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Price-To-Rent Ratios as a Measure of Residential Real Estate Value

Published by Lawrence Roberts | December 26th 2008 | Views:

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Price-to-rent ratios represent the cost of a dwelling unit relative to the cost of a comparable dwelling unit. This ratio is also subject to the same variability exhibited by the price-to-income ratio. This is not surprising considering rent is generally paid out of current income, so incomes and rents tend to track one another fairly closely.

The ratio of rent to income has stayed within a range from 13.6% to 16.5% from 1988 to 2006. This demonstrates renters have been putting roughly the same percentage of their incomes toward housing for the 18 years period of data examined. The evidence from the sudden and dramatic changes in the price-to-income ratio and the price-to-rent ratio points to a housing bubble. If these two measures of value had been supported by a rise in the rent-to-income ratio, the increase in prices might have been explainable by a shortage in dwelling units causing all consumers of housing to see an increase in the percentage of their income going toward housing. Evidence from the rent-to-income ratio is to the contrary.

Buyers were never forced to buy; it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. The exotic financing was not a result of high prices; it was the cause of high prices. Lenders were keen to offer these products because they were not taking the risk, and it allowed them to keep transaction volumes high which is how they were making money.

By late 2007, the market balance had shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers: their dreams of riches from perpetual appreciation were in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homeowners with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.

The Great Housing Bubble saw an unprecedented rise in the price-to-rent ratio. This was strong evidence of the housing bubble. When the bubble began to deflate this ratio dropped down to near its historic norm.
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