In the heady days of condo buyers rushing to outmaneuver each other with fat offers on New York City residential properties, boring old fundamentals like price-to-earning ratios got tossed out the floor-to-ceiling window.
This measure — the sale price of a property relative to the rental income stream it could generate — had been a classic rule of thumb for setting a property’s value. The underlying idea, even in rarefied markets like Manhattan, is that a home’s price should directly reflect what the property could rent for.
Since the mid-1970s, the accepted nationwide ratio stood at sale prices of 15 times a property’s annual rent. In an indication of just how out of whack the boom market distorted this norm, the national ratio of median annual rents to median home prices soared above 25 to 1 in 2007, according to an October report from the Center for Economic and Policy Research and the National Low Income Housing Coalition.
“Basically, Housing Economics 101 says that the cost of a home should be a direct reflection of what it could rent for, a stream of income you could receive,” said Danilo Pelletiere, research director of the National Low Income Housing Coalition. “We got away from that quite a bit.”
Now that buyers, renters, brokers and lenders must focus on economic fundamentals, this old yardstick is getting dusted off. Economists are watching it closely as key indicator of health, not just for the real estate sector but the economy as a whole. New York brokers who never thought much about sale price versus rental rates — except as a tool for persuading renters to buy — are paying closer attention, too.
“I never priced a property based on that,” said Brian James, associate broker at Prudential Douglas Elliman. “This is definitely of interest and could be a very useful tool in pricing homes in New York City for 2009.”
Like many other indicators people are watching these days, this one is going down. Price-to-earnings ratios have been plummeting nationwide, while New York, long touted as a market unto itself, is also seeing a slump.
When the housing bubble burst initially, markets such as Las Vegas took early hits with lots of foreclosures. Now, cities including New York are catching up, logging more real estate price declines and foreclosures.
Moody’s Economy.com says prices for New York metro area single-family residences have dropped 10 percent since the peak of the market. Those declines mean price-to-earnings ratios are dropping, too. Through the end of the first half of 2008, the most recent time period for which data were available, the ratio was 15 to 1 in the New York area. That’s down from a peak of 18 to 1 in late 2005 through the third quarter of 2006, according to Moody’s Economy.com.
“The price-to-rent balance is looking like it is starting to come back in line with historical trends prior to the boom,” said Marisa Di Natale, senior economist at Moody’s Economy.com.
Balances are shifting, but the numbers have still not hit bottom, economists and researchers say. New York is among cities such as San Jose and San Francisco likely to see their price-to-earnings ratios plummet further, as a consequence of prices having moved up faster and higher than in other places.
“It has room to come down still,” Di Natale noted.
How low they will fall, and what impact that will have on a market already hammered by the credit freeze, rising unemployment and trillions of dollars erased from stock portfolios remains to be seen.
Some real estate insiders point out that, while important, this metric has its limits. As a comparative statistic focusing on a given property and similar properties nearby, it does not factor in the many perks that can set a residence apart, especially in Manhattan.
“It’s a broad stroke measure,” said Sofia Kim, vice president of research at StreetEasy.
Price-to-earnings ratios have spiked and retreated before. In the late 1970s, the national ratio jumped to about 18 to 1, before leveling out at about 15 from 1984-87, according to the Center for Economic and Policy Research and the National Low Income Housing Coalition report.
Previous cycles typically took about four to five years to fall back into line, noted Pelletiere of the National Low Income Housing Coalition.
The issue now, however, is that the steady upward march since around 1995 makes the historical benchmarks less relevant. Past cycles were smaller and less dramatic, with the ratio never rising above 20 times the annual rent. By contrast, the most recent cycle has lasted since the mid-1990s.
“My sense is it’s a bigger problem than in the past,” said Pelletiere.