2 Most Important Home Purchase Metrics: price-to-rent & debt-to-income

Each quarter The Economist refreshes their global home price tables to show where homes are over/under valued relative to rents and income. As I often say, local pricing is quite different from national pricing, but this Economist update is still relevant because it reiterates how consumers should evaluate a home purchase.


To gauge whether homes are cheap or expensive we use two measures, both of which compare current estimates with a long-run average (in most countries, going back to 1975). This average is our benchmark for “fair value”.

The first gauge is a price-to-rents ratio. This is analogous to the price-earnings ratio used for equities, with the rents going to property investors (or saved by homeowners) equivalent to corporate profits. The measure displays a massive range, from a whopping 78% overvaluation in Canada to an undervaluation of 37% in Japan. The other measure, the ratio of prices to disposable income per person, stretches from a 35% overvaluation in France to a 36% undervaluation, again in Japan.

America’s housing-market revival looks sustainable in part because the sharp correction in house prices over the past few years has made homes cheap by historical standards. A year ago house prices were still falling, by 3.6%. There has been a turnaround since: the latest data show prices rising by 4.3%. But based on the ratio of prices to rents, houses are still 7% undervalued; judged by the price-to-income ratio, they are 20% below fair value. It also helps that mortgage rates are at historic lows and are likely to stay that way, since the Federal Reserve has promised to keep an extremely loose monetary stance for the next couple of years.

Of these two Economist metrics, the price-to-rent ratio is much more critical for homebuyers to understand what they’re getting into. But first comes another ratio: a deb-to-income ratio measures total housing cost (plus all other debt) against income to determine whether a you can afford a home. All lenders will qualify borrowers using this ratio.

Then step two is the price-to-rent ratio, which compares renting vs. buying options someone has in any local housing market.

To properly compare rents and home prices you can’t look at the table above for prices—though doing so is encouraging since it shows the U.S. as a whole is undervalued. Your local market isn’t necessarily going to be the same, especially if you live in an area where home prices have been rising for more than a year now. Local market pricing isn’t going to come from any broad price stories in the mainstream press. It must come from street-level analysis you do with a realtor.

More on debt-to-income below, and more on price-to-rent tomorrow when Case Shiller’s November home price report is released.

[UPDATE: HERE'S PART 2 ON RENT VS. BUY ANALYSIS]


Reference:
- The Economist’s January 2013 Global Home Price Roundup

- Can you afford a home? (more on debt-to-income ratio)

- For my local readers: Bay Area Home Price Maps (January 2013)

- Recent home price posts on TheBasisPoint

 
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