I am starting to see signs of imbalances emerge in the form of high asset prices, especially in real estate, and that trips the alert system...But I am conscious that today, the house price-to-rent ratio is where it was in 2003, and house prices are rapidly rising. I don’t think we’re at a tipping point yet—but I am looking at the path we’re on and looking out for potential potholes.
On Price-to-Rent Ratios and Inflation Measures
My preferred measure for Price/Rent is to use the measure from the Federal Reserve's Financial Accounts report for the Market Value of Owner Occupied Real Estate for Price and the measure from BEA Table 7.12 for Imputed Rent of Owner Occupiers. These should represent more of an independent estimate in each period of the aggregate Price/Rent level. The Case-Shiller index is a value weighted index, and the aggregate Fed/BEA numbers should act like a value weighted index. The difference between these measures should basically point to measurement drift in the measure that McBride, and presumably Williams, are using. And, the difference is substantial.
Since 1995, the Case-Shiller/OER ratio has diverged about 23% from the Fed/BEA ratio. That suggests that either Case-Shiller home prices have been overstated or rent inflation has been understated by more than 1% per year over the past 20 years. This is surprising, because even as measured, rent inflation has been persistently high throughout this period. I have used this persistent inflation - centered in the problem metropolitan areas (NY, SF, etc.) - to argue that there has been a persistent housing shortage.
I think what we are seeing here is a form of substitution effect. There isn't a measurement error, per se, in either the OE rent or the Case-Shiller price measure. But, what we have been seeing is rent inflation in the problem cities driving up prices with stagnant housing stock. The prices there are rising due to both the rising rents themselves and due to rising Price/Rent levels, which we can see are especially strong in the Case-Shiller 10 cities, relative to the national level. So, marginal new homes have to be built outside those cities, and those homes have lower Price/Rent ratios.
Even if rent inflation and price changes of each individual house are accurately tracked over time, the fact that marginal new housing stock tends to have a lower Price/Rent will mean that we have overestimated the price of the home of the typical household. Measures of real and nominal housing expenditures (rent and imputed rent) would not be biased by this substitution. And, the Case-Shiller measure of home prices would not be biased regarding the homes. But, the substitution does mean that Case-Shiller does overstate the cost of homeownership for the typical household over time.
I think this bias in Case-Shiller may be somewhat inevitable, because persistently high rent inflation and the related inflation of Price/Rent will tend to only be sustainable in a supply-constrained environment. In an unencumbered market, new building would be attracted by the high Price/Rent level. If high Price/Rent persists, then it seems likely that marginal new building will have to occur in lower Price/Rent locations.
In a narrative sense, for every household that remained in a condo in San Jose whose imputed rent rose from $4,000 to $4,200, and whose price rose from $1 million to $1.1 million, there was another family who moved to from San Jose to Phoenix and bought a home with imputed rent of $3,800 that sold for $800,000. This bias in the Case-Shiller indexes created a false sense of an over-heated housing market in the 2000s in two distinct ways. Regarding rent, from 1995 to 2006, households spent a stable level of their incomes on housing (rent), about 18%. But their real housing expenditures over that time declined by about 13%. Since Case-Shiller tracks homes, not households, it does not reflect this shift to less valuable housing.
Regarding Price/Rent, as mentioned above, there appears to be a bias since 1995 of about 23%. Together, this means that the typical house, tracked by Case-Shiller, overstates the change in the price of the typical household's home since 1995 by about 39%. The average household lives in a home with lower imputed rent and a lower Price/Rent ratio because they have been downshifting on their housing consumption. This was especially the case during the boom. The divergence between the Case-Shiller Price/Rent ratio and the Fed/BEA ratio mostly happened between 2002 and 2008. As with so many factors I have considered in this series, this is basically the opposite of what everyone thinks happened during that time.