The Housing Chronicles Blog: Why potential rents may help provide a home pricing floor

Tuesday, January 15, 2008

Why potential rents may help provide a home pricing floor

Over the last few months, I've been asking why housing bears calling for pricing declines of 3o-40% don't consider the impact of potential rents for the same properties, but have yet to get a decent answer. For example, while it's certainly true that incomes in Southern California didn't keep pace with exponentially rising home prices, apartment rents also outpaced incomes, doubling over the last decade in many areas of Los Angeles County and, according to a report by Marcus & Millichap (registration required) rising by 25% since 2003.

What that means is that while home prices might be overpriced up to 30-40% relative to economic fundamentals such as median incomes and household demand, that doesn't mean they're going to tank on their own; it's simply more complicated than a third-grade math problem. From an article in the Christian Science Monitor:

In this decade's raging real estate market, property values became untethered from reality, economists say. Home prices rose much faster than people's incomes or the rent that houses could earn when leased.

Now, home prices are in the process of moving back toward a more normal relationship with those fundamentals, housing experts say.

Ok, we've all heard this before. This isn't news. But maybe this is:

But that doesn't mean that home prices will travel a predictable route...

Some paths might involve more of a rise in rents or personal incomes – and a smaller decrease in home prices – over the next several years, for example. In effect, that would allow home prices to stay fairly flat while other factors adjust...

"Prices don't necessarily have to plunge," says Mark Zandi, chief economist at Moody's in West Chester, Pa. "If rents and incomes increase by 5 percent per annum … we would be back to those historical norms" in about five years.

"More likely, prices fall 10 percent" or so, he says. That would restore balance to the housing market sooner.

Just as stock market investors look at the ratio of a company's share price to its earnings, home buyers can look at the price-to-rent ratio.

Prices have outrun rents by a greater margin in some cities than in others, Merrill Lynch found in its research. Phoenix, Washington, New York, Miami, and West Coast cities lead the pack of high fliers. Prices in many inland cities don't look far out of kilter. But every region of the country is affected.

Finally, some of the common thinking of the past has also changed, perhaps for good but it's too soon to tell:

The typical home cost about three times the average annual household income in 1990. Today, it costs more than four times household income, which is currently about $48,000 a year, according to the Census Bureau.

It's not clear that prices have to fall back to the 1990 income ratio.

Much of the recent home-price run-up reflects speculation that urban land is becoming more valuable, says Robert Shiller, a Yale University economist who studies investment bubbles. He calls that assumption "vulnerable" now.

"Land prices outside of the cities are still quite low," he said in a recent briefing for reporters. "Agricultural land is only about $2,000 an acre."

Cities have long commanded a premium due to everything from high-paying jobs to cultural amenities. That won't totally change. For American buyers and sellers, it's just a question of haggling to find a new price level.

That's also why I'd expect prices to decline far faster in outlying suburbs than in cities close to employment centers and offering more transit options.

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