Home Prices and Rents
By Arnold Kling
From 2000 to 2007 the nationwide P/R jumped from 15 to 24, an increase of 60%. The figure went from 12 to 21 in Tampa, 11 to 26 in Washington, D.C., and 28 to 51 in California’s East Bay, an area that includes Oakland and the area east of the city.
The historical norm for the price-to-rent ratio is 15. But I have argued that it ought to be 25. My thinking is that if the real, after-tax, after-depreciation interest rate is 4 percent, then the P/R ratio is the inverse of that, or 25.
If you agree that the P/R is headed back to 15, then the article is correct to forecast major adjustments, with rents rising and prices falling. If you think that P/R can stay above 20, then the adjustment will be relatively minor.
Thanks to reader Prashant Kothari for the pointer.
UPDATE: lots of comments suggest that people aren’t following my rent-buy calculations.The basic formula is that you buy whenever
rental rate + appreciation – interest cost
is greater than zero. Otherwise, you rent.
What about taxes and maintenance? You can adjust “appreciation” for property taxes and maintenance, or you can put them in separately:
rental rate + appreciation – tax rate – maintenance – interest cost
The rental rate that sets everything to zero is the rental rate that makes “rent vs. buy” neutral. For example, if the mortgage rate is 6 percent, rents and prices on as-good-as-new residences go up 4 percent per year, but maintenance and taxes are 1 percent each, you have
0 = rental rate + 4 – 1 – 1 – 6
so that the rental rate is 4 percent.
If you think prices are only going up 2 percent as a long-term average, then the rental rate is 6 percent. But that means you are assuming that even if you maintain your house in as-new condition, it will only appreciate at 2 percent per year.