In Depth Analysis: CalculatedRisk Newsletter on Real Estate (Ad Free) Read it here.

Wednesday, June 01, 2005

Price Rent Ratio Update

by Calculated Risk on 6/01/2005 05:03:00 PM

OFHEO released their Q1 2005 report showing a 12.5% annual housing price increase nationwide over the past year. Kash on Angry Bear breaks down the data by key metropolitan areas and provides a graph of inflation adjusted house prices: New House Price Data.

Another way to look at the data is to compare house prices vs. equivalent owner's rent for different areas of the Country. This measure of fundamental housing value, called the price-rent ratio, was suggested by the Federal Reserve's Krainer and Wei in "House Prices and Fundamental Value". The following graph shows the U.S. and Los Angeles price-rent ratios since 1982. The price component is from the OFHEO home price index and the rent series is from the BLS owner's equivalent rent index.

Click on graphs for larger image.

The LA housing bubble of the late '80s is very clear. After the bubble burst, it took several years for the Price-Rent Ratio to return to normal. For a graph of the LA bust see "After the Boom".

Krainer and Wei "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."

The owner's rent equivalent data series from the BLS starts in '97 for many areas. Using (1997 = 1) the following graph compares the Price-Rent ratio for Los Angeles, Washington D.C., Miami and Wichita / Peoria.

It should come as no surprise that LA, DC and Miami house prices are all significantly above the Owner's equivalent rent.

But is there a bubble in Peoria? The data suggests that housing in Peoria, Wichita, and Indianapolis are all about 15% overvalued. However I don't expect nominal price decreases in those areas. More likely is slow appreciation (below the inflation rate) for a few years until rents catch up with house prices.

The Price-Rent ratio suggests that housing is overvalued in most of the United States and significantly overvalued in the larger metropolitan areas.