Ratio rentals

WHEN The Economist last published its round-up of global house prices in September (see article) there were only two countries (Switzerland and China) in which prices were higher than a year earlier. Since then many housing markets have strengthened. The latest survey shows that house-price inflation has turned positive in six countries, and in Hong Kong the rate of increase is now in double digits. Even where prices are still falling year on year, markets are healing. In America the S&P/Case-Shiller index of prices in ten big cities was unchanged in October, after five monthly increases. That has left prices 6.4% below their levels 12 months earlier; go back a year and house-price deflation was almost three times as high.

That markets are now stabilising could suggest that prices have fallen far enough to correct the excesses of the global housing bubble. To test that hypothesis The Economist has created a fair-value measure for property based on the ratio of house prices to rents. The gauge is much like the price/earnings ratio used by stockmarket analysts. Just as the worth of a share is determined by the present value of future earnings, house prices should reflect the expected value of benefits that come from home ownership. These benefits are captured by the rents earned by property investors, which are equivalent to the tenancy costs saved by owner-occupiers.

Shares are deemed pricey when the p/e ratio is above its long-run average. Similarly, homebuyers are likely to be overpaying for property when the price-to-rents ratio is higher than normal. By that yardstick house prices seem low in only a handful of countries in our survey, as the final column in the table shows. One is Japan, where steadily falling property prices mean the price-to-rents ratio is 34% below its average since 1975. Switzerland's ratio is also less than its long-run average. Germany looks cheap as well, and since our valuation benchmark goes back only to 1996 and so misses out a period when German house prices were frothier, may be cheaper still.

The global housing bubble passed Japan and Germany by, so it is not surprising to learn that housing is cheap there. A more striking finding is that America's housing bust has taken prices back to their long-run average value against rents. Based on the Case-Shiller national index, American house prices had fallen to 3% below their fair value by the third quarter of 2009, well down from their inflated values at the start of 2006 (see chart). Another index from the Federal Housing Finance Agency, the regulator of Fannie Mae and Freddie Mac, tells a different story. On that basis America's house price-to-rents ratio is still some 14% above its average. But that measure may not fully capture how far values have fallen, as it excludes homes that were paid for with subprime mortgages, for which fire sales are more common.

The correction in house prices has not gone as far in other countries. In Britain, where prices are increasing again, housing still looks expensive (if not quite as dear as in Australia). Prices in China are rising, too, but its market does not yet look bubbly. Hong Kong is a different matter. Its notoriously volatile market is booming again, even though the price-to-rents ratio is already more than 50% above its historical average. At least house prices are still falling in the euro area's overvalued markets, such as France, Spain and Ireland.

No valuation measure is perfect. One flaw with the price-to-rents gauge is that it takes no account of shifts in real interest rates. Spain and Ireland have enjoyed far lower real rates than they did before they joined the euro in 1999. These might justify smaller rental yields and thus a higher fair-value price-to-rents ratio than suggested by history. That would help explain why Spain's price-to-rents ratio has trended upwards over time, in contrast with Britain's, which has fluctuated more obviously around its long-run average.

Partly for this reason, fair-value gauges can also be sensitive to how far back the figures go for each country. Ireland may look less overvalued than Spain because the available data go back only to 1990 and omit a period of less bouncy markets. If the average price-to-rents ratio is calculated from 1990 onwards, Spain's market is overvalued by 24%, rather than the 55% shown in the table (based on figures from 1975). That would make both markets similarly overpriced.

In spite of these blemishes, the price-to-rents gauge is a useful check on how puffed-up property markets are. A housing boom turns into a bubble when prices are driven up by expectations of future price gains. Scarcity of supply or population shifts are often used to rationalise high house prices, but such fundamentals should push up rents, too. That house prices in America are back in line with rents suggests the worst of its correction is over (although a further downward leg is possible since past housing busts have pushed prices below their fair value and there is a large stock of unsold houses to clear). Europe's housing correction, however, seems far from over.