House Price to Rent Ratios Just Too Peaky

While this Stalwart scours the Asian property markets for potential investment, he cannot be excited about the valuations he finds. As a real estate simpleton, usually we just think about the rental yield, simply a years rent as a percentage of the total property's cost. We feel that if the yield can't beat your mortgage rate, then you're pretty close to "renting" even if you buy the property.

In our search for what rental yields have been historically, and what they are globally, we came across this excellent Economist article from yes, June 2005, which sums up the question of historical property valuation very nicely, and compares the housing cycles from different countries. Housing bulls,  while they've continued to be making money for the last 3-4 years while the Economist has been bearish, should at least take a look, and accept the fact that in many other countries, price declines have happened and even been protracted, even for "great locations".

The most compelling evidence that home prices are over-valued in many countries is the diverging relationship between house prices and rents. The ratio of prices to rents is a sort of price/earnings ratio for the housing market. Just as the price of a share should equal the discounted present value of future dividends, so the price of a house should reflect the future benefits of ownership, either as rental income for an investor or the rent saved by an owner-occupier.

Calculations by The Economist show that house prices have hit record levels in relation to rents in America, Britain, Australia, New Zealand, France, Spain, the Netherlands, Ireland and Belgium. This suggests that homes are even more over-valued than at previous peaks, from which prices typically fell in real terms. House prices are also at record levels in relation to incomes in these nine countries. ...

To bring the ratio of prices to rents back to some sort of fair value, either rents must rise sharply or prices must fall. After many previous house-price booms most of the adjustment came through inflation pushing up rents and incomes, while home prices stayed broadly flat. But today, with inflation much lower, a similar process would take years. For example, if rents rise by an annual 2.5%, house prices would need to remain flat for 12 years to bring America's ratio of house prices to rents back to its long-term norm. Elsewhere it would take even longer. It seems more likely, then, that prices will fall. ...

But even if prices in America do dip, insist the optimists, they will quickly resume their rising trend, because real house prices always rise strongly in the long term. Robert Shiller, a Yale economist, who has just updated his book “Irrational Exuberance” (first published on the eve of the stockmarket collapse in 2000), disagrees. He estimates that house prices in America rose by an annual average of only 0.4% in real terms between 1890 and 2004.

Anyhow, for this Stalwart, we believe that we'll be holding off for now. As long as rent is cheap relative to the cost of a property, it probably makes sense to invest our money elsewhere, and keep paying the rent. Freedom to get up and move without hassle also has value. Perhaps we'll be buyers when the Price to Rent Ratio is around 100-120, judging from the Economist chart above. If rental rates rise to make this a reality, fine, then its time to buy, at least we know its a good yield a that point, but on the other hand if housing prices fall to bring this to fruition then we will be feeling mighty vindicated.

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