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.