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The New Home Economics: An Unconvincing Theory

Contributed by mm | December 10, 2003 10:35 PM PST

I cannot understand the logic in this Fortune article about home price movements due to changing "carrying cost," defined by the article as mainly mortgage expenses and real estate taxes.

The line of the thinking in the latter half of this article seems to be:

1) Price-to-Annual-Rent-Ratio (P/R ratio) is a good way to look at the home economics (which I agree). Normal range of P/R ratio is usually 11-12 but recently P/R goes as high as 20 in hottest markets.

2) The article then attributes the P/R ratio spike as partly a result of falling carrying costs (which may somewhat make sense, but increased P/R ratio should be more construed as increased price due to more affordability and lower rent level; falling carrying costs are only an indirect factor)

3) Now the article claims that if expenses (mortgage interest + real estate taxes) increase, net cash flow to investors (rent - expenses) will sink, and as macroeconomic atmosphere calls for rate increase and real estate tax jump, house price is going to drop. As P/R in hot markets are 20, each $1 increase in carrying cost increase translates to $20 drop in property value.

The storyline flawed because the author failed to recongize that property owners may well pass along the expenses increases to renters. One can hardly imagine if interest rate goes up three years from now, rent is going to keep the current level. If rent will rise in conjunction with the mortgage interest increase, the author's theory will evaporate immediately.

I usually admire Fortune stories, but this article really disappoints me.

This Post Has Received 1 Comment. Share Your Opinions Too.


realshazard Commented on December 17, 2003

Rent is probably less sensitive to interest rates than house prices. Sure, with higher rates/inflation there will be more renters/higher rent, but rent hasn't kept pace with housing prices, and its hard to see when the too will get back in balance - probably when housing comes back down and rents move up. The article makes the basic point that rising taxes/higher rates are bad news for housing, and renting right now is cheaper than owning.


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