Your approach is perfectly reasonable and along the lines of how I (and many people on this board) would value property. With a few minor issues.
Issue #1. A “typical” price-to-rent ratio of 10.
This means that if you purchased the house for cash, the rent would come in at gross yield of 10% annually.
If, like today, other investments are paying 5-6% risk free, 8-10% moderately risky, and > 10% speculative, than this ratio is too low.
If (like in late 80’s), risk-free investments pay > 10% than this ratio is probably too high and you’d have to get down to a number like perhaps 8.
Here’s an historical example for what it’s worth:
A 3 bed/ 1bath in Clairemont sold for ~160 K in April 1996 (near the last bottom). Rent would have to have been 1333 per month to meet your ratio of 10. Rents in the area were about $1100 per month at the time, giving a ratio of ~ 12, 20% above your number. This is an equivalent gross yield of about yield of about 8.3%. Guess what the interest rate on a 30-year mortgage was in 1996 ? (Ans: ~8-8.25%).
Issue #2. Prices must fall 45%.
Actually using your analysis the price-to-rent ratio needs to fall 45%. Not just the price (unless the change were instantaneous) Since there are two factors 1) price and 2) rent, there are many ways for this to happen:
One extreme: 10% reduction in price and 35% rent increases over the next 7 years (<5% annual increases).
Sensible guess: 25% reduction in price and ~4% average rent increases over 5-6 years.
Another extreme: 50% price reduction and 5% decrease in rents over some time period.
