Home prices: Where's the bottom?

After two decades when home prices and rents changed at fairly similar paces, soaring home prices since 2000 have pushed the price-to-rent ratio about 33 percent above its long-run average, according to research by Merrill Lynch in New York.

For several decades, home prices have tended to rise faster than average wages. But the period since 2000 saw an even quicker rate of increase.

"Prices don't necessarily have to plunge," says Mark Zandi, chief economist at Moody's Economy.com in West Chester, Pa. "If rents and incomes increase by 5 percent per annum … we would be back to those historical norms" in about five years.

"More likely, prices fall 10 percent" or so, he says. That would restore balance to the housing market sooner.

Currently, the for-sale market has a 10-month supply of previously owned homes and a nine-month supply of newly built homes.

"They don't ring a bell at the top or the bottom" of a real estate cycle, Mr. Walters says. But a balanced market has about a six-month supply of homes.

"As you see fewer and fewer 'for sale' signs, that's an indicator," he says. "Maybe one per block" should be typical.

Just as stock market investors look at the ratio of a company's share price to its earnings, home buyers can look at the price-to-rent ratio.

Prices have outrun rents by a greater margin in some cities than in others, Merrill Lynch found in its research. Phoenix, Washington, New York, Miami, and West Coast cities lead the pack of high fliers. Prices in many inland cities don't look far out of kilter. But every region of the country is affected.

During the boom, borrowers and lenders both began believing that the rise in property values would never end.

Some evidence seemed to support this view. By one government index, home prices still haven't had an annual decline in a generation of tracking.

And the factors that determine a home's value aren't set like a foundation of poured concrete. For example, in recent years, innovations in finance have made credit more available and, often, cheaper. That can make homes more valuable compared with people's earning power.

Income hasn't kept pace

The typical home cost about three times the average annual household income in 1990. Today, it costs more than four times household income, which is currently about $48,000 a year, according to the Census Bureau.

It's not clear that prices have to fall back to the 1990 income ratio.

Much of the recent home-price run-up reflects speculation that urban land is becoming more valuable, says Robert Shiller, a Yale University economist who studies investment bubbles. He calls that assumption "vulnerable" now.

"Land prices outside of the cities are still quite low," he said in a recent briefing for reporters. "Agricultural land is only about $2,000 an acre."

Cities have long commanded a premium due to everything from high-paying jobs to cultural amenities. That won't totally change. For American buyers and sellers, it's just a question of haggling to find a new price level.

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