Rents and Real Estate Prices

In the long run, home prices should move in tandem with rents. Or so the theory goes. As anyone who is reading this blog probably knows, Bay Area home prices grew much faster than rents for most of the last decade. That's the main reason why some people claimed that we were experiencing a bubble: Owning a home became so much more expensive than renting that nobody would buy a home unless he expected prices to continue rising rapidly.

Indeed, now that home prices are headed down (at least in most parts of the Bay Area), the buying panic has subsided and many buyers have moved to the sidelines. And as long as prices continue heading down, buyers have a strong incentive to remain on the sidelines. (The logic of bubbles works in reverse when prices are falling.) At some point, however, prices will stabilize and buyers will face a difficult question, namely, how do you determine the fair value of a home?

I won't address that question directly today. (I'll get back to it soon enough.) Instead, I'll take an indirect approach that requires some heroic assumptions, but has the virtue of being quick and dirty. Consider the chart below, which shows the Case-Shiller home price index for the San Francisco metro area, adjusted to remove the impact of inflation.

Even after the recent plunge in the housing market, inflation-adjusted (i.e., "real") home prices are still far higher than they were ten years ago. By itself, however, that observation doesn't say much about the "fairness" or "correctness" of current housing prices. The main reason is that rents are higher now than they were ten years ago. How much higher? I don't have a good historical rent series at my fingertips, but academic studies have found that real Bay Area rents have increased by around 1.5% per year over the last several decades. (There are good reasons to expect that result, but that's a story for another day.)

The chart includes an artificial "rent" index, set to equal the initial (1987) value of the Case-Shiller home price index. The rent index is artificial because it does not purport to track actual rents, but is instead constructed so that it grows by exactly 1.5% per year. Since real rents have grown at roughly the same rate, the artificial index should track historical rents fairly closely, although of course it won't reflect fluctuations around the historical trend.

Over the 21-year period from 1987 to now, Bay Area home prices have increased faster than rents, even after accounting for the recent downturn in the housing market. That’s indicated in the chart by the deviation of the home price index from the rent index. The home price index has increased by 68% (in inflation-adjusted terms) since 1987, while the rent index has increased by only 36%. If you assume that homes were fairly valued in 1987 -- a truly heroic assumption -- then the chart suggests that they are still overvalued by about 23%, even after the dramatic price declines that occurred in most parts of the Bay Area.