There is a scary feeling in US Real Estate Markets right now. Home prices are skyrocketing out control, increasing by as much as 20% year-over-year in certain markets. Anyone looking to buy a home right now is having to compete with multiple offers, waive contingencies, and bid significantly over ask. Meanwhile, the US is down 10 million jobs year over year and the economic recovery has stalled.
How can prices increase so much when the fundamentals of the economy are so poor? As I discussed in a previous post, a perfect storm of first-time buyers and reduced inventory has resulted in a home price surge. But this surge will be temporary – after all, there are only so many households that have the income and credit score needed to buy a home during a recession.
This puts future home buyers and real estate investors in a precarious position. Many are wondering if now is the right time to buy or if it’s better to wait. Your correct path forward is based on the city you are looking at.
Some areas – which I dub “Bubble Cities” – are significantly overpriced and on the edge of a housing crash. Home buyers and investors should hold off on purchasing in these Bubble Cities. But there are other areas that are fairly priced and will likely hold strong in the event of a downturn. Home buyers and investors should feel confident buying in these “Stable Cities“.
At this point you’re likely asking yourself: “That makes sense. Some cities are better to buy in right now than others. But how do I tell the difference between a Bubble City and Stable City?”
The place to start is by using a metric called Price to Rent Ratio. The calculation is fairly simple: take the typical home value in a market and divide by the typical rent. The resulting ratio shows how expensive real estate is relative to the cash flows that can be earned by renting the real estate. For example:
San Francisco: $1.2 million price / $2,993 monthly rent ($36k annually) =33 Price to Rent Ratio
Dallas: $271k price / $1,593 monthly rent ($19k annually) = 14 Price to Rent Ratio
San Francisco’s Price to Rent Ratio (“PRR”) of 33 means that it would take an investor 33 years to earn back their initial investment at current rents. In Dallas it would only take 14 years. This difference makes investing in Dallas real estate much safer than San Francisco since the initial returns are higher and payback period shorter.
However, there is another element of additional risk to San Francisco: markets with high PRR’s have significantly more downside risk in the event of a housing downturn. That means that investors buying into San Francisco right now could be facing a loss in value in addition to a long payback period.
The graph below highlights this phenomenon. The markets with the highest PRR’s in 2006 experienced the deepest crash from 2006 to 2012. Markets with PRRs above 25 averaged a price decline of over 40%! Meanwhile, markets with PRRs below 15 averaged only a 10% price decline.
The simple reality is that high prices create more risk. Why? Well, for prices to get really high to begin with, there needs to be speculation. Speculation means home buyers and investors overpay for property based on the expectation of further price increases in the future. Speculation can cause home prices to go up very fast, as well as down really fast when the people bursts.
Fortunately, rent – the denominator in the PRR calculation – is more much stable. Rental rates will rarely go up or down by more than 5% in a given year, whereas prices have been known to swing by +/-20% or more. In the long-run, changes in prices will regress towards changes in rents. This can be illustrated by looking at the price and rent history of Las Vegas in the graph below.
Las Vegas had massive increases in home prices (orange line) in the mid-2000s, follow by massive declines from 2006 to 2012. But rent growth – the blue line – stayed relatively steady throughout. Investors paying attention to PRR in Las Vegas back in the mid-2000s would have known it was time to sell.
On a positive note, the convergence of the orange and blue lines in recent years indicate that Las Vegas’ housing market is much healthier now than it was 10-15 years ago.
The Moral of Story: high prices, indicated by high PRRs, are a sign that the local housing market is getting overheated. Home buyers and investors should avoid buying in these markets in 2021 and wait for the inevitable crash that brings values in these markets back down to earth.
Bubble Cities in 2021: San Jose, San Francisco, Seattle, Salt Lake City, Los Angeles, Austin, Boise, and Denver.
These markets have all experienced large increases in their PRRs over the past 15 years while also maintaining a high overall PRR (20+). That is a recipe for future price declines. Interestingly, these markets are all high-growth Southwest / Pacific markets. The same profile that got hit very hard in the last housing downturn.
Stable Cities in 2021: Chicago, Philadelphia, Hartford, Miami, Fort Myers, Tampa, Atlanta
These markets have all experienced declines in their PRRs over the last 15 years while maintaining low overall PRRs (<15). This group is split between “Rust Belt” markets like Chicago and Hartford and southeast markets like Miami and Atlanta. Those southeast markets got hit very hard in the last downturn but their fundamentals have improved significantly since then.
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