is temporarily so low.

This is not a new normal – except for so many who do not study or remember history – this is the old normal all over again.
Keep in mind also what an increase in mortgage rates from 4% to 7% (near to the long term national average rate) may mean for the price of such a home? All else held static, it would require a ~30% price correction to sustain the current monthly payment. This would drop the $530,000 house to ~$370,000.

So how might we approach purchasing a home or a rental now?

1.      Consider the article “Why U.S. Housing Prices Won’t Recover” by Jack Hough on Marketwatch, and

2.      Consider the below interesting (dare I say, useful) linked interactive graph as relates to your specific case analysis. Click on the below image to jump to the New York Times web site tool: