As a plugged-in reader notes, Fortune Magazine looks at historic Price to Rent ratios (pages 76-88) across 54 major metropolitan areas in an attempt to forecast where home prices are headed.
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 “behave much like price/earning rations 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 ration to exceptional heights, sooner or later the relationship is bound to return to its historical average.
Of course, rather than prices falling rents can rise. And while Fortune forecasts a 28.3% correction in the Price to Rent ratio over the next five years for the San Francisco MSA, they’re forecasting it’s derived from a 10% drop in prices along with an 18% increase in rents. Over in the East Bay, however, the Fortune forecast is a bit more grim as they’re calling for a 38.1% correction driven mainly by price declines of >30%.
And of course, the concept of a housing P/E (and rising rents) shouldn’t catch any plugged-in readers by surprise.