I would be careful about assigning too much value to price-to-income ratios, although they do convey some important information. In my view, there is only one thing that matters in valuing the “typical” home or condo: rental equivalents. At the end of the day, the only thing in finance of any importance is CASH: How much is there? How do I get my hands on it? How much risk is associated with getting my hands on it? For the vast majority of assets on the planet, everything else is, ultimately, just smoke and mirrors. Doesn’t mean that other approaches won’t work for a while… but when the dust settles the only thing that matters is CASH.
The typical home is just a housing unit that you decided to purchase instead of rent. Figuring out the cash flows from it isn’t rocket science. As I’ve said before, a rational person will be willing to pay a premium to own versus renting because ownership has certain advantages that are worth the premium, including: (1) Your “rent” won’t increase (much) if you get a fixed-rate loan (this has value), (2) For some people there is a peace of mind associated with ownership and being “settled” (this has value), and (3) There is a tax advantage to ownership (this has value as well).
Now, what premium a rational person should be willing to pay depends the value attached to these three issues (and perhaps other lesser issues I haven’t mentioned). For some people the premium may only be 20% (that is, they would be willing to shoulder total gross housing-related payments that are 20% greater than the cost of renting the same unit). For others #2 has more value such that maybe the premium is 35%. But no matter how you slice it it’s probably not greater than 50%… which is the REAL problem with the SoCal housing market (and others).
To use an example, a condo in my building just sold for $510/sq. ft. (which is eggregious, by the way). Applying that PPSF to my unit (which I own) implies a valuation for my unit of 19x rent. If I apply a 20% ownership premium to my unit’s rental equivalent (using standard conforming financing) I come up with a “real” value of about 12x rent. So, I fully expect the value of the units in my building to decline 30% (more than they already have), give or take, by the time this bubble hits bottom.
Now, once you get to homes above $1 million this analysis largely goes out the window. Because here you’re talking about art, not housing. The value is in the eye of the beholder. Rental equivalents will send you a signal regarding the value of the piece of house/art, but ultimately it’s “pure” supply and demand – the cash flows aren’t so relevant.
But for the vast majority of housing, the value is ultimately determined by how much cash it’s capable of generating with some premium attached for the items listed above. The biggest mistake a person can make in evaluating an investment decision is losing sight of the cash.
