Wednesday, January 2, 2008

What Do Rents Have To Do with Home Values?

Several of my favorite blogs (see Calculated Risk today and The Big Picture last month) have reported on efforts which attempt to estimate how far home prices are out of whack by looking at historic ratios between rents and home values. There's no question home values are inflated relative to rent levels, but I'm skeptical that the historical relationship has much to tell us about where home values will be over the next few years for several reasons:

1) Historically rents have been much more volatile than home values at the market level (for example, in San Jose during the implosion effective rents dropped around 25% while home values barely twitched). If rents and home values had much to do with each other it seems like the correlation should be closer.

2) Until the last 5 years or so you could say with a fair amount of confidence the primary drivers of home values were demand (best indicated by employment levels), additions to supply (best measured by new housing starts), and interest rates (lower rates = bigger loans = higher values). Now, we have had demonstrated lax underwriting standards can also lead to leverage-driven value inflation (see my previous post which runs through the numbers on this). None of this has anything to do with rent levels; if anything, rents tend to move in the same direction as home values when the movement is driven by employment and supply changes.

I think the underlying fallacy in associating rents with home values is the belief that people weigh the costs of renting vs. buying and make a rationale choice. No doubt some people do that, but I think most people will buy if it's at all possible and lax underwriting made it possible for more people to buy at higher prices. Even more important, those sales made it possible for everyone who had already bought to leverage up based on the higher values and lax underwriting.

So where will we end up? On the positive side, additions to supply are slowing and interest rates are stable to declining, both positive drivers. On the negative side, if we do slide into a recession the demand vacuum created by employment losses is going to compound the present problem in a really unpleasant way. Rolling 12 month average employment growth is slowing now, and a downturn in that average historically signals a recession with bad real estate consequences (previous post here). The other big unknown and potentially huge negative factor is where mortgage lending underwriting standards stabilize. It was lax underwriting which got us into this mess, and historically underwriting tightens significantly when lenders incur losses. It's entirely conceivable lenders will overtighten and compound the current problem. On the other hand, there will be a lot of pressure, especially on FHA and the GSEs, to keep credit flowing. A recession combined with conservative underwriting will push prices below historical norms. Unfortunately, that seems like the most likely scenario to me.