Price/Rent Ratio

People typically won’t spend more in monthly costs to own a home than they would rent. While prices soar from time to time, sending the ratio to exceptional heights, the relationship eventually should return to its historical average.

Take a deep breath.  We can’t tell you what your house would fetch tomorrow.  But we can help you through the fog of whipsawing prices and vacillating views to develop a clear picture of what your house will most likely be worth in five years or so.  Over long periods housing, like stocks and bonds, follow a set of economic fundamentals.  No matter how far prices get unhinged in a speculative craze – and we’ve just witnessed a blowout – those basic forces eventually regain their grip.

In most markets people won’t lay out much more in monthly costs to own a house or a 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 the price/earnings ratio for stocks.  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 level.

It’s a gamble to purposely rent on the theory that home prices will eventually come down.  If they don’t, the inability of a resident to benefit from equity increases could hurt their ability to get back into the market. 

Take an example.  Let’s say the historical average for price/rent ratio in San Diego is 20.  You listed your home for $ 1,000,000.  Let’s also assume the market rent for this house is $3,000 per months or $36,000 a year.  By dividing $36,000 into $1,000,000 you arrive at a price/rent ration of 27.77.  In the next several months, you lower your asking price to $895,000.  Now the price/rent ratio is 24.86 using the same rent.  Another way for you home to get closer to the historical price/rent ratio of 20 is for the rents to rise and not the asking price to drop.  So how much farther does your home’s value have to drop to get more in line with the historical price/rent ratio?  If the rents stayed the same, then the value would drop to $720,027.  But the rents most likely will not stay the same.  Another way to look at is, what will be the value of your home in 5 years if the rent increase 3% a year for a total of 15%.  At the current asking price of $895,000, a price to rent/ratio of 24.86, a historical price/rent of 20 and rent increases of 15%, your home’s value in 5 years will be approximately $854,367.  Will a buyer be willing to pay $854,367 for your home if the home is going to be worth the same in 5 years-probably not.

All of this is not an exact science.  But it does give sellers a better since when pricing their homes in today’s market. The price/rent ratio is just one of the ways a person can make a judgement of what direction home values will go.

In the example above a price/rent ratio was ued for all of San Diego and that includes all single family and condos. A better and more accurate way to measure is to use stats from just a single neighborhood. Single family and condos should be looked at separately.