Why potential rents may provide a pricing floor, Part II

The universe is a strange place: one day I ponder why I've not seen nor heard many good, discussions about the relationship between potential rents and housing prices, and the next day a story appears in one my favorite sources, The Wall Street Journal, on that very subject. To be sure, in many places growth in prices so far outpaced those of rents that tenants are getting some great bargains from owners desperate to lease at any cost:

...in the regions hit hardest by the subprime crisis, finding a rental apartment is easier and, in some cases, cheaper than it was before the crunch. Some homeowners forced out by foreclosure are finding rental deals that are at "discounts of 50% to 70% off what they were paying on their mortgages," says Brenda F. Gerdes, who owns Management Specialists Inc. in Port St. Lucie, Fla.

Vacancies have risen in 29 markets in the fourth quarter of 2007, including Las Vegas, Palm Beach, Memphis, Orange County, Calif., and Orlando, according to Reis Inc., a New York real-estate research firm. Ron Witten, a Dallas-based housing analyst, estimates there are 760,000 vacant condos and homes for sale nationwide beyond what the market could normally carry, in addition to a surplus of 350,000 vacant rental properties.

From a national perspective, that's certainly bad news. But what about markets such as Northern and Southern California, where average rents are among the highest in the country and vacancy rates remain lower than the 5% level generally considered market equilibrium (such as 3.5% in L.A. or 4.0% in San Francisco)? Shouldn't home prices fall less in stronger rental markets, and wouldn't condos hold up better in some cases?

While thousands of single-family homes also are coming on the market, renters prefer condos to houses, which typically have more expensive upkeep. "Tenants have to pick up more of the bills," says Artur Ciesielski, a Phoenix real-estate agent.

Perhaps a quick and easy rule of thumb is to simply apply the 5% rent-to-price ratio to determine if a particular property is overvalued, even though in certain areas that may still be too low:

Rents remained at around 5% of home prices throughout much of the postwar period, but beginning in 1996, home-price growth rapidly outpaced rent growth. By the end of 2006, home prices had more than doubled while average rent was up just 48%, driving down the annual rent/price ratio to 3.48%.

A study by one former and two current Federal Reserve economists suggests that home prices will have to fall by 15% over the next five years while rents increase by 4% a year to return that rent/price ratio to normal.

Then of course there's the cheery perspective of my banker friend, Brian McDonald:

If rents go up, it implies that incomes go up, which means higher inflation, which serves to maintain the value of a home but actually lowers it when valued vis-à-vis the general price index. If rents don't go up and incomes don't go up, then prices of RE will likely go down. It is unlikely that you'll see rents go up but incomes remain flat. Perhaps in some areas, but this will be the exception and not the norm.

'Vis-a-vis?' That's some fancy writin'!