Should you rent or buy your house? I’ve always answered this question using an arbitrage relationship that should obtain between a house’s rental rate and the real rate of interest. The rental rate is the ratio of the annual cost of renting a comparable house to the price of the house.

profitability = rental rate + appreciation rate – interest cost

For example, if a house rents for \$12,000 a year (\$1000 a month) and sells for \$240,000, then the rental rate is .05. If it appreciates at a rate of .01 (one percent per year) and the interest rate is .06 (6 percent), then profitability is zero.

When profitability is positive, the economic cost of buying is less than the economic cost of renting. When profitability is negative, renting is less expensive. The rental rate is the ratio of rent to price, which is the inverse of a house’s “P/E” ratio.

Here are three pieces that discuss the price of housing from the standpoint of the P/E ratio:
A story from CNN/Money
A piece from the San Fransisco Fed economics letter
an article by econometrician Edward Leamer

In his paper from a year ago, Leamer said that the P/E ratio is higher than its historical average, although not by much: house prices were 11 percent above the value indicated by the historical norm. However, in my view, the real interest rate may well be below its historical norm by an amount that is at least as large. In that case, the arbitrage decision still favors buying over renting. It seems that Leamer reached a similar conclusion, by a slightly more roundabout means. writing

Nationally, there is thus no bursting housing bubble in the immediate future. But this index could turn around rapidly if Mr. Greenspan decides to increase short-term interest rates. A flattening of the yield curve, rising mortgage rates, and weaker appreciation could all add up to a significant drop in housing.

For Discussion. Are housing prices out of line with rents, and if so, is the discrepancy sufficient to be labeled a bubble?