One rarely mentioned measure of the extent of the housing boom, and the shift from boom to bust, is the sharp change in the level of home prices in relation to their rental value.

 

The rental value of a house is the income you could expect to get from renting it out. In the case of a home you own and live in, the rental value tells you roughly what you would have to pay to rent your home; in this sense, it tells you the “shelter” value of your home.

 

The ratio of home prices to rental value is akin to a price/earnings ratio for stocks. As with P/E stock ratios, there is no “right” or “wrong” price/rental ratio for housing. There is, however, a long record of historical ratios, which can give us a sense for whether current valuations are unusually high or low. The record also suggests that with respect to both stock prices and home prices, extraordinarily high ratios are often unsustainable.

 

The chart below shows the ratio of the average home price to an index of the “rental value of owner-occupied housing” (an estimate of how much home owners could get if they rented out their own homes). Two versions are plotted: one is based on the average sales price of new homes, the other on the price of previously-occupied homes.

 

Both ratios soared to record highs in recent years. From 1997 to 2002, the ratios were “catching up” to the previous record highs reached in housing boom of the late 1980s. But after that, they rose faster and farther into uncharted territory. From early 2004 to late 2005 (when the ratio peaked), the price of a previously-occupied house increased more than five times faster than its rental value—an indication that people were buying homes more for their investment value than for shelter or for the rental income they might provide.

 

Now, the trends have reversed. The average sales price of a previously-occupied home peaked at $307,000 in mid-2006, and has decreased to $280,000 (as of December). The price of a new home peaked at $369,000 last August and has since fallen to $348,000. Meanwhile, rental values have been increasing at a faster pace than they did during the housing boom. Consequently, the ratio of home prices to rental values has turned downward, for both new and existing homes, and it will fall further if the housing market continues to weaken. Again, there is no “right” ratio. But these ratios remain at the high end of their historical range—in other words, even after the recent decreases, house prices are still high relative to rental value.

For a more detailed analysis of trends like this one in home pricing, become an Annual Sustaining Member.