Bay Area Home Prices Are Within 15% of Long-Run Equilibrium

My favorite way to assess 'fair value' for home prices is to compare them to rents. On that basis, Bay Area home prices appear to be about 15% higher than they 'should be'. Take a look at the chart, below, which shows Bay Area home prices, rents, and median household incomes for the period since 1975.

Note: You can find descriptions of the data series here.

After briefly reaching a level consistent with long-run equilibrium, Bay Area home prices began climbing again in the spring of 2009. Prices have increased by about 18% since then, and are now somewhere between 10% and 15% above equilibrium.

In my last post, I said that prices probably won't fall appreciably as long as the unemployment rate holds steady. How is that consistent with prices being 15% above equilibrium?

There are two ways for the relationship between prices and rents to adjust: prices can fall or rents can rise. Historically, rent increases have been the dominant adjustment mechanism. For instance, between 1990 and 1996, the price-to-rent ratio fell by 21 percentage points but price declines were responsible for only 8 percentage points of that adjustment; rent increases accounted for the rest. I expect a similar pattern of adjustments this time around.