Rent-Price Ratio

• The price-rent ratio is the average cost of ownership divided by the received rent income (if buying to let) or the estimated rent that would be paid if renting (if buying to reside):

The latter is often measured using the "owner's equivalent rent" numbers published by the Bureau of Labor Statistics. It can be viewed as the real estate equivalent of stocks' price-earnings ratio; in other terms it measures how much the buyer is paying for each dollar of received rent income (or dollar saved from rent spending). Rents, just like corporate and personal incomes, are generally tied very closely to supply and demand fundamentals; one rarely sees an unsustainable "rent bubble" (or "income bubble" for that matter). Therefore a rapid increase of home prices combined with a flat renting market can signal the onset of a bubble. The U.S. price-rent ratio was 18% higher than its long-run average as of October 2004 (Federal Reserve Bank of San Francisco report

).

Tracking the Rent-Price Ratio

One indicator is the rent-to-price ratio—the difference between the price of a house and the amount of rent tenants would pay to live in it. If a house priced at $283,000 would rent for $10,000 a year ($833 a month), the rent-price ratio would be about 3.5%. Economists Morris Davis, Andreas Lehnert, and Robert Martin tapped into a national home-price database and found the rent-price ratio averaged 5.29% from 1960 to 1995. But from 1995 to 2006 a home-buying frenzy drove the ratio down to a historically low rate of 3.5%. The ratio climbed to 3.93% in the first quarter of 2008.

By that benchmark, assuming modest rent growth, home prices may need to fall 10% more over the next two years to bring the ratio near to its historic average. While the market hasn't yet reached bottom, the ratio signals that residential real estate could soon be more attractive. "I am much more optimistic than the market seems to be right now," says Davis. "Two years ago, I was pessimistic."