Tuesday, November 25, 2008

Price-to-Rent Ratio

by Bill McBride on 11/25/2008 10:37:00 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 through Q3 2008 using the Case-Shiller National Home Price Index:

Price-to-Rent Ratio Click on image for larger graph in new window.

This graph shows the price to rent ratio (Q1 1997 = 1.0) for the Case-Shiller ational Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used.

Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is probably 60% to 70% complete as of Q3 2008 on a national basis. This ratio will probably continue to decline with some combination of falling prices, and perhaps, rising rents. The ratio may overshoot too.

Price-to-Rent Ratio Cities The second graph shows the price-to-rent ratio for three cities: Los Angeles, Miami, and New York. On this monthly graph, January 1997 = 1.0. The OER from the BLS for each individual city is used.

Some combination of falling prices, and perhaps rising rents, will probably push the ratio back towards 1.0. By this measure of housing fundamentals, it appears that Miami has corrected about 80% or more of the way to the eventual bottom, Los Angeles about 65%, and New York just over 40%.

Price-to-rent ratios are useful, but somewhat flawed. They give a general idea about house prices, but there are other important factors (like inventory levels, price to income and credit issues). We are getting closer on prices, but it appears we still have a ways to go.

One thing is pretty certain - as long as inventory levels are elevated, prices will continue to decline. And right now inventory levels of existing homes (especially distressed properties) are near all time highs.