Evidence Investing

 
 
So taking another angle on our look at the housing real estate market...   Price-to-Rent Ratio.

From the good people at CalculatedRisk comes a excellent article and a even more excellent graph (yes, I love pictures).  Based on the brainy but understandable letter to the SF fed regarding the housing bubble in 2004 by economist John Krainer (which you can find here and I suggest you read if you have a chance), the price-to-dividend ratio used to value equities in finance can be applied to the housing market in by way of the Price-to-Rent Ratio.  

Krainer says, "The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house."

Makes sense doesn't it?  So lets look at the graph:
Picture
Pretty interesting, huh?   So we can use this information in a couple of ways.  

1) Historically speaking 0.9 is the approximate average ratio for this market.  And right now we seem to be about 10% above the historical average...which corresponds with the data from my previous post on housing prices.  Nice!

2) We should really keep an eye on this particular metric in the future for bubbles (which you know are going to happen again sometime, somewhere).
 
ecoPOLITICAL 03/19/2010
 
I warned you there would be some of this!  ;)  Enjoy
 
Housing Prices 03/16/2010
 
I think its fair to assume that most people would agree that we are not out of the woods yet, but I get the feeling that people are getting ansy... to buy at these 'cheap, cheap prices.'  Just how much lower can housing/real estate prices go??  Well, to look at that question, I would like to show a really excellent bit of research done by Ironman at his top-quality blog (PoliticalCalculations).  

We can look at housing prices related to the past to try to get a handle on this, but the problem is that there are so many factors (inflation, jobs, supply/demand, etc, etc) that it makes it a really tough multi-varient problem to figure out a housing price predictor that works half way decent...

In his post (A Better Method for Detecting Housing Bubbles), he says:  

"But what would be a better method for determining whether house prices might be in a bubble? Is there a way to detect a bubble forming in its earliest stages? 

We think we've developed a better method, which is in part based upon our observations of age and income driven spending. What we found is that personal spending for housing was a very strong function of personal income. 

That observation gives us an alternative way to determine how much Americans of a given income spend on housing and given the strong correlation between income and housing expenditures, we can substitute personal income in place of the measure of rent used by the federal government. We can then plot non-inflation-adjusted house prices against that personal income, which would give us insight into not just whether house prices have decoupled from the economic fundamentals supporting them, but when as well. 

We did just that with median house prices and median household income in the United States since 1967.  What we find from our chart is that the U.S. housing bubble clearly began in 2000, with a distinct deviation away from the two otherwise linear trends that we observe in the data."


Click here for the full post WITH graphs...