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The conditions are now right for homebuyers looking long-term

Finally, Time to Buy a House

U.S. house prices have fallen by nearly one-third in five years, and the nation's homeownership rate is dropping at the fastest rate since the Great Depression.

Two key measures now suggest it's an excellent time to buy a house as a long-term residence or an income property (but not necessarily for a quick flip). First, the nation's ratio of house prices to yearly rents is nearly restored to its pre-bubble average, suggesting the financial advantages of homeownership once again await buyers. Second, when ultra-low mortgage rates are taken into consideration, houses are the most affordable they've been in four decades of data.

Two mantras prevalent during the real estate bubble were that a house is the best investment you'll ever make and that a renter "throws money down the drain." Whether buying is a better financial deal than renting isn't a stagnant fact but a changing condition that depends on the relationship between prices and rents and the cost of financing, among other factors.

But the math is shifting in favor of buyers. Stock-oriented folks can think of a house's price-to-rent ratio as akin to a stock's price-to-earnings ratio in that it compares the cost of an asset with the money it's capable of generating. For investors, a lower ratio suggests more income for the price. For prospective homeowners, a lower ratio makes owning more attractive than renting, all else held equal.

Nationwide, the ratio of median home prices to rents on average-size apartments is 11.3, down from 18.5 at the height of the housing bubble, according to Moody's Analytics. The average price-to-rent ratio between 1989 and 2003 was about 10, according to Moody's. So valuations appear almost back to normal, on average.

But for most house buyers, mortgage rates are a key determinant of their total costs. Rates are so low right now that houses in many markets look like bargains, even if price-to-rent ratios aren't hitting new lows. The latest rate is still less than half the average since 1971.

As a result, house payments are more affordable than they've been in at least four decades of data. The National Association of Realtors Housing Affordability Index hit 183.7 in August, near a record high in data going back to 1970. A reading of 100 would mean that a median-income family with a 20% down-payment can afford a mortgage on a median-price home. The index's historic average reading is 120. So today's buyers can afford handsome houses -- but prudent ones might opt instead for moderate houses with skimpy payments.

For example, a median house in Phoenix costs $121,700, according to Zillow.com. With a 20% down-payment, a buyer's monthly payment would be about $470. Rent for a comparable house would be more than $1,100 a month, according to data provided by Zillow.com. That suggests buyers are much better off, even after adjusting for their additional expenses.

Of course, all of this assumes mortgages are available -- no given now that lending standards have tightened. But long-term data on down-payments and credit scores suggest conditions are more normal than many buyers think, according to Stan Humphries, chief economist at Zillow.com. "If you have good credit, a job and a down-payment, you can get a mortgage," says Mr. Humphries. "There's more paperwork and scrutiny than five years ago, but things are pretty much like they were in the '80s and '90s."

Not all housing markets are cheap, of course. Mr. Humphries says Zillow has developed a new price-to-rent ratio that uses price and rent estimates for each individual property rather than city medians, to better reflect the choices facing typical buyers. A fresh look at the numbers suggests Detroit and Miami are plenty cheap for buyers, with price-to-rent ratios of 5.6 and 7.7, respectively. New York and San Francisco might favor renters, with ratios of 17.6 and 17.2, respectively. The median ratio for 169 markets is 10.7.

For investors seeking income, one back-of-the-envelope way of seeing how these numbers stack up against yields for other assets is to divide 1 by the price-to-rent ratio, resulting in a rent yield. The median market's rent yield is 9.3% and Detroit's is 17.9%. From those yields, a real estate investor would have to subtract for taxes, insurance, upkeep and other expenses, and costs vary widely by market and case. But suppose total expenses are 4% of the purchase price. Rents for residential housing in many markets look attractive, even after expenses.

It's little wonder that, as The Wall Street Journal reported in August, even investment funds are dabbling in single-family houses.

A few caveats: First, not all transactions are average ones. Even in attractively priced markets, buyers should shop carefully. Second, prices may well fall further. Celia Chen, a senior director at Moody's Analytics, expects that prices will fall another 3% before bottoming early next year and rising slowly thereafter.

Third, property "flipping" can be dangerous even when prices are rising. That's because absent a real-estate boom, house price gains simply aren't that exciting. Research by Yale economist Robert Shiller suggests houses more or less track the rate of inflation over long time periods.

That's what we'd expect from something made from sticks and stones and other ordinary materials. Houses aren't the magic wealth creators they were made out to be during the bubble. But when prices are low, loans are cheap and attractive investment yields are scarce, as now, buyers should jump.
Source: “The conditions are now right for homebuyers looking long-term” SmartMoney (Oct. 14, 2011)