By Arnold Kling
Brad DeLong says that in the housing market, one person’s capital gain is another person’s capital loss.
Yes, many people who have refinanced have now boosted their own consumption spending because they feel (and are) richer. But why haven’t those who will buy your house in thirty years and their parents cut back on spending by an equal amount as they strive to accumulate the bigger nest egg that they will need?
What Brad is saying is that there are people who are “short” in the housing market. Children and others who will own a house one day are in this short position now. As home prices go up, they lose, but they do not reduce consumption to compensate.
This weekend, I became curious enough about high home prices in our area to check them against a rule of thumb. My rule of thumb is that the ratio of a home’s price to one month’s rent should be roughly 300. The rule of 300 is based on a price-earnings ratio of 25, where earnings are the annual rents on a home. Multiplying annual rent by 12 months gets you to 25×12 = 300.
Anyway, I used the ads in the Washington Post to find a home for sale and a home for rent in our area that are roughly comparable. The rental was for $1750 per month, and the asking price on the home for sale was $549,000. That is within the ballpark of the rule of 300. My conclusion is that home prices are not a bubble in our area. If the ratio of home price to monthly rent were close to 400, that would have me very concerned.
One little-remarked fact about the 1982-2000 stock market climb is that housing values did relatively poorly over that period, so that in many locations the ratio of prices to rents fell below the rule of the 300. While the run-up in house prices since 2000 is significant, it has done little more than catch up for the previous poor performance.
As of now, I think that there is little or no margin of safety in buying a house, at least in the Washington, DC area. My guess is that if you buy now, you might see paper gains for another couple of years if prices overshoot their fair value, but over the long haul your house will not outperform other assets in terms of risk-adjusted return.
For Discussion. Try testing the rule of 300 in your area. Remember that you need to find a home for rent that is comparable to the home for sale against which you are benchmarking. Use the comments section to report your results.