Rent to Value Spread: Where are we headed?

This past Summer, people became familiar with the term "crack spread" as gasoline topped $3 a gallon in the U.S. The crack spread is the margin between crude oil prices and the prices of refined gasoline. A large spread means the refiners are making fat profits. In stocks, investors are concerned with the price to earnings ratio. In real estate we also have a ratios to look at; an important one is between the cost of the raw material (the house or building) and the price of the finished product (the rent). This rent-to-price ratio or spread is something that real estate investors should pay attention to. I began noticing about three years ago that the spread was getting out of sorts. We were seeing the prices of houses increase, yet rents were actually decreasing. In our area we've seen rents decrease about 15% over the last three years, while house prices continued to increase at 2-3% a year (no, we're not in one of the hot spots that saw big increases). This spread became so large that it was squeezing profit margins and it made more sense to sell off houses than continue to rent them. So beginning about three years ago I began selling down our single family house inventory and now we just have a few left. Fortunately we got most of them sold before the sub-prime lending crisis threw lending and real estate markets into turmoil.

What created the problem was the overbuilding and over lending which has affected all areas. Rents were falling because people who normally would have rented for a few more years before saving enough to buy a house, and even people who should never have bought a house, were jumping in to home ownership. At one closing recently where we sold a single family home, it turned out to be to an unmarried couple with no money (literally), no credit and no regular jobs. They seemed like nice folks who wanted the American dream, but they just weren't ready for it. This confirmed for me the lending crisis was going to get much worse. Builders compounded the rent problem. As they found themselves sitting on homes without buyers, many turned to renting, creating a temporary over-supply in rental markets. Not having experience with landlording, many builders ended up with the bad tenants that experienced landlords were shunning which just compounded the builder's problems.

There is another spread in real estate, which is the difference between new and existing home sales. I also saw that getting entirely too large beginning about three years ago. People began to pay premiums of nearly 30% more for identical housing that was new rather than existing. This spread told me there were problems coming for new housing, unless existing housing prices were going to jump up to match (they didn't). Now most of the builders in our area are bankrupt, out of business or on the ropes, and they are offering concessions that effectively have lowered the prices of new housing dramatically.

Sure enough, my experiences were backed up this week as some Federal Reserve economists released a study saying that the rents to prices spread had gotten away from the norm. Their study showed that between 1960 and 1995 the rent to price ratio remained fairly steady at 5 to 5.5 percent (I assume they mean annual rent to price, though 5% would be a bad ratio for a savvy investor - that's another post I need to do), but from 1995 on has fallen steadily to a low of 3.5 percent in 2006. When a ratio like this gets away from the norm, the question is which factor will move towards the other (or will they both move towards each other). The economists who did the study concluded that housing prices would have to move down to get back into relationship with rents. They predicted house price declines of 3% a year for the next 5 years, and were factoring in "normal" rent increases continuing at 4% a year.

I would have to disagree somewhat with their assessment. First, most areas have not been seeing rents increase at a rate of 4% annually. Before the recent decline of 15% over the last three years, we saw rents stay flat for about seven years (and we are in an area of population growth and housing demand). I'd love to see rents start increasing 4% a year. But, with the economists' general assumption that it will be prices that fall to return their ratio to the norm, I think they may not have it right. Prognostication is a dangerous game, but I'll take a stab at it in the next post.