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Abstract
The price-rent ratio is commonly used as an indicator of housing value. New data sources remove previous technical limitations on ratio construction and use, providing information on a monthly basis at the town, neighborhood, and ZIP Code levels. In this study, I explore the new data and find significant variation in price-rent ratios found across local markets that is correlated with local property tax rates, household income, and age. This work should encourage further study on crossmarket ratio analysis, as well as the development of local indices to more effectively assess the possibility that a specific local market may be underpriced or overpriced.
Housing analysts tend to focus on changes in house prices in order to understand the dynamics of a residential market. However, it is difficult to tell whether rising prices signal an emerging bubble or are justified by market conditions, and whether decreasing prices indicate a potential bargain or reflect deteriorating factors in the economy. Therefore many analysts also look at house prices relative to another variable that reflects economic fundamentals of supply and demand.
A residential house price-rent (P/R) ratio is one way to evaluate whether house prices are overvalued or undervalued. Using this ratio is comparable to analyzing a stock priceearnings (P/E) ratio, which shows how much investors are willing to pay for a share of stock per share dollar of earnings. For example, if the stock of a company is currently selling for $15 and its earning per share is $1, the P/E ratio would be 15. While a P/E ratio is simple to calculate, interpretation can be tricky. In general, a high P/E ratio, as compared to company historical trends, other companies in the same industry, or the market, indicates that investors are expecting higher future earnings growth; if that expectation is unfounded, the stock may simply be overvalued and its future price may drop. The inverse would hold for a low P/E ratio.
Potential rent, even for an owner-occupied house not intended to be rented, can be viewed as a house's "earnings." The P/R ratio then looks at house price relative to potential rental earnings. It is calculated by dividing a house's value by what the house could be rented for a year. For example, a...