U.S. Economic Outlook: July 2018

Price-to-Rent as an Overvaluation Metric

By Frank Nothaft Housing Affordability, Real Estate

My Outlook commentary last month explored the CoreLogic Market Conditions Indicator as a monitor of overheated home prices.  For metros that our Indicator has flagged as ‘overvalued’, it’s important to look at other metrics for confirmation.  A price-to-rent ratio can provide additional perspective on whether prices are out of sync with valuation fundamentals.

To construct a price-to-rent ratio we used CoreLogic’s Home Price Index and Single-family Rent Index, set the ratio equal to one in the first quarter of 2001 when homes were fairly valued in nearly all metros, and observed how the ratio has evolved to today.[1]  That ratio shows that home prices have grown more quickly than rent in most metro areas, which would provide confirmation of overheated values if cap rates had remained roughly the same.

What Affects Cap Rates

Before we go any further, let me explain “cap rate” so we’re all on the same page.  A cap rate is used by real estate professionals to convert net operating income on an investment property into a market value.  While a cap rate is relatively stable over short time periods within a metro area, cap rates will vary across metros and over a long period will fluctuate based on the level of long-term interest rates, the perceived riskiness of real estate investments, and tax code changes that affect real estate profitability (Exhibit 1).  Of these three factors, the one that has changed the most between 2001 and today has been the level of long-term interest rates.  Consequently, cap rates for single-family rental homes are down significantly since then.  The cap rate decline implies that the price-to-rent ratio would need to grow by more than 60 percent since 2001 before today’s prices are disconnected with rental income fundamentals.

Price to Rent Ratio for Select Metros

When we examine select metros that our Market Conditions Indicator found to be ‘normal’ in 2001, we found that price-to-rent ratios were up by more than 60 percent in the Los Angeles and West Palm Beach metros, two places that the CoreLogic Market Conditions Indicator had flagged as overheated today (Exhibit 2).  Metro areas that our Market Conditions Indicator has tagged as ‘overvalued’ and have a high price-to-rent ratio are at heightened risk of a value correction, especially as long-term interest rates rise.

[1] Because single-family rental homes have a median value that is less than the median value of all single-family homes, the calculations used the CoreLogic HPI for homes with a purchase price greater than 75 percent of the local area median and no greater than the median price.

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