Housing economists have long used a home price/rent ratio as one way to gauge whether or not home prices are inflated or undervalued.
Moreover, on a very practical level, relating home prices to rents can give you a more detailed view of whether there's a financial payoff to homeowning, says Gary Smith, Pomona College professor and co-author of "Houseonomics."
A housing P/EThe use of a price/rent ratio is analogous to employing a price/earnings ratio for stocks. When a stock price is high, and its earnings per share relatively low, the P/E is high. A high P/E often indicates that the stock is too expensive, and the share price is headed for a drop.
What someone is willing to pay to rent a place is that home's "earnings." And, just as in the stock market, a high home price related to the rental earnings mean homes values will probably drop.
For a specific look at how a home's P/E is determined, let's consider a home that is listed for either rent or sale in suburban Chicago.
The home has been rented for the past three years for $1,600 per month. It is currently listed for sale at $400,000. Dividing the price by the total annual rent of $19,200 gives a "housing P/E" of 20.83. According to Moody's Economy.com, the long-run average housing P/E is 16, so a P/E of 20.83 suggests that this home may be somewhat overpricedThis method is to be used in USA. Use same method elsewhere. Also keep in mind that the price of an independent house built as one house on one plot of land is different from a same sized flat in a building with several flats in a plot as the price of land is considered.
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