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The Rent Ratio's The Thing

Bruce Bartlett on the possible housing bubble:

Economists at the Federal Reserve Bank of San Francisco point out that one can get some idea of whether housing prices are out of line with fundamentals by comparing them to rents. This yields a ratio akin to the price/earnings ratio that investors use to gauge stock prices. On that basis, home prices are at historically high levels that appear unsustainable.
He goes on to cite a bunch of possibly contrary evidence, but I don't understand why the buy/rent ratio point isn't almost entirely dispositive here. Shifts in the fundamentals that increase home prices should increase rental prices proportionally, but buy prices have increased faster. If demand for home purchases is rising faster than demand for home rentals, it seems to me that that can only mean that people are buying houses as speculative commodities -- spending more than the house is really worth to them in the expectation that it's value will only increase in the future. That means a small dip -- or even a market that stays flat for a little while -- could send the whole thing into reverse. Right?

December 15, 2004 | Permalink

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» Housing Bubbles and Rent Ratios from Outside The Beltway
Bruce Barlett observes that the Fed's recent increases in the discount rate will increase the likelihood that the so-called "housing bubble" will burst. As the Federal Reserve moves to raise short-term interest rates once again, flags are raised ... [Read More]

Tracked on Dec 15, 2004 6:27:32 PM

» Interest Rates and the Rent/Buy ratio from Deep Thoughts by Dan Ryan
Matt Yglesias and Brad DeLong have been engaged today in an interesting colloquy about housing prices, interest rates, and the falling rent/buy ratio (here, here and here). As Professor DeLong notes, as interest rates fall, the same mortgage payment su... [Read More]

Tracked on Dec 16, 2004 2:16:24 AM

Comments

"but I don't understand why the buy/rent ratio point isn't almost entirely dispositive here"

Because people don't buy apartments, and mostly don't rent houses? You live in both, but other than that they're not strictly interchangable.

Posted by: Brett Bellmore | Dec 15, 2004 10:31:46 AM

Also, as the article vaguely suggests, it is misleading to speak of a housing market in the U.S.. There are thousands of housing markets. No doubt that are some markets in which rates of appreciation are not sustainable, but that really isn't unusual.

Posted by: Will Allen | Dec 15, 2004 10:45:48 AM

It seems to me that Matthew is assuming that the demand for buying, as it relates to the demand for renting, has not changed, other than for speculation. But it seems to me that there could be other reasons that demand to buy has increased with respect to renting - one of which, as mentioned in the article, is the greater availability of mortgages (due to the greater availability of no/low money down and ARMs).

Posted by: Al | Dec 15, 2004 10:47:48 AM

Sounds like wishful thinking on the part of someone who doesn't own a house. There is a value which people place on "owning" as opposed to renting and while it is not infinite, it is very very large and it accounts for the fact that the house you can rent for $1500/mo in Seattle will probably sell for $350,000...which from an investment standpoint makes no sense.

We have been hearing this story for decades -- and there is no question that the disparity is true. But the key question is in the article to which Yglesias links: "Therefore, the critical question is what will happen when interest rates inevitably rise from their current, historically low levels?"

One response is that that rising interest rates will put a downward pressure on housing prices but since many people have substantial control over when they sell, the supply of houses will go down, thus maintaining prices or at least avoiding some calamitous collapse.

Posted by: David Sucher | Dec 15, 2004 10:55:19 AM

"Therefore, the critical question is what will happen when interest rates inevitably rise from their current, historically low levels?"

Historical low levels for the last 30 years, but not historically low for the last 100 years. Which brings into question the inevitable rise.

"Economist Arnold Kling points out that much depends on whether market rates rise because of inflationary expectations or because real rates are rising because of an increased demand for credit."

Posted by: Chad | Dec 15, 2004 11:00:38 AM

There are three housing demand factor sets: demographic, service flow and asset demand. There haven't been demographic changes large enough to explain anything near the change in demand. Service flows are the consumption benefits of the housing unit, location and that sort of thing - nothing doing there. Asset demand however is dependent on interest rates, disposable income, house prices and the return available on alternative assets - lots going here...

Low interest rates, increasing disposable income and low returns on other investments all boost the demand for housing, and will push up the price until it offsets these increases. What else can people invest in? Not the stock market, thats for sure.

No one should buy a house solely on the expectation of price rises. Either you want to live in it (the service flow compensates you) or you can pay the mortgage from the rental income. If you buy when neither of those are true, you're an idiot.

Posted by: James | Dec 15, 2004 11:04:03 AM

What Will and Al said.
The key here is the strange availability of very cheap money to buy a house despite some other unsustainable trends in the current account deficit and the general fund deficit, and the Presidential ability deficit.
I would like to understand a lot more about the hedging of very large holders of 30 year fixed rate mortgages.
Let me also ask a question that I do not understand. If we are legitimately concerned about a nuclear China, why should we not be much more concerned about China deciding to wage an economic war against us? The latter seems, from the Chinese side, much preferrable to the Chinese, and it would appear to me that we would be quite vulnerable (as would the Chinese, but not nearly to the extent that they would in a nuclear situation).
Is the concept of economic warfare, rather than traditional warfare so foreign to the Chinese that it is not considered a threat?

Posted by: Robert M Schroeder | Dec 15, 2004 11:06:18 AM

The rent/price ratio is not really the critical number here, because so few people buy their houses outright. They mortgage them, so the relevant number is the rent/mortgage payment ratio. Low interest rates mean that the same mortgage payment will get you a more expensive house. Apparently if you look at the rent/mortgage payment ratio it's slightly above historical levels. If you further refine your comparison to compare prices for the same house (as opposed to the median house, in case the median house is becoming nicer), things are supposedly even less bubbly.

This is bad news for people with ARMs, and not great news for those who are going to want to sell their house soon, but it shouldn't provoke huge numbers of personal bankruptcies or anything.

Posted by: Jake McGuire | Dec 15, 2004 11:11:18 AM

MattY -- There are, of course, other factors to think about. Buying a house is like pre-paying rent from now to infinity. It could be that homebuyers know that rents are going to rise precipitiously in x number of years, and have factored that into their offers for homes.

And people also overpay for homes (compared to equivalent rental value) because they can customize the home more than they can customize a rental unit. There is also the abstract 'pride in owership' which somepeople will pay for.

But overall, MattY and the Federal Reserve are probably right. There is no reason to expect that 'pride in ownership' has increased dramatically int he past few years, or that people's interest in customizing their home has increased. It's the change in the rent/own ratio that needs to be explained in order to argue that there is no housing bubble.

(One could argue, like Al does, that low interest rates and more accessible mortgages have made monthly mortgage payments cheaper, and people are irrationally assuming rates will stay low forever and thus bidding up the value of homes. And that apartment builders are not irrationally taking advantage of temporarily low rates to buy rental properties. But that's an argument in favour of a bubble, not against it.)

Brett Bellmore -- In the city, we have this newfangled thing called a 'condominium'. You should come up from the farm sometime to take a look.

Posted by: Ikram | Dec 15, 2004 11:19:48 AM

I think that rental prices can offer some good insight into the fundamentals of the housing market, but that is somewhat dependent on us believing that the percentage of people who want to rent and buy are stable. In markets with a large influx of people, that is probably on non-awful assumption. But in the more stable markets you should realize that people who go from renting to buying are increasing the demand in the buying market and are decreasing demand in the rental market. So it is not completely inexplicable (even without invoking speculation) that a buying market might show an increasing price while a rental market might show a decreasing price.

Posted by: Sebastian Holsclaw | Dec 15, 2004 11:23:58 AM

It's interesting that in Matthew's world the decision to buy or rent is just one of arithmetic. Must be nice to have that kind of money, but maybe not so nice to live in such a state of social anomie.

In the real world, people rent because they can't afford to buy. "Can't afford"- those are key words in determining what you can pay.

Other people buy because they have other values that outweigh the arithmetic. I know, this sounds strange, maybe even incredible, but some people think about where their family lives, whether they like the community, or where they would like to retire.

"For truth is always stranger, stranger, in fact, than the strangest of fiction."

Posted by: serial catowner | Dec 15, 2004 11:24:28 AM

I don't think neccessarily China has any ill will involved but they may wreck us financially following their own interests.

They have half a trillion in U.S. bonds and the dollar is sinking. They are slowly selling those off and that pushes the dollar even lower. If it starts taking a real nose dive and they pull the plug and dump them all you can wipe your ass with $100 bills.

Posted by: absynthe | Dec 15, 2004 11:25:42 AM

Hmm that typo renders the sentence almost unreadable. Should be "...In markets with a large influx of people, that is probably a non-awful assumption.

Posted by: Sebastian Holsclaw | Dec 15, 2004 11:27:18 AM

It's interesting that in Matthew's world the decision to buy or rent is just one of arithmetic. Must be nice to have that kind of money, but maybe not so nice to live in such a state of social anomie.

This is totally irrelevant to the point of the original post and borders on trollish behavior.

Also, arithmetic is something that liberals ought to and do embrace. If you're looking for the anti-intellectual party, look elsewhere.

Posted by: JP | Dec 15, 2004 11:54:33 AM

> This is totally irrelevant to the point of
> the original post and borders on trollish
> behavior.

How about this: the utility function for the rent/buy decision is complex and contains factors that may not be fully reducable to monetary terms. A single, childless, 24 y.o. yuppie may not be the best choice to analyze this decision.

Cranky

Posted by: Cranky Observer | Dec 15, 2004 12:05:09 PM

Aren't rental prices and house prices determined by different, though related, factors? Rent by what you can pay now, houses by where you expect the local economy to be in the future. If the economy is currently mediocre but everyone expects it to improve, rents will be low relative to the price of buying a house.

Posted by: Maestro | Dec 15, 2004 12:25:03 PM

As a single, childless, 25 year old yuppie, I think it's ridiculous to berate Matthew for simply attempting to look at this rationally. Ever heard of first-order analyses, people? And I am someone who is almost always in favor of buying if possible.

It's an excellent point about the multiple markets. Having lived in two of the worst markets in the country (NYC & the Bay Area) and another pretty bad one (Boulder) I gotta point out that housing dynamics depend greatly on state and local laws. Here in Cali, Prop 13 might give you a small but constant incentive to buy sooner rather than later, and hold--even if that means charging slightly lower rent. The density and preoponderance of rent control renters in huge cities like New York might also be depressing the rental half of the ratio, nationally. How much of this has to do with the fact that it's easier to raise cash on a home equity loan than most other kinds, especially with the oft-mentioned cheap market in mortgages? How much of this has to do with increases in lot size?

In the extreme long term, you should be better of owning. Even with our standardized American-dream of home ownership, traditionally Americans don't look at property with this kind of old-world sense of "the family house." The assumption is that the house will be sold when the parents retire or die. Maybe that's changing as America's immigration profile changes?

These are interesting questions to be asking, and there's no reason Matt can't ask them.


Posted by: Saheli | Dec 15, 2004 12:30:42 PM

Because people don't buy apartments, and mostly don't rent houses?

I second Ikram's response to this one: Come on up from the farm sometime and I'll show you how we live here in Silicon Valley.

Home rental is a popular option for people who move into the area with families and aren't ready (finally and maybe psychologically) to put money down on a $650,000 starter home (typically 1500 sq. ft. on <1/8 acre and about 50 years old).

South Bay is a densely populated suburban area, so it won't surprise you to find that they're not building a lot of new single family homes. What might surprise you is that they're not building many new rental apartments either (because rentals don't pay off?). What they are mostly building is townhouses and condos. So around here, if you want to live in a nice new apartment (dual pane windows, A/C, and other amenities) and have less than a 45 minute commute, you better buy that apartment.

Posted by: Paul Callahan | Dec 15, 2004 12:38:22 PM

Three major economic advantages exist for buying vice renting:

-A huge deduction on federal income taxes subsidizes the former

-Hedge against inflation: One locks in one's monthly payment when buying whereas rent continues to escalate.

-Equity: Even if the price doesn't appreciate, part of the money one pays monthly accrues as value (admittedly, a small part in the early years of traditional mortgages). If the house price does appreciate, that added value is also gained upon resale. Even if one buys again in the same housing market, this nets a huge down payment on the next, more luxurious home.

Posted by: James Joyner | Dec 15, 2004 12:41:50 PM

There is a value which people place on "owning" as opposed to renting

Yes, but it seems that the value has been changing recently. That's the big question. What's going on?

I'll go with Jake McGuire's explanation.

The rent/price ratio is not really the critical number here, because so few people buy their houses outright. They mortgage them, so the relevant number is the rent/mortgage payment ratio. Low interest rates mean that the same mortgage payment will get you a more expensive house.

I don't want to go all chicken little on you about ARMs, but I do kind of worry sometimes that the "ownership society" is going to turn into the "foreclosure society" if interest rates suddenly shoot up.

Posted by: Paul Callahan | Dec 15, 2004 12:45:33 PM

Umm. Housing prices, with much development happening in the suburbs and exurbs, are directly dependent on cheap energy(Heating and air-conditioning) and especially on cheap oil(commuting costs).

They are indirectly dependent on cheap oil keeping interest rates down, and the dollar and US asset prices artificially high.

The bubble is not demand driven, but is in part a reflection of the overpriced dollar.

Posted by: bob mcmanus | Dec 15, 2004 12:49:01 PM

I agree completely. The Rent to Equity ratio of houses has rarely, if ever, been higher. Furthermore, the advent of ARM, interest-only, and no money down mortgages is significantly increasing speculation in the market. I have heard that as many as 15% of mortgages are risky and a spike in interest rates could result in significant sell off.

Furthermore, human bias's are fueling this binge. People tend to invest based upon the recent past, rather than the long term past. If you look at housing markets over the last 30 years, rather than the last 5-7 years, housing prices have rarely appreciated at a rate greater than inflation (California is CPI +2%, Oklahoma is CPI - 1.0%). However, in the hot markets (SF, NY, San Diego, etc.), the last 5-10 years have seen much higher returns. People tend to extrapolate from 5 rather than 30 years, and it gets them in trouble.

Second, as was brought up in MY's comments, real estate is really multiple markets, not one big market. Unfortunately, many people are taking the results in very land-restricted areas (SF, San Diego, Seattle, NYC) and applying those returns to places where land is cheap and development is easy (Henderson, NV, Phoenix, AZ, El Paso, TX, etc.) So a lot of folks are investing in real estate in places where the fundamentals are far worse than they're assuming.

I could go on and on. In summary, if you're looking to buy a place to live, real estate might be a good investment, but if you're looking at real estate as a speculative short term investment, or an investment who's income will cover the leverage you've placed yourself under, you're playing with fire.

Posted by: Kilroy Was Here | Dec 15, 2004 12:51:20 PM

See Angry Bear on this Matt. Basically guys at the New York Fed believes this is do to an increase in housing quality vs rental quality.

Posted by: Rob | Dec 15, 2004 12:58:46 PM

There haven't been demographic changes large enough to explain anything near the change in demand.

We are in the midst of a huge immigration boom. Mortgage lenders are developing loan products for recent immigrants with scant U.S. credit histories. A Baby Boomlet is entering the age of establishing careers, getting married, and having children. People in their 50s and up are contributing to an extraordinary surge of interest in second and vacation homes. Old people are living longer and healthier.

Posted by: Holden Lewis | Dec 15, 2004 1:00:40 PM

See Angry Bear on this Matt. Basically guys at the New York Fed believes this is do to an increase in housing quality vs rental quality.

That would explain the discrepancy between condos and rental apartments in South Bay. But people pay a premimum for mostly unimproved 50s era tract houses as well.

Posted by: Paul Callahan | Dec 15, 2004 1:02:04 PM

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