I’m not sure I buy James Kwak’s argument that high Price-to-Rent ratios in housing are not a fundamental sign of a bubble. He writes:
I say this approach is partial but not perfect because current potential rental income is a poor proxy for the long-term value of a house. The fact is that most people buying houses aren’t going to be renting them out, and what they care about is the price at which they will be able to sell that house in 10 years, which depends in part on the price at which that buyer will be able to sell the house 10 years after that, and so on.
When people asked me about the wisdom of home buying during the bubble my stock response was, “think of your house as a place to live.”
That is, overwhelming the returns that come from owning a home are going to come from the “real dividend” of actually living in the house. In the long run prices may rise and prices may fall but your primary concern has to be keeping your family warm and dry.
In this context, the first time homebuyer in particular is going to be choosing between renting a home and buying a home. Its true that homes are rarely rented in the suburbs, though to some extent that’s a function of costs and preferences. However, fundamentally a first time homebuyer is choosing between continuing to rent and living in the spaces that are available to rent or choosing to buy and living in their own home.
If buying is a lot more expensive than renting there will be a tendency for potential first time homebuyers to continue renting. New homebuyers are key to the entire market for housing for several reasons.
One, move-up buyers need to sell there house to someone. Unless there are enough move-down buyers to replace each move-up buyer, the move-up buyer must be selling to a first time homebuyer. Fewer first time homebuyers mean fewer move-up buyers and a weaker overall market.
Second, there are always people exiting the home market because of death. If there is a shortage of new homebuyers then the overall number of homeowners will eventually fall.
So the choice of renting versus buying is key to supporting the entire home market. Additionally, there are people savvy enough to exist the home market if prices become too inflated, though I give that they are a rarity.
Now James makes the additional point that
it’s entirely possible that the relationship between house prices and rents could change over that timeframe due to any number of economic factors – the homeownership ratio; shifts between the exurbs, suburbs, and cities; the aging of the population; and so on. There’s no axiom that says that these ratios – price-to-rent or price-to-income or price-to-earnings for that matter – have to remain constant over the long term.
True, but you need to make a case for this. Price-to-rent ratio reflects a fundamental relationship in the market and if you believe the fundamentals have changed then you need to say why. If price-to-rent ratio is skyrocketing as it did during this bubble then you need to be able to explain why the fundamentals are shifting so rapidly.
Suggesting that the fundamentals of housing have shifted so much that in a few years time the price-to-rent ratio has doubled is an extraordinary claim and thus requires extraordinary evidence. Flashing a big warning sign that requires substantial justification is the value of important ratios like price-to-rent or price-to-earnings.