article concluded that the risk

of a price bubble in the Texas

residential market was low. This

assertion has held true, as the

average price of homes sold in

Texas rose 6.1 percent in 2005

and 5.6 percent in 2006. The

latest 2007 estimates of average

home price appreciation show a

4.5 percent increase.

The median price of homes sold

in Texas rose 5.1 percent in 2005

and 4.6 percent in 2006. Estimated

median home price appreciation

for 2007 shows a 3 percent

increase.

fter a five-year boom fueled by

low mortgage rates and a growing

national economy, what

went up in the U.S. real estate

markets from 2001 to 2005 reversed

directions in 2006. Once

again the Real Estate Center is being

asked, “will there be a house price bubble in Texas?”

The initial response is that real estate markets are local and

regional markets, while national economic trends are averages

of local and regional economic indicators. Consequently,

what is said about national averages may not hold for local and

regional economies.

The risk of a housing price bubble in Texas is still low. Here

is why.

Prices of real estate properties, like other asset prices, are

equal to the sum of the present values of future streams of

earnings to be derived from the assets. House prices are equal

to the sum of the discounted values of future net rents. Net

rents are rents after deductions of housing costs (taxes and

maintenance costs). This fundamental relationship between

house prices and net rents may be disturbed in the short run by

supply and demand imbalances, but values of houses over their

useful lives are determined by net rents.

The relationship between house prices and rents resembles

the relationship between stock prices and dividends (or earnings),

but there is an important difference. While stock prices

and earnings are not influenced by the family incomes of

stockholders, house prices and rents are influenced by the family

incomes of owners and renters of dwelling units. Competition

among buyers and renters of residential units to buy or

rent “better” residential units makes regional family income

an important determinant of regional home prices and rents.

Abilene 70,100 5,532 12.7 64,500 5,244 12.3

Amarillo 95,800 6,108 15.7 92,700 5,544 16.7

Austin–Round Rock 164,100 8,100 20.3 161,000 7,608 21.2

Beaumont–Port Arthur 77,700 5,256 14.8 73,900 4,980 14.8

Brownsville-Harlingen 65,200 4,584 14.2 62,100 4,488 13.8

College Station–Bryan 112,000 6,276 17.8 105,200 6,372 16.5

Corpus Christi 92,200 6,288 14.7 83,500 6,324 13.2

Dallas–Fort Worth–Arlington 141,100 7,536 18.7 133,900 7,368 18.2

El Paso 88,000 5,472 16.1 78,600 5,220 15.1

Houston–Baytown–Sugar Land 129,800 7,236 17.9 123,400 6,960 17.7

Killeen–Temple–Fort Hood 97,900 6,588 14.9 93,800 6,480 14.5

Laredo 94,100 5,364 17.5 87,200 5,268 16.6

Longview 89,500 5,460 16.4 87,400 5,304 16.5

Lubbock 93,800 6,228 15.1 84,600 6,396 13.2

McAllen-Edinburg-Mission 66,500 4,644 14.3 61,200 4,704 13.0

Midland 87,800 5,400 16.3 85,200 4,980 17.1

Odessa 54,000 4,908 11.0 53,100 4,656 11.4

San Angelo 80,000 5,736 13.9 80,300 5,376 14.9

San Antonio 105,600 6,852 15.4 97,200 6,528 14.9

Sherman-Denison 86,400 5,880 14.7 90,600 5,736 15.8

Tyler 106,100 6,252 17.0 99,000 6,072 16.3

Victoria 85,700 5,364 16.0 72,800 5,424 13.4

Waco 92,200 5,748 16.0 89,200 5,628 15.8

Wichita Falls 79,800 5,496 14.5 74,000 5,520 13.4

Sources: U.S. Census Bureau and Real Estate Center at Texas A&M University

The stock market analogy suggests that price/earnings (P/E)

ratios for stock in stock markets contain the same information

as the ratio of home prices to rents in residential markets. P/E

ratio in stock markets is the ratio of expected future earnings

to current earnings. Higher P/E ratios imply higher expected

future earnings compared with current earnings.

If these expectations prove to be wrong, the market will

“correct” stock prices, and the prices will fall, resulting in

more appropriate P/E ratios. The severity of the correction

depends on how high the P/E ratios have been.

To know whether house prices in an area have risen to levels

not likely to be sustained by fundamentals, look at house

price/rent (P/R) ratios for houses in the area and compare them

with a “normal” P/R ratio for residential markets. But what is

a normal P/R ratio in the U.S. residential markets?

United States $226,900 1.00

Austin–Round Rock 171,700 0.76

Dallas–Fort Worth–Arlington 134,900 0.60

Houston–Baytown–Sugar Land 124,100 0.55

Sources: National Association of Realtors and Real Estate Center at Texas A&M University

House values are determined by net rents. Stock priceto-

earnings ratios can be helpful when studying home

price-to-rents ratios. Monitoring these ratios can yield a

“normal” price-to-rent ratio for an area, which in turn can

suggest whether a price bubble may occur.

Here again, the stock market analogy may help. The normal

P/E ratio in the stock market is the market P/E ratio — that

is, the average of P/E ratios for all stocks traded in the market

over a long period. The normal P/R ratio for the U.S. housing

markets is the average (or median) house price for the United

States divided by average (or median) annual rent for the

United States.

The argument for this method of computation of P/R ratio

is that local and regional house prices and rents in the United

States are mean-reverting variables because of the free flow of

resources and people. Regional and local rents and home prices

may deviate from the

national averages in the

short run, but they revert

to national averages in

the long run.

When P/R ratios for

residential markets are

computed, it is assumed

that the impact of family

incomes on house prices

is of the same magnitude

as the impact of family

incomes on rents.

This assumption is reasonable because in the long run, higher

incomes drive both house prices and rents.

ouse price/rent ratios are computed by

dividing the regional house prices

by regional rents in 2005 and 2006

(Table 1). The normal P/R ratio in

2005 — the P/R ratio for the United

States in 2005 — was 22.7. The P/R

ratio for Texas was 16.2, only 71

percent of the national average.

Among the state’s metropolitan areas,

Austin–Round Rock had the highest

P/R ratio (21.2) in 2005, followed by Dallas–Fort Worth–

Arlington (18.2), Houston–Baytown–Sugar Land (17.7) and

Midland (17.1). Odessa experienced the lowest P/R ratio (11.4)

in 2005, followed by Abilene (12.3), McAllen-Edinburg-Mission

(13.0), and Corpus Christi and Lubbock (13.2).

The P/R ratio for the United States rose from 22.7 in 2005

to 24.3 in 2006. Over the same period, the Texas P/R ratio rose

from 16.2 to 16.8. But despite this rise, the 2006 Texas P/R

ratio was still only 69.1 percent of the national average.

The P/R ratio for Austin–Round Rock in 2006 was 20.3,

smaller than in 2005. After Austin–Round Rock, Dallas–Fort

Worth–Arlington with 18.7 and Houston–Baytown–Sugar Land

with 17.9 had the largest P/R ratios, both larger than their 2005

ratios. The P/R ratio for San Antonio rose from 14.9 in 2005

to 15.4 in 2006 but was still significantly below the national

average.

The lower-than-national-average P/R ratios for Texas and

its metro areas suggest that the risk of a home price bubble is

minimal. In fact, the mean-reverting nature of home prices and

rents indicates that even higher home prices and rents may be

expected in the foreseeable future.

Movement of investment funds from and to different asset

classes as well as movement of people and resources from and

to different regions of the country result in the convergence of

the long-run P/R ratios for homes and the long-run P/E ratios

for stock prices. Analyzing long-run price and earning data for

stocks (from Shiller) suggests a long-run P/E ratio of about 20

for the U.S. stock market,

or a 5 percent yield

including inflation rate.

Assuming the same

long-term P/R ratio

for the U.S. residential

markets, the P/R ratios

for the United States in

2005 and 2006 exceeded

the long-term P/R ratio

(Table 1). There is much

news these days about

slower home price

growth and even home price decreases in a number of U.S. regions.

But all Texas metro areas except Austin have P/R ratios

of less than 20.

As in any economic study, some data and statistical problems

must be acknowledged. The home price data used in this

research are for owner-occupied units. Rent data are contract

rents defined by the U.S. Census Bureau as “rent agreed to or

contracted for, regardless of any furnishings, utilities, fees,

meals, or services that may be included.”

Regarding the home prices, prices for rental units and owneroccupied

units in any area normally follow each other although

with some time lags. The prices of apartments, condos and

co-ops — residential units mostly used for renting — in major

Texas metro areas were well below the national average in

third quarter 2007 (Table 2). The ratios of prices in metro areas

to the average price for the United States again indicate that

the risk of a home price bubble for Texas in current economic

conditions is low.

Real Estate Center.

D. Marc McDougal, Lubbock, chairman; Ronald C. Wakefield, San Antonio, vice chairman; James Michael Boyd, Houston; Catarina Gonzales Cron, Houston;

David E. Dalzell, Abilene; Tom H. Gann, Lufkin; Jacquelyn K. Hawkins, Austin; Barbara A. Russell, Denton; Douglas A. Schwartz, El Paso;

and John D. Eckstrum, Conroe, ex-officio representing the Texas Real Estate Commission.

are free to Texas real estate licensees. Other subscribers, $20 per year. Views expressed are those of the authors and do not imply endorsement by the

Real Estate Center, Mays Business School or Texas A&M University. The Texas A&M University System serves people of all ages, regardless of