The fundamental value of all housing prices is equivalent rents. Rents define the fundamental value of real estate because rental is a direct proxy for ownership; both rental and ownership provide for possession of property. Most people believe comparable sales define the value of real estate. In reality, comparable sales measure the collective foolishness of buyers who often have no idea what a property is really worth.



Equivalent rents are a major component of the United States Government’s Consumer Price Index (CPI). According to the US Department of Labor, "This approach measures the change in the price of the shelter services provided by owner-occupied housing. Rental equivalence measures the change in the implicit rent, which is the amount a homeowner would pay to rent, or would earn from renting, his or her home in a competitive market. Clearly, the rental value of owned homes is not an easily determined dollar amount, and Housing survey analysts must spend considerable time and effort in estimating this value." Prior to the first California housing bubble in the late 1970s, the housing cost component of the CPI was measured using actual price changes in the asset. When this bubble created an enormous distortion in this index, the rental equivalence model was constructed. It has been used to smooth out the psychologically-induced housing price bubbles ever since.

An argument can be made for the real cost of construction as the fundamental valuation of houses. If house prices in a market fall below the cost of new construction, no new houses will be built because a builder cannot make a profit. If there is continuing demand for housing, the lack of supply will create an imbalance which will cause prices to increase. When new construction becomes profitable again, new product will be brought to market bringing supply and demand back into balance. If demand continues to be strong, builders will increase production to meet this demand keeping prices near the real cost of construction.

Based on a theory of rational market participants, one would expect that when prices go up and the cost of ownership exceeds the cost of rental, people choose to rent rather than own, and the resulting drop in demand would depress home prices: The inverse would also be true. Therefore, the proxy relationship between rental and ownership would keep home prices tethered to rental rates. However, this is not the case. If there were only a consumptive value to real estate, the cost of ownership and the cost of rental probably would stay closely aligned; however, since there is an opportunity to profit from speculative excesses in the market, rising prices can lead to irrational exuberance as buyers chase speculative gains.

Rental rates tend to keep pace with wages because people normally pay rent out of current income. As people make more money, they compete for the available rentals and drive prices up at a rate about 1% greater than the overall rate of inflation. There are times when supply and demand issues in local markets create fluctuations in this relationship, but as a rule, rents track wages pretty closely. Since house prices are tied to rents, and rents are tied to wages, house prices are indirectly tied to wages. When house prices increase faster than wage growth, the price levels become unsustainable, and if the differential is too great, a bubble is inflated.

The Great Housing Bubble witnessed an unprecedented detachment from fundamental valuations. The crash in housing prices was no surprise to those who understand the real value of residential real estate. It was a complete surprise to those who foolishly believe comparable sales represent the true value of property.