It appears wherever you go now the question on everyone’s lips is not “are the good times over?” but “how bad will it get?” It appears, in certain parts of the United States, a lot further. An often-cited indicator of how far the real estate bubble has to fall is the price-rent ratio. Often called the price to earnings ratio for real estate, the price-rent ratio is calculated by the formula of (house price/annual rent in an equivalent housing unit).

A price-rent ratio has no meaning in the abstract. A price-rent ratio of 10, for example, isn’t necessarily a good or bad ratio. The ratio has to be compared against historical price-rent ratios in the same area (here is a sample of price-rent ratios in the south-western U.S. which have to revert back to the norm) and this is where things get scary.  The Federal Reserve of San Francisco published a report in 2004 about a possible housing bubble forming since price-rent ratios where significantly above historical ratios (this study has been cited quite a lot lately with hindsight, as always, being 20/20). The issue is that this same study, and others after it, have found that price-rent ratios only return to historical averages through a great dependency on decrease in housing price (i.e. housing values fall back to historical averages) rather than increase in rent. This makes sense because rents are subject to external factors, such as rent control and available rental stock, which do not affect non-renters. The conclusion? In order for the real estate market to get back to “normal”, there will have to be a fall in housing prices.

How far? Depends where you live. Fortune Magazine published projections on 25 real estate markets poised to fall. They tend to be clustered in California and Florida. This supports the view that recessions tend to have regional impacts; certain regions will be the real losers of recessions while others will get off much more lightly.  But how much are we talking about on average? Noted economist, Paul Krugman, stated in the March 31 issue of Fortune Magazine, an average decrease of 25% nationally and up to 50% in some areas (Miami and L.A. were specifically mentioned).

For those who are (happily) owning real estate not located in the United States, you are not immune. When I started looking up research for this post, I noticed the global price-rent ratios are at historical highs. MoneyWeek, an English publication, had a few choice words for Vancouver real estate comparing it with Syndey’s housing bubble that popped. Locally, a developer is introducing a condo with introductory prices at $1.5 million- when prices on any asset get that outrageous, it is usually a sign we are on the last legs of any boom cycle (the parallel analogy being the BCE going private transaction- the dollar figure is obscene and marked the end of the private equity deals in this cycle- if they even complete it).

What does this all mean for you?

• if you are in your 20’s-40’s, and are going to live in your house for 10 plus years, the short term effects on these adjustments will be negligible. If you have a weak stomach, do not bother even asking what the neighbor sold their house for until at least 2010. Like any other asset, the longer you hold on to it, the greater the possibility you will not lose money.
• if you are in your 50’s and 60’s and (i) recently bought a home; and (ii) have little equity in it; and (iii) and intend to sell soon, depending on where you live, you could be in for a rough ride (the trinity of troubles).
• Regardless, remember the primary reason you buy real estate- shelter. In the grand scheme of things, real estate is still a good investment if the primary purpose is shelter for the long term; a place where you can raise your family safely and put down roots. The larger issue is that, over the last ten years, societal views on real estate have increasingly shifted towards treating real estate as an investment you leverage, flip and hop in and out of like we were real estate day-traders. Most day-traders earlier this decade lost their shirts or stopped doing it after a while. Looks like history is repeating itself.