Comparative rent is the primary method of evaluating the fundamental value of any property. The price-to-rent ratio links the cost of ownership with the cost of rental. This link is direct because possession of property can be obtained by either method. The cost of ownership encapsulates all of the financing terms and other variables associated with possession of real estate as does the cost of rental. Price-to-rent ratio fluctuates over time as changes in the cost of ownership and terms of financing makes financing amounts vary and house prices vary as well.
One of the major components of any projection using price-to-rent ratios is the projection of future rents. On a national level rents have been rising at a 3.6% rate from 1988 to 2007. This is 0.6% greater than the rate of inflation and 0.3% greater than the rate of wage growth. In Orange County, California, rents have been rising at the rate of 4.7% from 1983 to 2007. This is 1.7% greater than the rate of inflation and 1.3% greater than the rate of wage growth.
Any difference between the rate of rental growth and the rate of wage growth cannot be sustained forever; however, the differential on the national level is small, and it can be attributed to changing customer behavior as people demonstrate an increased willingness to spend more on housing related costs. The rate of rent growth over wage growth in Orange County is a bit more troubling. Orange County is second only to Honolulu, Hawaii as the most expensive place to rent in the United States and the continued growth of rents in excess of wages is not sustainable.
The unprecedented spike in the national price-to-rent ratio is clear evidence of a massive, national real estate bubble. As the ratio demonstrates, there was no increase in rents justifying market pricing. The only other explanation which would deny a market bubble would be a dramatic lowering of ownership costs through other means. Although lower interest rates did lower ownership costs somewhat, the resulting savings due to lower interest rates only explains about one-third to one-half of the increase in prices. The remainder is caused by the use of exotic financing and irrational exuberance.
Predictions based on the price-to-rent ratio are arguably the most robust because the ratio has been stable over long periods of time, and for good reason; the comparative cost of ownership to rental is a logical basis for valuation. If house prices return to their historic average of the 1988 to 2004 period of 181, then national prices will fall 27% peak-to-trough, bottom in 2011 and return to the peak in 2020.
The ratio of price-to-rent in Orange County, California, where the city of Irvine is located, has shown more variability than national figures. There was a coastal bubble taking off in the late 80s and collapsing in the early 1990s. The premise of prices reverting to fundamental valuations can be clearly seen in the changes in the price-to-rent ratio in Orange County. In the mid 1980s, the market was bottoming out from the first coastal residential real estate bubble associated with the inflationary times of the late 1970s. From 1983 to 1987, the price to rent ratio stabilized between 176 and 185, a range of about 6%. After the coastal bubble, prices stabilized in 1994 to 1996 in a range from 175 to 178.
Projections using the price-to-rent ratio assume prices will fall again to the range from 175 to 185 before stabilizing. The reason prices stabilize in this range is because it is here that the cost of ownership approximates the cost of rental, and Rent Savers buy real estate and form a support bottom. If house prices in Orange County return to their historic price-to-rent stability range, prices will fall 22% peak-to-trough, bottom in 2013, and return to the previous peak by 2019; however, if rental increases do not sustain their 4.7% historic rate, the bottom may be somewhat lower, and the return to the previous peak would be delayed.
Using the price-to-rent ratio is one of the most accurate predictors of the market bottom. The stability of the price-to-rent ratio is remarkable considering the variability in economic terms. The only times this ratio deviates from its tight range is when irrational exuberance takes over a market during a financial mania like the great housing bubble.
About the Author:
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at:
http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog:
http://www.irvinehousingblog.com/
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Date Published :
Jan 1 2009