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Looking Past the Home Price Question

NEW YORK ( MainStreet ) -- Economists are furiously debating whether home prices are "bouncing along the bottom," ready to rebound, or poised for another dip. Millions of prospective homeowners are eagerly awaiting the conclusion. After all, no one wants to invest in a money loser.

But maybe those buyers are focused on the wrong question. Price is not as important as value, two measures that sound the same but aren't.

That's among the conclusions in a SmartMoney piece by Jack Hough, who uses home price data back to the 19th Century to show that, once inflation is figured in, home prices don't go up at all over the long term. There are spikes, like the one in the last decade, often followed by price collapses. But on average, home prices rise at the inflation rate. In contrast, some other investments, including stocks, rise considerably faster than inflation to produce real profits.

Experts have known for a long time that homes are not especially profitable investments, though it's hard to convince homeowners.

This does not mean, however, that a home is a bad buy. Instead, the home should be viewed as a purchase for consumption, just like shoes, cars and food -- necessities that produce no investment return. The home's value, as opposed to its price, is determined by how well it serves the owner's need for shelter.

And that largely depends on the cost of the alternative: rent.

Right now, home prices in many parts of the country are low relative to rent, making buying the better option. This is seen in the "rent yield," figured by dividing annual rent by the sales prices of comparable properties. If you paid $12,000 a year to rent a home worth $120,000, the rent yield would be 10%. Hough points out that even if you adjust for things like taxes and maintenance on the home, the yield in many markets exceeds 5%, not bad then considering bank savings are paying next to nothing.

Trulia.com has a rent-vs-buy index that shows markets where buying makes the most sense. This price-to-rent ratio divides home prices by rents, the inverse of the rent yield index, so the lower the number the better. (Convert it to rent yield by dividing 1 by the price-to-rent ratio.)

Trulia's most recent survey found it is cheaper to buy than to rent in 98 of the 100 largest markets.

Why has the balance shifted toward renting in so many places? It's a combination of the drop in home prices and the rise in rents due to greater demand from people who cannot buy or don't want to buy.

Buying does not make sense unless you plan to stay in the home for at least five years -- the longer the better. That will provide time for appreciation to cover buying and selling costs like the real estate agent's commission.

Finally, if the home is a consumption item and not an investment, it makes sense to buy the cheapest home that serves your needs. Buying a McMansion packed with rooms you rarely use is like buying a dozen eggs and letting half of them spoil.

By Jeff Brown

Jeff Brown's personal finance columns have appeared in over 100 newspapers. He has blogged for The New York Times and PBS' Nightly Business Report, and he writes regularly for Knowledge@Wharton, the business journal at the Wharton School at the University of Pennsylvania.

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