Millions of Americans have been devastated by the bursting of the US housing bubble. Most of them are people who bought close to the peak of the market then lost their down payments and more when prices collapsed. Home values in the US are back to 2002 levels and people who bought near the top have lost over 30%.
The moral of the story is clear – when housing is significantly overvalued it’s better to rent than to buy.
But what about people who did the prudent thing and rented during the bubble? Did they also pay a price? And what about Canadians renting today waiting for the Canadian housing bubble to burst?
To answer that question, let’s look at an example of someone living in today’s bubbliest North American market – Vancouver. According to the latest Rental Market Report from CMHC, the average rent for a Vancouver condominium is $1,474. The average price of a Vancouver condo is $445,458.
Traditionally, real estate values are proportional to rents. The rule of thumb is that homes should cost about 15 times their annual rent. For example, a condo that rents for $1,000 per month ($12,000 per year) should sell for about $180,000. For the average condo in Vancouver, the current ratio of price to annual rent is 25.2 – implying (as did my earlier post) that Vancouver is due for a 40-50% correction.
So let’s compare two scenarios: renting during a bubble versus buying in a normal market.
Scenario 1 – Renting in today’s Vancouver condo market.
At today’s average monthly rent ($1,474), the annual cost of renting would be $17,688.
Scenario 2 – Buying that same condo if there were no bubble.
In a normal market, the average condo would be selling for 15 times annual rent – $265,320. Assuming condo fees of $3,000/year and property taxes of $1,750, the total annual cost of owning would be about $4,750/year (for the purposes of this discussion, let’s ignore mortgage costs). Additionally, an owner could expect that condo to appreciate. The long-term average inflation rate in Canada is 3.26%. Being conservative and using the average inflation rate, this condo could be expected to appreciate $8,650 during the first year.
The total benefit of buying over renting would be annual savings plus appreciation. In this case that number would be $17,688 – $4,750 + $8,650 = $21,588. For someone able to purchase that condo for $265,320 without a mortgage, this benefit would come out to 8.14%. That’s how housing bubbles hurt people who do the prudent thing and rent during a bubble. It deprives them of a tax free return of over 8%.
And in the event readers are wondering if a price to rent ratio of 15 is realistic, 98 out of 100 US housing markets now have a price to rent ratio less than 15!
So says Bill McBride, author of Calculated Risk. In my opinion, his blog is the single best source for information on the US housing market. I’ve followed his blog for years, and can’t think of a single time he’s been wrong.
First there are two bottoms for housing. The first is for new home sales, housing starts and residential investment. The second bottom is for prices. Sometimes these bottoms can happen years apart.
For the economy and jobs, the bottom for housing starts and new home sales is more important than the bottom for prices. However individual homeowners and potential home buyers are naturally more interested in prices. So when we discuss a “bottom” for housing, we need to be clear on what we mean.
For new home sales and housing starts, it appears the bottom is in, and I expect an increase in both starts and sales in 2012.
And it now appears we can look for the bottom in prices. My guess is that nominal house prices, using the national repeat sales indexes and not seasonally adjusted, will bottom in March 2012.
There are several reasons I think that house prices are close to a bottom. First prices are close to normal looking at the price-to-rent ratio and real prices. Second the large decline in listed inventory means less downward pressure on house prices, and third, I think that several policy initiatives will lessen the pressure from distressed sales (the probable mortgage settlement, the HARP refinance program, and more).
Of course these are national price indexes and there will be significant variability across the country. Areas with a large backlog of distressed properties – especially some states with a judicial foreclosure process – will probably see further price declines.
And this doesn’t mean prices will increase significantly any time soon. Usually towards the end of a housing bust, nominal prices mostly move sideways for a few years, and real prices (adjusted for inflation) could even decline for another 2 or 3 years.
But most homeowners and home buyers focus on nominal prices and there is reasonable chance that the bottom is here.
Writing about the San Diego housing market, Rich Toscano at Piggington’s Econo-Almanac has a great explanation of the historical relationships between house prices, incomes and rents.
Longtime readers know that I consider the price ratios to be absolutely fundamental to determining whether housing is fairly valued. It makes intuitive sense that home prices would tend to track incomes and rents: incomes, because they determine how much money people have available to pay for housing; and rents, because rent prices reflect how much San Diegans are willing and able to pay to put roofs over their heads when there is no speculative or investment element involved. The historical record bears out this intuitive logic, as San Diego’s home price-to-income and price-to-rent ratios have tended to be strongly mean-reverting over time.
The San Diego ratios were calculated with slightly different data, so the absolute numbers aren’t the same as Vancouver’s. However, today’s deviation from historical averages in Vancouver are comparable with the situation in San Diego in 2005.
So what is the likely future for home prices in Vancouver? Unless Vancouver is different, historical price-to-rent and price-to-income ratios will return at some point. Absent a significant jump in incomes and rents, the only way these ratios can get back to normal levels is with a very significant drop in prices. If this was to occur over the next couple of years, it would take a 40-50% fall. Like this: