A very interesting study was made public in December of 2007 by two Fed Governors and a professor of Economics: Morris A. Davis, a Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison Andreas Lehnert and Robert F. Martin, Federal Reserve Board of Governors. They took a look at rentals over a thirty year period and compared them to sales prices. The basic idea was that cash flow from rent could be looked at as a percentage of the price. and this percentage is in fact, a dividend.
Its simple really, if I borrow $100 and get $10.00 a year in interest I have a dividend of 10%. $100/$10=10%. If bought a house for $100 and rented it out for $10 for the year, I would be getting a 10% return on my investment. This study calls this relationship the “price to rent ratio”.
Then they looked at this relationship of price to rent from 1960 to end of 2006 to try and understand true value.
Here are some observations:
1. From 1960-1995 the rent to price ratio was 5-5/1/2%.
2. From 1995 to end of 2006 the ratio went to 3.5% The true historic return had declined because the price of real estate has risen so dramatically and much faster than the rent rate.
3. The rent/price ratio is now about a third below its long-term average.
Students of investing love to point out "the history of investing teaches us that sooner or later all investments return their averages",. With this in mind the study looked at what it would take for property to return to its historic rent to price ratio of 5-51/2%.
Conclusion: The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade. House prices will need to fall a lot for the real ratio to return to historical norms.
It is an interesting way to look at price to return and try and answer the question of what is value and where is price going.
