Whether you're a homebuyer, seller or an owner, you probably have one central question about this market: Where are prices headed from here?
You can gain some insight into the pricing puzzle by focusing not just on home values, but on rental rates.
Housing economists have long used a home price/rent ratio as one way to gauge whether or not home prices are inflated or undervalued.
Moreover, on a very practical level, relating home prices to rents can give you a more detailed view of whether there's a financial payoff to homeowning, says Gary Smith, Pomona College professor and co-author of "Houseonomics."
A Housing P/E
The use of a price/rent ratio is analogous to employing a price/earnings ratio for stocks. When a stock price is high, and its earnings per share relatively low, the P/E is high. A high P/E often indicates that the stock is too expensive and the share price is headed for a drop.
What someone is willing to pay to rent a place is that home's "earnings." And, just as in the stock market, a high home price related to the rental earnings mean homes values will probably drop.
For a specific look at how a home's P/E is determined, let's consider a home that is listed for either rent or sale in suburban Chicago.
The home has been rented for the past three years for $1,600 per month. It is currently listed for sale at $400,000. Dividing the price by the total annual rent of $19,200 gives a "housing P/E" of 20.83. According to Moody's Economy.com, the long-run average housing P/E is 16, so a P/E of 20.83 suggests that this home may be somewhat overpriced.
Getting Back To Normal?
A look at the national home price/rent ratio over the past few years shows a heated run-up in prices, and a consequent deflating of the "bubble."
Housing economist Celia Chen of Moody's Economy.com tracks a nationwide index of median home prices to median rents. She reports that the ratio hit a peak of about 25 at the end of 2005. Since then, home prices have been sliding and the ratio has been dropping.
In the first quarter of this year, says Chen, the ratio is down to about 20, which is closer to its long-run average of 16.
Comparing median prices to rents is useful for tracking broad trends. But how rents compare to home prices varies considerably in different areas of the country.
Indeed, a recent analysis of the cost of owning a single family home relative to renting conducted by Chris Mayer, professor of real estate at Columbia Business School, shows variations amongst the major metro areas. In all the markets, owning is negatively impacted by today's tight credit conditions, which is exerting a downward pull on prices. Still, markets such as Cleveland, New York and San Diego show that owning relates relatively favorably to the cost of renting, while other markets like Phoenix and Miami show an advantage to renting.
While a P/E ratio is helpful for determining whether a home is a good buy, consumers should examine a home's "dividend" to see whether or not owning a home really pays off, Smith advises.
For the home in suburban Chicago described above, assuming a 20 percent down payment on the home, a 30-year fixed rate mortgage at 6 percent would have a monthly payment of approximately $1,920 (rounded up). Here's an example of how a consumer would plug in various numbers to calculate a home dividend. Utilities are not factored in, as renters often pay those separately.
The negative home "dividend" in this example suggests, just as the home's P/E ratio does, that it may be more advantageous to rent -- unless you plan to stay put for several years or more. "Even when the home dividend is negative, over time, homeowning pays off, since your housing costs are relatively fixed and rental rates will increase," notes Smith.
In his book, Smith looks at another example of a home's dividend -- a three-bedroom home purchased in the Indianapolis suburb of Fishers for $135,000 with a 20 percent down payment. The same home would rent for approximately $15,000 a year. It's key to make an "apples to apples" comparison, finding the price of renting a single family home that's very similar to the single family home being purchased
Smith tallies up all the costs of ownership (mortgage, taxes, insurance, maintenance) and then compares that to all the benefits of owning -- which include the $15,000 rent "savings" and the income tax savings from mortgage interest and property tax write-offs. For the Fishers, Ind. home, the annual dividend comes out to more than $5,000.
Unless you stay in the home for just a year or two, it's more profitable to buy than rent in places like Fishers. If you move again quickly, however, real estate commissions and moving expenses will eat up the dividend.
Like Fishers, lots of other areas offer generous home dividends. "Much of the heartland does, and other places, too, like the Dallas and Atlanta areas," Smith says.