Low rents mean house prices will fall

The size of rents in the UK signal that further house price falls are due

Relatively few people measure house prices against rents compared with, for example, supply and demand or house prices to earnings. Some landlords like it, possibly because they spend lots of time looking at rent and yields for their property businesses anyway. Some analysts believe it is the best measure. The Economist is one of its leading proponents, and the OECD has used it as one of its gauges.

There are two popular ways to measure it, starting simply with dividing average house prices by average rent. You can take it a step further by deducting landlords' expenses from the rent.

Then you look at how this compares with the past. If the ratio shows that house prices are much higher compared to rents than the average, this could be a sign house prices are too high.

What's this measure saying now?

The measure currently shows that the difference between rent and house prices is much bigger than average, which could mean house prices are overvalued.

According to the Economist in January, Britain's house prices compared to rents are 29% overvalued. (You can read the report here. If you're not a member you can get a free trial which gives you access.)

According to the OECD, the UK's house prices to rents at the end of 2009 were 42% higher than the long-term average. (Read its report here.) This year both rents and house prices have risen at roughly the same rate so we can assume the Economist's and OECD's figures wouldn't be dramatically different today.

I doubt the addition of Northern Ireland to the OECD's figures is causing the difference of 13 percentage points, which means it's using different data to the Economist or calculating it differently.

Why favour this measure?

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The theory behind comparing rents (or rent minus landlord's expenses) to house prices is that it's similar to the PE ratio, which is what investors use to value stocks. The PE ratio tells you how expensive a stock is (the P or 'price') when compared with the company profits (the E, 'earnings'). The house price to rents measure might be of similar use in that it too measures the price versus the money you could get out of it.

Why criticise that?

There are potential downsides to this measure. Let's look at five of them briefly:

1. Rents might rise

Like many measures of house prices, this ratio could be corrected in two ways: house prices could fall or rents could rise. Alternatively, they could meet somewhere in the middle.

During 2008, for example, house prices fell but some sources claim rents rose. Rents have risen this year and there have been a few reports showing that landlords will increase rents due to risks of defaulting on their mortgages if interest rates rise.

2. We're lacking petri dishes and guinea pigs

Other house-price measures have been studied a great deal with a lot of supporting evidence and discussion brought to the table. Most sciences require laboratory and real life tests before a theory gets any serious backers.

The comparison with PE ratios may seem intuitive but, unlike the PE ratio – which has been analysed to death – house prices to rents has had relatively few minds on the problem.

3. We're suspicious

Trusting statistics takes at least a small hop of faith at the best of times. Access to the raw data in this area is low or it takes too long to reproduce it, which means it's harder to check its quality. In any case, I can't find a top quality source of raw data.

4. We don't know if it's 'all change'

Another problem that affects many measures is the question of whether things change, so that the average historical rate is no longer valid. Some people feel intuitively that things don't change and others feel intuitively that they do.

If they don't change we should use data going back as far as possible and that's all nice and simple. If they do, we have trouble. How far back do we go to calculate the average rate and how do we know when a new paradigm starts? Plus, when a new paradigm starts, how will we work out what the 'new' average ratio should be, as there'll be no historical data?

Economics being a relatively new science, I suspect this question could take time to answer.

5. It may not be that simple

A problem with most measures, this included, is that there are other factors, such as interest rates and supply and demand. I've seen both of those be used to criticise and support measures involving rent. Every short-term house-price measure has the weak point of not including other factors. So far the think-tanks that have tried to forecast house prices by combining many measures have been wrong more often than right. Alarmingly so.

What'll happen to house prices?

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If this measure is an effective one, the ratio will have to narrow. The questions are when and how?

We've seen in the past that bubbles can be sustained for a long time, even by this measure, so we can't assume house prices will come down now or even for years.

What's more, rents may rise all or part of the way, so that house prices don't need to fall so much to return to average. A sudden spike in rents over a few years would close the gap as effectively as falling house prices.

However, it's worth remembering that most other measures are showing house prices are overvalued too.

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