I’ve been working on an article about the ‘buy versus rent decision’ for the past week. It’s melting my brain. In the meantime, here is one facet of the question I’ve been grappling with—the relative pricing of home purchases compared to rents and incomes. TLDR: it doesn’t look great for home prices.

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My dad has a photo of himself as a 10-year-old boy scout, standing on a mountain in Tanzania with his troop. He was the scout leader. What's most notable about the photo—aside from my dad's evident pride in his hard-won title—is the disproportionately large size of his nose compared to the rest of his tiny body. It’s adorable.

Luckily, he eventually grew into his nose—and if you believe him—today people often tell him he looks like the actor Richard Gere.

With time, everything sorted itself out.

Growing pains

The economy has grown surprisingly rapidly over the past few years. But home prices have grown even faster. Today, two valuation anchors for home prices—the price to rent ratio and the price to income ratio—are both wildly stretched.

It’s tempting to think these ratios will eventually subside to their more typical levels via steep falls in home prices. That’s what happened in 2007-09.

But the Great Financial Crisis was the exception that proves the rule: home prices rarely fall (at least in nominal terms). Sellers prefer to sit on the sidelines rather than cut prices. As Robert Shiller wrote in 2003, “home prices are sticky downward. That is, when excess supply occurs, prices do not immediately fall to clear the market.”

So how do we get back to normal looking valuations? One path—maybe the most likely one—is modest home price gains which lag those in rents and incomes in the years to come.

Home prices have risen too fast. But like a young boy growing into his nose, it may just take time for the rest of the economy to catch up.

DEEP READ

This wouldn’t be the first time home price growth cooled while the rest of the economy caught up. The price-to-income ratio was also stretched in 2014. Over the subsequent 5 years, real incomes grew by 21% while real home prices only rose by 3%.

If homes prices buck the typical rising trend and stagnate for some time, which regions are more vulnerable?

Oranges to oranges

Research has shown that, at the county level, high price to rent ratios successfully¹ forecast subsequent price moves².

But it’s not as simple as betting against the counties with high price to rent ratios. New York City, for example, has always had a high ratio (over 50x). Instead, it makes more sense to look for vulnerabilities in counties with high the price to rent ratios adjusted for local prices.

Adjusted for prevailing home prices, places like Orange County, Florida, look overvalued. Oddly enough, another Orange County—in California—seems sharply undervalued.

The table below lists all US counties with their most recent median rents and home prices (both for 2 bedroom units, for comparability), and their price to rent ratios. Clicking on the table will take you a site where you can rank the counties by each metric.

Price and rent statistics, 2 bed units, by county

Take these numbers with a grain of salt. In my area for example (Park Slope, Brooklyn), aggregate statistics far underprice rents.

Still—if a rising tide will no longer lift all boats—properly calibrated price to rent figures might usefully feed into a broader analysis of which areas are most vulnerable to years of stagnating home prices.