We had a number of questions in the Tuesday chat on rental rates compared to home prices. One asks for comments on current rental rates compared to home prices, another asked if there is a hypothesis on correlation or possibly causation between rents and prices and a third asked for a long term picture while noting that there have been studies in the past and that some analysts see an increasing to turn to renting rather than buying.
To start, lets look at some data with the chart. This shows the ratio of the S&P/Case-Shiller Composite Index of 10 Cities to the U.S. CPI Owners Equivalent Rental (OER) index. A number of studies going back to a short paper published by the San Francisco Fed in October, 2004 use the CPI OER as the measure of rents. The chart was scaled so that the first observation in January, 1987 was 1.0. Setting January, 1987=1.0 is arbitrary. If we decide based on the overall trends shown by the S&P/Case-Shiller indices that the period from 1987-1999 experienced roughly normal home prices, we would find the average Price:Rent ratio for the normal period is 0.97 — almost the same as 1.0. Given all this, what does the chart show? Price:rent ratios peaked with home prices in 2006 and have come down a lot, but still remain about 15% above the normal level. In other words, relative prices favor renting because it is cheaper. Is that the whole answer to whether renting or buying is a better economic choice? No. first, rents might rise and home prices might fall and the relative prices would reverse. Second, for some renters or owners there are tax benefits not captured here and finally some people prefer owning and others prefer renting unless the cost differences are extreme.
None of this answers the questions on correlation or causation. Because owning a home and renting a home are substitutes for one-another, one would expect the prices to be positively correlated and generally move together. Both will depend on demographics and how attractive the neighborhood is. There are other factors — interest rates and mortgage availability — which can drive rents and prices in opposite directions. The second chart shows the two series — S&P/Case-Shiller 10 Cities and US CPI OER, side by side. They generally move together.
Causation: looking at the underlying economics, factors such as demosgraphics, employment, incomes, supply of homes, financial conditions and the characteristics of the cities involved determine both home prices and rents. It would be incorrect to say that home prices drive rents or that rents drive prices. There is correlation but not causation.
Given the normal price:rent ratio defined at the beginning, the long term could see a modest decline in home prices compared to rental rates. However, another factor — whether the recent boom and bust has lessened the home ownership part of the American dream — remains to be seen and understood.
Click here to view the July 26th Live Chat post with more Q&As.