Back in October 2004, Fed economist John Krainer and researcher Chishen Wei wrote a Fed letter: House Prices and Fundamental Value.



Kainer and Wei presented a price-to-rent ratio using the OFHEO house price index and the Owners' Equivalent Rent (OER) from the BLS.



Here is an update to their graph.



Click on image for larger graph in new window.



This graph shows the price to rent ratio (Dec 1982 = 1.0) for both the OFHEO House Price Index and the Case-Shiller National Home Price Index. For rents, the national Owners' Equivalent Rent from the BLS is used.



The Fed letter used the OFHEO index (Blue), but this index includes refinances and has other problems. The OFHEO index shows that prices have barely fallen from the recent peak, and therefore the price-to-rent ratio has barely declined.



Data is available quarterly for the Case-Shiller National Index starting in 1987. For this graph, the price-to-rent ratio for Case-Shiller in Q1 1987 was set to the OFHEO price-to-rent for Q1 1987.



Looking at the price-to-rent ratio based on the Case-Shiller index, the adjustment in the price-to-rent ratio is probably more than half way complete as of Q1 2008 on a national basis. This ratio will probably continue to decline with some combination of falling prices, and perhaps, rising rents. And the ratio may overshoot too.



The second graph shows the price-to-rent ratio for three cities: Los Angeles, Miami, and New York. On this monthly graph, January 1987 = 1.0. The OER from the BLS for each individual city is used.



Some combination of falling prices, and perhaps rising rents, will probably push the ratio back towards 1.0. By this measure of housing fundamentals, it appears that Miami has correct about 2/3 of the way to the eventual bottom, Los Angeles about half way, and New York about 40%.



This ratio has flaws, but it gives a general idea of how far prices need to fall (or rents increase). It would be nice to add Houston (with the booming energy business), but the data isn't available.