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Either the market prior to the recent runup in house prices has been wrong for decades, or you are missing something. Are you a homeowner? I have been for about 18 years now, and I've found that maintenance (roofing, paint, HVAC repairs, broken water pipes, etc) runs at least 1 percent per year, and real estate taxes another 1 percent. To get a real return of 4%, then, annual rent has to be at least 6% of the house price. That would give a P/R ratio of 16.7, not far from the 15 you cite as the historical average.
Jeff, I don't think you can figure the rate of return you need without saying something about the mortgage rate (after taxes), minus general inflation.
Why must the mortgage rate enter into the calculation? Since not all property for rent is mortgaged, rates on mortgages would seem a red herring.
As for inflation, rents would normally keep pace with inflation, so I don't see why that is an issue either.
I think Jeff's simple estimate is pretty good (assuming people do require a 4% return)
Or just imagine that the property were to be sold to someone else who needs to finance it.
Mortgage rates matter for the price-to-rent ratio because of cost of capital.
If you are buying a house to rent it out, then either you need enough income to service the mortgage, or you need enough cash to buy the house outright. If you buy it for cash, and the rental income would not be enough to service the mortgage, then you'd get a better rate of return on your cash by investing in mortgage-backed securities (or stocks or bonds, which in an efficient market would have the same risk-adjusted rate of return as mortgage-backed securities).
The same logic applies to primary residences. If you'd need a mortgage, you have a choice of making mortgage payments or paying rent. If you're paying cash, you're income on the value of your house is the rent you're not paying, which competes with the income you could get by selling your house and investing the procedes.
Location, location, location. In large metro areas, high P/Rs are easily justified, in the countryside they are not. Why are things different today? Burgeoning congestion. Once congested rents rise faster than incomes, not with inflation.
In large metro areas, high P/Rs are easily justified, in the countryside they are not. Why are things different today? Burgeoning congestion. Once congested rents rise faster than incomes, not with inflation.
Huh?
Higher prices are certainly somewhat justified (and also very much driven by restrictive zoning), but why exactly do think that higher price to rent ratios are easily justified? Many of the location factors that raise prices also raise rents in an attractive area.
And why are you arguing that high P/R ratios are "easily justified" in congested areas but simultaneously claiming that rents rise faster in those areas? I don't understand.
Maybe Lord is claiming that a higher P/R ratio is justified because R is expected to rise in the future. Much like a stock in which earnings are low today but expected to increase significantly tomorrow.
(I'm not justifying his theory, just trying to explain it.)
I think that p/r stays down blow 25 because the incentives are better to take care of a property you live in, if you own it.
Arnold, you're the one who posited a 4% real rate, not me. I simply pointed out that the cost of capital is not the only expense a landlord faces. If you add in those costs as well as the 4% real cost of capital, you get my numbers. What's so complicated about it?
The 4% real rate represents the cost of capital. If the cost of capital depends on mortgage rates, or any other rates, then those rates (or some function of them) should be substituted for the 4%.
Mortgage rates are only indicators of capital cost. If they are low enough to be greatly preferred to other ways of raising capital, that will affect the capital cost. Maybe it is (was) below 4% due to low mortgage rates?
The point Jeff H makes is that AK's ratio of 25 completely ignores every cost that would be borne by homeowners or landlords but not by renters *except* capital cost (for which he uses 4% as a rough guide).
I don't quibble with the 4%. It may not be perfect, but it's only there for the sake of argument. I, like Jeff, quibble with the idea that cost of capital is the only cost to consider. Homeowners pay real estate taxes and major maintenance costs that renters do not. That difference should be, and is, reflected in the price. If I could rent for no more than what I'd pay in interest for a mortgage, why would I ever sign up for taxes and maintenance?
Jeff Hallman's simple little calculation is just as detailed as AK's original calculation.
I'm thinking that AK needs to talk to some landlords.
OTOH, the general model is reasonable, and if returns on capital generally can be expected to be 3% rather than 4% going forward, that would imply a sustainable jump in the P/R.
Arnold, AFAICT, this is a serious error. The fact that it's been mentioned to you more than once in comments and you still persist in pulling this 25 P/R ratio out without commenting on these issues kinda gives me the willies about trusting you for economic information.