Where to Buy, Where to Rent
When should you rent versus buy? It's a question lots and lots of people are asking these days. Armed with intriguing new post-crash data on the relative costs of renting versus buying, The New York Times' David Leonhardt suggested that the significant decline in real estate prices was making buying a home a much better proposition in a growing number of communities across the country. (The Times offers a great interactive rent-or-buy tool, if you're currently thinking about this).
Leonhardt's analysis provoked an intriguing debate among many of the Web's most thoughtful economics commentators. Ryan Avent, writing at Free Exchange, urged caution. Felix Salmon thinks housing prices still have a ways to fall, especially as inflation eats away at them. Robert Shiller, the Yale economist who initially identified the housing bubble, and the tech bubble before that, also believes real estate prices may still have further to fall. Leonhardt replies thoughtfully here and here.
Given my ongoing interests in housing and The Great Reset, my team and I decided to take a closer look at what might be behind these patterns. The basic measure is called the housing price-to-rent ratio, or HPR ratio. As its name implies, it is a simple ratio of the costs of purchasing a house compared to the annual costs of renting. Specifically, we wanted to explore to what extent HPR ratios are associated with key economic and demographic characteristics of U.S. cities and regions.
We based our research on the Times' analysis but developed our own larger data-set. The Times' data, which covers 54 large metro areas, are hard to match up with the more conventional metro definitions used by the Census and other data-gathering organizations. So, my colleague Charlotta Mellander used the same basic methodology to calculate our own HPR ratios for a larger sample of metropolitan regions that we could match to a wide series of regional indicators. Our measure of house prices is essentially the same as the Times; it's the fourth-quarter 2009 house price series from the National Association of Realtors. Rent data is harder to come by, so we use data on 2008 median contract rent from the American Community Survey. We feel confident that this 2008 rental data does not skew our analysis too badly, since housing prices have fallen more dramatically than rents over that period. Our data series covers 133 metropolitan regions. The data sets line up fairly well. Our HPRs are, generally speaking, slightly higher than the Times' calculations. However, New York and Los Angeles have significantly higher HPR ratios on our measure. This is likely a result of the way these regions are defined in the two data-sets, since we use similar fourth-quarter data on housing prices. Still, the two measures are closely correlated, with a correlation of nearly .8 (.78). We also ran the same analysis on the Times' data and the magnitude and direction of the correlations are essentially the same.
The map above, prepared by the Martin Prosperity Institute's (MPI) Zara Matheson, shows the HPR ratios for U.S. metro regions.
With Mellander's help, we ran a series of scatter-graphs and performed a simple correlation analysis to probe the associations between key demographic and economic factors and the HPR ratio.
The relationship between relative costs of owning vs. renting and housing prices is, well, striking. The line in the scatter-graph slopes steeply upward and the fit is quite good. The correlation between the two is a whopping .83. In simple terms, it's much more costly to own than to rent in places where housing prices themselves are higher. In fact, the ratio, perhaps not surprisingly, appears to be driven by housing prices.
Source: Data on homeownership or owner-occupied housing units is from the American Community Survey.
So what about homeownership? The correlation between the HPR ratio and homeowership is negative (-.51). In other words, the costs of owning are relatively lower in places where more people already own their own homes. The reason is basic, actually: where housing is more expensive, fewer people can afford to buy. Looking at the scatter-graph above, New York, Los Angeles, San Francisco, and Seattle are all far above the line. That is, they all have even higher HPR ratios than their relatively low levels of homeownership would predict.
How do the relative costs of renting versus buying a home relate to a region's economy? The short answer is that the relative cost of owning is significantly higher in more advanced and affluent regions. We looked at the relationship between the owning vs. renting and three common measures of regional development -- economic output (measured as gross metropolitan product per capita), average incomes, and average wages. The HPR ratio is significantly associated with all three. The correlation between the HPR and economic output is .45. The correlation between it and average incomes is .44. And the correlation between the HPR and average wages is .47. The HPR appears to reflect regional wealth.
Source: Data on wages is from the Bureau of Labor Statistics
The scatter-graph (above) compares the costs of owning versus renting to regional wages. The line runs steeply upward. Los Angeles, New York, San Francisco, Seattle, and San Diego are all above the line. Their HPR ratios are even higher than their average wages would predict.
What about unemployment: how is it related to costs of owning versus renting? Unemployment is generally higher in communities with higher rates of homeownership, as I noted earlier this week. We find that places with higher HPR ratios have lower rates of unemployment. The HPR ratio is negatively associated with unemployment rate, with a correlation of -.34. In other words, unemployment is lower in places where owning costs more than renting.
Previously, we've seen how smart regions have higher levels of income, economic output, and overall well-being. It costs relatively more to own in smarter, more advanced regional economies. We measure smart regions in terms of the level of human capital; the percentage of the workforce in creative, knowledge-based, and professional occupations; and the level of technology-based industry. The HPR ratio is positively related to all three. The correlation between the HPR ratio and human capital (measured as the share of metro population with a bachelor's degree or higher) is .4. The correlation between it and the creative class is .41. Conversely, the HPR ratio is significantly lower in communities with a higher percentage of traditional blue-collar, working-class jobs, with a correlation of -.3. The HPR ratio is higher in regions with greater concentrations of high-tech industry. Our measure of high-tech industry is an updated version of the "tech-pole index" originally developed by the Milken Institute. The correlation between it and the HPR is .51. The HPR is not only tied to regional income and wealth, it is also tied to the underlying factors that generate regional prosperity.
Source: Our measure of the creative class follows Rise of the Creative Class and is based on data from the Bureau of Labor Statistics.
The scatter-graph (above) plots the HPR ratio against the percentage of the workforce in creative class jobs. Again, New York, Los Angeles, and San Francisco, and to a slightly lesser extent Seattle and San Diego, are well above the line with HPRs considerably greater than their creative class economies would suggest. The costs of owing versus renting are significantly higher in creative class economies.
That brings us to happiness and well-being. A much-cited study by University of Pennsylvania economist Grace Wong Bucchianeri found that homeowners are no happier than renters (PDF), and also face higher levels of stress. In my earlier post, I found homeownership to be negatively correlated with happiness and well-being. But how does the relative cost of owning versus renting relate to the happiness and well-being of communities? Happiness, we find, is greater in regions with higher HPR ratios. The correlation between the two is .47. That is, people are happier in places where it is more expensive to buy than to rent.
What to make of all of this: where exactly should you buy, and where should you rent? Leonhardt suggests that it's worth buying when the ratio is 20 or less. Dean Baker sets the threshold somewhat lower: He says it makes sense to consider buying when the ratio is 15 or less.
From where I sit, the picture looks a bit more complicated. It boils down into two distinct questions. The ratio of owning versus renting provides a good handle on the first of these. It enables you to objectively compare the ongoing costs of owning versus renting your home. But it is not as good on the second question. Avent zeros in on this when he says that housing is a "highly leveraged, undiversified, relatively illiquid bet, with a return that is highly correlated to local labor market conditions."
This second question is about economic context. Is the house located in a growing economy, one where its value is likely to go up, and where you can sell it if you need to? Looked at this way, it may be that places with higher relative costs of owning versus renting are the better bet. Consider that the places with the "best" relative cost of owning are older Rustbelt cities like Detroit, Pittsburgh, and Cleveland, and Sunbelt cities of sand like Phoenix, Las Vegas, and Tampa. But, the ones with the "worst" are high-tech centers like Silicon Valley, Seattle, and Boulder, places with lots of natural amenities, or on our measure the big super-star cities of New York and Los Angeles.
Here's what David Albouy, a University of Michigan economist who has done detailed studies (PDF) of the factors that determine regional housing prices, has to say:
If prices reflect the present discounted value of future rents, then a low price-to-rent ratio today suggests that future rents will be low, probably because local amenities or job opportunities will be less desirable. Financially, you're putting a bet on a place that now looks like a loser, but more importantly you're making it harder to move out of a place where the prospects don't look so good. The other thing is that homeownership may be over-rated socially. It eats up tremendous time and money. Talented people may benefit themselves and society more by providing or developing products for the larger public, rather than devoting their time to amateur home-improvement (although some fix up houses pretty nicely).
In the end, the costs of owning are relatively higher in communities with higher levels of economic output, higher incomes, and higher wages -- that is where there is higher effective demand. They are also places with among the lowest levels of homeownership and where there is likely a relatively large pool of people who would like to be able to buy a house there someday. Not to mention they are the places with stronger underlying economic prospects -- witnessed in their higher levels of human capital and more high-tech and creative economic structures. They are the places that, generally speaking, are attracting skilled people, generating new technologies and industries, which provide the greatest economic opportunity.
If I had to bet on real estate I'd bet on just these kinds of places. (It's what I did, actually: I bought in D.C. and Toronto, but chose to rent in Pittsburgh and Miami). And my hunch is the high cost of owning a home as opposed to renting in these places -- like their higher housing prices to begin with -- reflects just that.
Next up: I take a detailed look at the newly released Case-Shiller Home Price Index.