Home Price to Rent Ratio

According to Case-Shiller data, the historical norm of home price to rent ratio is about 15 --- home price is about 15 times annual rent. I did some research and found that this ratio for high end homes and high income families with conventional mortgage is about 20 - 22 with tax savings and property tax factored in, at least in the first year.

The assumption is the following:
Home price range 800K to 1.2M
20% down payment
1.2% property tax rate
6% interest
Family at top tax bracket (Federal 35%)

I calculate the tax saving, and then subtract the tax saving from the mortgage interest payment and add the opportunity cost of down payment. The result is owner's effective annual cost. The home price is about 20 to 22 times this effective annual cost. Of course, any home maintainence cost or HOA, Home Insurance has not been counted for. And the assumption of 12 month rent may not be realistic either.

Owner's Effective Annual Cost =
Annual Mortgage Interest - Tax Saving + ( Down Payment * Savings Interest Rate)

Thus Price-rent ratio for high end homes can be as high as 20 to 22 instead of 15.

Some Observations:
This new Price-Rent ratio may justify some high prices in desired neighborhoods. But many neighborhoods in SF Bay area still seem too expensive even with this ratio, such as Palo Alto, Cupertino, Mission San Jose, Burlingame, Mountain View, etc. Even with the 20% price down from the peak, home prices in those areas are still over 25 times annual rent. On the other hand, some low-end neighborhoods in SF Bay area have seen the Price-Rent ratio come down to 15 to 20, such as most of Alameda County (excluding Mission San Jose of course).

Some conclusions:
Using price-rent ratio 15-18 for low-end houses and 20-22 for high-end houses in SF Bay area, the low-end seems much closer to a "fair" valuation than the high-end. Some low-end neighborhoods may have already reached the Case-Shiller's norm value of price-rent ratio. This is consistent with the comparison of price movement between the high-end and the low-end. The latter has come down by 30-40% from the peak due to large number of sub-prime foreclosures, while the former has only dropped 20% from the peak.

The downward pressure on prices still remains in the high-end real estate market. What can be even worse is that both interest rate and tax are going up (meaning less tax deduction from mortgage interest for high income earners). And rent in history never increases nearly as fast as interest rate during inflationary periods. And that will put downward pressure on the above calculated price-rent ratio for high end homes.