How many articles have you read over the last six months that use the price to rent ratio (P/R ratio) to establish exactly how over priced the current housing market is? While I am firm believer that housing is currently over priced, I personally have found the predictions of expected drops to be fairly extreme. The predictions are based off price to rent ratios, which (as the claim goes) historically revert to the mean. But I think these articles miss one very important point — cities change!

I will use Baltimore (my home) as the primary example, but my argument could work for many real estate markets out there. The above linked CNN article says Baltimore housing should drop 27.8% over the next five years because the current price to rent ratio is 20.7, where as the 15 year average is 12.6. What exactly is the price to rent ratio? This number is simply the cost of a home divided by the yearly rent for such a home. Hence for Baltimore, if the average home were $250k (a reasonable guess), the rent would be ~$1000 monthly (that is, $250,000 / 20.7 / 12 for monthly).

Assuming price to rent ratio is a mean reverting value, this means one of two things: (1) homes will significantly drop in price or (2) rent prices will sky rocket until the historical average P/R is met. In reality, it will be both effects. The article does assume a modest increase in rent, but to mean revert, the article predicts that housing will still fall a staggering 27%.

Before I make my point, look at these numbers of different P/R for different cities throughout the country. Notice something obvious — different cities can have very different historical P/R ratios. Los Angeles is 16.0, San Diego is 22.4, New York is 11.7, Raleigh is 19.4. P/R’s are different because these are different cities (duh).

What this tells me is that when cities change, so can their P/R ratios. And cities are changing all the time. While I can’t speak for other cities out there, I can very confidently say that Baltimore has changed dramatically in the last 10 years. Many of the higher paying DC jobs have moved north toward Baltimore. The city has physically transformed from the inside out from a poor, crime-infested city to one booming with a revitalized downtown and always-crowded convention center. Is it so inconceivable that the P/R ratio might change also?

Here’s the ironic part. Baltimore’s P/R will still be mean reverting! However, this could be because the 15 year average moves more towards to the current P/R, not because the current P/R moves toward the old 15 year average P/R. For example, say the P/R says at the new P/R level for the next 15 years. Well, in 15 years the 15 year average P/R will be dead on! This is obviously a self-fulfilling prophecy, but that’s the whole point!

In conclusion, I do believe many housing markets (including Baltimore) are over priced. However, I doubt the accuracy of the P/R ratio analysis when calculating exactly how far these places have to far.  I believe -27% is just another example of sensationalizing the news. This analysis does not leave room for transitioning cities which many cities in America are currently doing. Also, I question using the 15 year average P/R since given enough years to adjust, this is only a self fulfilling prophecy.