What are rents saying about home values today? To answer that question, Fortune worked with Moody's Economy.com to estimate adjustments needed to get prices and rents back in balance. According to our calculations, prices in most markets will fall by double digits over the next five years.
Here's how we reached that disturbing conclusion. We started with the median price of existing homes in 54 metropolitan areas, using numbers from the National Association of Realtors. We then compared those prices with the annual rent on similar properties - houses, condos, and apartments with the same number of square feet as the median-priced house in each market - using figures prepared by Property & Portfolio Research, a commercial real estate research firm. That gave us a price/rent ratio for each area. Economy.com then compared the current P/R ratio with its average over the past 15 years and calculated how much it would have to decline to return to its historical norm. The average drop for all the markets we surveyed is 28%.
But that's not the whole story. The adjustment doesn't come exclusively from a fall in prices - rising rents also help close the gap. To complete the picture, Economy.com assembled a forecast of rental growth in each market; the average rise in our 54 markets is a total of 12% over the next five years. So to reach the average correction of 28%, prices need to drop only about 16%.
Of course, that's still a big bite. And in many areas the outlook is far worse. In the major Florida cities, Orlando, Miami, and Tampa, prices need to fall 28% to 34%. It's a similar story in inland California markets such as Sacramento (-26%) and the East Bay (-31%). In East Bay boom towns like Walnut Creek, a four-bedroom house that might have fetched $1.56 million in the spring may go for less than $1.1 million in five years.
In a handful of cities, our formula suggests that prices will actually rise. Home values should increase slightly in Dallas, Indianapolis, Cleveland, and a few other locales the bubble missed. In Detroit houses are so cheap - the median is around $100,000 - that even a shift in the economy from disastrous to mediocre is all that's needed to lift both rents and prices.
You can see the results for 54 areas around the country in this table. We also show the impact of the projected adjustment on a typical high-end house - one that sells for double the local median price - and indicate what that price will likely be five years from now.
We specify how much of the adjustment in each area will come from rent increases, and how much from price declines. Our forecast assumes moderate economic growth and job creation, and fairly stable interest rates. An unexpected boom or severe recession, of course, would change the picture.
One more note about our methodology. The home prices we used are taken from June data. At that point prices in many areas had already declined from their peaks. Since then, of course, we've had the subprime crisis and credit crunch, which have put further pressure on prices. So in many cities and towns, they have already started on the painful path back to rational levels.