Price-to-rent ratio suggests housing is 30% overvalued
High degree of market overvaluation suggests for the foreseeable future house prices will appreciate far less than the average of the last 40 years.
My favorite measure of value for individual properties and the entire market is the ratio of rent to home ownership cost. I prefer this method because it incorporates the effect of mortgage rates and more closely emulates the conditions people face when they decide whether to rent or own.
Another method economists examine is the ratio of price to rent. It’s a blunt instrument because it doesn’t capture the impact of mortgage rates, but demonstrates the imbalances and distortions caused by record-low mortgage rates.
Home shoppers today are right to be concerned about another housing bubble. The tools on this site are designed to help spot this bubble if it forms and direct people to the properties with the best cost-to-rent ratio available in the market.
Relative to rent, house prices are similar to the stable period from 1993 to 1999. And the new mortgage regulations will prevent future housing bubbles because the “Ability to Repay” rules will prevent reckless lending. That being said, it’s always wise to be cautious. If we do start inflating another housing bubble, it will show up in the data, and I will sound the alarm.
by Bill McBride on 3/31/2015 11:19:00 AM
In October 2004, Fed economist John Krainer and researcher Chishen Wei wrote a Fed letter on price to rent ratios: House Prices and Fundamental Value. Kainer and Wei presented a price-to-rent ratio using the OFHEO house price index and the Owners’ Equivalent Rent (OER) from the BLS.
Here is a similar graph using the Case-Shiller National, Composite 20 and CoreLogic House Price Indexes.
This graph shows the price to rent ratio (January 1998 = 1.0).
Back in 2013 I wrote the Housing market impact of 25 years of falling mortgage interest rates. In that post I noted, “House prices have been boosted about 30% due purely to the decline of interest rates from the mid 90s to today.” The chart above is confirmation of my calculations.
As I demonstrated above, twenty-five years of falling interest rates have inflated house prices well above where they would be if interest rates hadn’t declined. By that metric, houses appear to be overvalued by 30%. However, that’s not the world we live in. Interest rates are low, and despite the recent spike, they are still well below the 7.63% of the mid 1990s, and in all likelihood they will stay low for quite a while. People who buy today may not experience much appreciation, particularly if mortgage interest rates go on a steady rise, but they are still locking in a cost of ownership below historic norms, and that has value.
So is it a good time to buy? If the buyer understands the real value they are obtaining is a roof over their head at a relatively low fixed cost, then yes, it is a good time. If a buyer believes they will see ongoing double-digit appreciation and make a fortune, rising interest rates are liable to disappoint them.
Looking forward, I expect the YoY increases for the indexes to move more sideways (as opposed to down). Two points: 1) I don’t expect (as some) for the indexes to turn negative YoY (in 2015) , and 2) I think most of the slowdown on a YoY basis is now behind us. This slowdown in price increases was expected by several key analysts, and I think it was good news for housing and the economy.
So Bill and I agree on that point, but unfortunately, both of us aren’t in good company.
The paper referenced above is one of the classic blunders of the housing bubble. The analysts looked right at the data showing a clear evidence of a massive distortion in the housing market, and rather than raise alarms about the impending collapse of housing, they reached the following conclusion:
The price-rent ratio for the U.S. and many regional markets is now much higher than its historical average value. We used a model from the finance literature to describe how the price-rent ratio can move over time. We found that most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation.
Their conclusions were obviously totally wrong as prices crashed shortly thereafter, but they sound eerily similar to what Bill and I conclude now. It gives me reason to pause and ask what’s different today, and this is where Bill and I differ.
Based on Bill’s other posts, it seems he believes we will grow our way to prosperity and fundamentals will catch up to pricing. I believe that will happen to a point, but other factors will come into play to prevent a catastrophe like the housing collapse of 2008.
Lenders learned is that no matter how foolishly irresponsible their lending gets, they will get bailed out by government cash and federal reserve interest-rate policy, and they can avoid mortgage default losses by loan modification can-kicking until prices rebound. As long as they don’t foreclose and resell for a loss, they can amend-extend-pretend their way out of any lending disaster.
If rising mortgage rates causes instability in the market, lenders will use their “new and improved” loss mitigation procedures, and sales volumes fall to lows never before measured, even lower than the worst sales years of the most recent housing bust. Prices probably won’t go down much, but the entire housing market will seize up as buyers can’t afford prices sellers must obtain. So while Bill and I agree on the pricing outcome, I think we do so for different reasons.