Home prices appear to be very attractive right now, after sharp declines following the collapse of the housing bubble. It would seem to be a good time to buy, but what if prices fall still further? Is there a good way to tell if your area is overvalued?
Judging whether a housing market is overvalued is more of an art than a science. Economists put a lot of time and effort into crunching numbers to try and determine if a market is overvalued or undervalued, and which way prices are likely to go in the future.
Rent to mortgage ratio
There is a fairly convenient method available to the average home shopper though, that doesn't require a degree in economics. It simply involves comparing local rents to mortgage costs for comparable properties. The beauty of this method is that it automatically accounts for a number of variables, such as income and relative demand, and produces a straightforward number that serves as a good rule of thumb regarding local real estate prices.
The key number here is 15. Historically, annual mortgage payments, including interest, run about 15 times higher than monthly rents on comparable properties in the same area. If the ratio is higher than that, it's a sign the market may be overvalued. Lower, the market may be undervalued and offer good bargains.
The ratio is based on assuming a 30-year fixed rate mortgage at the prevailing interest rates. To calculate it for your area, take the typical price for a home you're interested in, then compare it to an apartment or other rental with the same number of bedrooms and similar amenities and quality of living. Assume a 10 percent down payment and the going 30-year interest rate. You can use an online mortgage calculator, such as the ones available in the pulldown menu at the top of this page, to help you calculate the annual mortgage cost.
Lower ratio, stable market
If the ratio is 15 or below, it suggests the market is relatively stable and further steep drops are not likely. Ratios of 20 and above indicate the market may still be overvalued and could see further declines. Some of the areas that have experienced some of the steepest price declines in recent years still show high price to rent ratios. Both the Los Angeles and San Francisco markets still have price to rent ratios of 30 and above. However, bear in mind than areas with dense populations historically command higher home values and tend have higher price to rent ratios as a result.
There are a variety of ways to determine typical home prices and rents. There are a number of major companies that provide national sales prices, but these tend to deal with price averages and means of all homes, rather than just the ones in the category you're interested in.
The best way is probably to simply look your local real estate and rental listings online and compare properties in similar neighborhoods. Some real estate companies also track average rents and home prices in their local areas - search "average rents/home prices" with the name of your community to try to find them. It's not exact, but you're just looking for a rule of thumb here.
Again, this isn't a foolproof method but at least can provide you with an idea of how stable prices are likely to be in your area. It's one more piece of information to consider when making the decision whether or not to buy a home.