Fortune looks to rent as a guide to housing markets
In this article on the CNN site, Fortune magazines attempts to predict the future health of major housing markets using the price/rent disparity as a guideline:
Many factors determine the value of a house. A family would consider the quality of local schools, the number of bedrooms, the size of the yard. Economists assessing a region look at interest rates, employment, and population growth. But over time the most reliable guide to home values is rents.
In most markets people won't lay out much more in monthly costs to own a house or condo than they would to rent a similar property unless they expect a huge profit when they sell. Indeed, speculators chasing quick profits did a lot to inflate the recent bubble.
But once the fervor fades, prices must fall to restore their normal, long-term relationship with rents. Rents exercise a kind of inevitable gravitational pull on prices. The ratio of prices to rents "behaves much like price/earnings ratios for stocks," says Yale economist Robert Shiller. "Like P/Es, price-to-rent ratios are mean-reverting." In other words, while prices soar from time to time, sending the ratio to exceptional heights, sooner or later the relationship is bound to return to its historical average.
The short of it is that they look at the historical price/rent ratio, look at current price/rent ratios, then determine how much housing prices must drop to correct to those historical ratios. On average, the projected decrease in housing prices is 28%. Adjusted for the expectation that rents will rise 12% in their target markets in the next five years, the final projected drop is about 16%.
But that's on average. As Bay Area residents, we know we're not in an average area. "Inland" California areas such as Sacramento and eastern Contra Costa county may see falls between 25 and 30% or so in home value. In contrast, they're projecting drops of 14% in New York, 10% in SF, 5% in Boston, and 4% in Chicago. The projected drop for San Jose is about 15%.
The biggest projected corrections, percent-wise, would have to occur in Miami, Los Angeles, Baltimore, "greater" Washington D.C., Seattle, eastern Contra Costa, and Orlando.
Will these corrections occur? Certainly, the housing market in the Bay Area has grown relatively static, and list prices have dropped. Given the similar slowdown in loans, it seems reasonable that housing prices will correct. On the other hand, owners in the Bay Area proper have a lot of motivation to just wait out a downturn period.
Quite a bit to think about.