In the summer of 2005, Bill Valentine, a chartered financial analyst and investment manager in Bend, Ore., took a very rational look at what, to him, seemed like a very irrational housing boom.
Annual price appreciation in his hometown was well in the double digits, new housing developments were springing up everywhere, and every coffee shop and lunch place in town was buzzing with talk of housing gains and new deals.
Yet, when Valentine drove through the hot neighborhoods and looked through the classifieds he saw an alarming trend: Houses were sitting vacant and rental prices hadn’t budged in years. “The spread between the costs of owning a house and renting the equivalent was so large, I had to ask myself at what point does owning no longer make sense?”
Valentine did the math on his own house, which had nearly tripled in value since 2000, and went to his wife, Jessica, with this proposition: Why not sell the house, cash in on about $400,000 in unrealized gains and lease it back, possibly for less than the cost of owning it?
“Her first response was, ‘Hell no,’” Valentine says. But after a year of continued market growth, she relented; in June 2006 the couple put a “For Sale” sign in their front yard.
The rental market as a crystal ball
Valentine’s idea was risky — and, admittedly, not very practical — but it brings to light the relationship between the rental market and the housing market. “I’m a statistics guy, so for me it makes sense to look at the cost of renting versus the real cost of owning,” says Valentine. “For most people, though, owning a house is the ‘American Dream,’ which takes renting out of the equation.”
Even if you never want to rent the roof over your head, it pays to keep tabs on your local rental market. Its health, or lack thereof, can offer insight into the fate of the housing market.
“Over time, rental prices and housing prices tend to move together,” says Gleb Nechayev, a senior economist with Torto Wheaton Research in Boston. “When the two show very different trends, that’s when you start seeing some indications of a correction in one direction or the other.” Theory goes, if the economic and demographic trends are driving home prices higher, those factors should also boost rents.
As Valentine noticed, when the cost of renting is disproportionately lower than the cost of owning, it suggests that the market is being propped up on speculation rather than fundamentals — and that kind of growth isn’t sustainable. On the other hand, if the cost of owning is disproportionately lower than the cost of renting, it’s an indication that the housing market is ripe for a recovery.
Economists refer to the relationship between renting and owning as a market’s price-to-earnings ratio, or P/E. The measure is widely used by stock analysts to gauge the relative value of a stock by taking its price, dividing it by a company’s earnings, and comparing it with the stock’s historical P/E or that of its peers. In the case of housing, a P/E is the median home price divided by the median annual rent. While the measure isn’t perfect, it is one way to see if a market is overvalued or undervalued relative to historical norms.
In relatively affordable markets, such as Atlanta or Houston, the median P/E for the past 25 years has hovered around 9. In markets where home prices have historically been high — Honolulu, New York, San Francisco — the housing P/E is typically twice as much. Homeowners have always paid a premium to own property in these markets and probably always will because rents (or “earnings”) grow at a much faster rate, says Mike Sklarz, senior economist for Cyberhomes.
It’s when the P/E deviates from its historical norm that economists start questioning whether the housing market is out of whack. And indeed, looking back, the P/E has corresponded with housing bubbles and busts.
In Los Angeles, the median P/E over the last 25 years is about 13. Yet, it peaked at more than 23 in 2006, when home prices were at their highest. Preliminary data for 2008 suggests that prices are getting closer to where they should be, but still have room to fall; the P/E is now about 17.
Just don’t bet the house on it
The P/E is useful, but it’s not perfect. For one thing, it doesn’t take into account interest rates, which can drastically affect housing affordability, notes Sklarz. Homebuyers, after all, care more about their monthly payments than they do actual home prices.
Similarly, changes in the local economy or shifts in demographics can change the dynamics of renting, owning or both — just as a company’s P/E can swing with a product breakthrough or a leadership collapse. Miami home prices, for example, are overpriced relative to where they’ve been in the past, but it’s possible that the historical P/E doesn’t account for changes in the market, such as a growing international population or a flood of retirees.
And of course the decision to buy a home ultimately comes down to more than economics. Assuming you plan to stay in the house and lock in a 30-year mortgage, you’re protecting yourself from inflation risk. Over time, home prices and rents go up, but you can rest easy knowing your mortgage payment won’t change — not to mention that you can paint your living room any color you want.
“A house, unlike any other asset, has utility,” says Valentine. “In that respect it’s very different from a stock or a bond.” Indeed, the Valentines probably would have made a nice profit had they sold when the market was high, rented for a couple of years and bought again when it was down. But, they weren’t terribly disappointed when in December 2006 they took their house off the market and went back to living the American Dream.
Crunch your own numbers
You don’t need a degree in economics to consider the relationship between rental prices and housing prices in your own market. Here’s how to gauge the economics of renting versus owning:
Step one: Estimate the expense of owning — how much you will pay in interest and property taxes each month. (Don’t factor your down payment or principal into the equation because, theoretically, that money is yours.) Assuming you put 20 percent down on a $300,000 house, take out a 30-year loan fixed at 6 percent and pay 1.25 percent of the market value in property taxes, that “expense,” which is comparable to rent, is about $1,500 a month.
Step two: If you itemize your tax deductions, subtract your tax bracket from 100 to estimate your after-tax expense of ownership. For the above example, someone in the 25 percent federal tax bracket would effectively be spending $1,125 a month on interest and principal after accounting for deductions. (For some homeowners, it still makes sense to take the standard deduction. In that case, owning won’t save you any more in taxes than renting.)
Step three: Compare your number with the cost of renting similar property. If the cost of owning is indeed lower than renting, it makes sense to buy. If, however, the cost of owning is substantially higher than the cost of renting, to break even you must sell the house for more than you paid.