John Krainer and Chishen Wei of the San Francisco Fed discuss housing prices in the latest FRBSF Economic Letter:
The finance paradigm holds that an asset has a fundamental value that equals the sum of its future payoffs, each discounted back to the present by investors using rates that reflect their preferences. For stocks, the payoffs requiring discounting are the expected dividends. This approach can extend to housing by recognizing that a house yields a dividend in the form of the roof over the head of the occupant. The fundamental value of a house is the present value of the future housing service flows that it provides to the marginal buyer. In a well-functioning market, the value of the housing service flow should be approximated by the rental value of the house.
In other words, valuation in the housing market can be usefully characterized in terms of price-rent ratios:
Although the price-rent ratio is high by historical standards, Krainer and Wei don't see no stinking bubbles (except maybe here and there).
... almost all of the movement in the aggregate U.S. price-rent ratio was accounted for by two factors—the proxy for future growth in rents and the proxy for future returns. Put another way, other factors, such as bubbles, do not appear to be empirically important for explaining the behavior of the aggregate price-rent ratio. At the same time, when applied to local real estate markets, in many cases the movement in the price-rent ratio predicted by the model is much greater than the actual movement; specifically, the results indicate that something other than our measures of future rent growth and returns explains price-rent ratios.
If, however, you are convinced that house-price/rent ratios must fall, the authors suggest you think in terms of prices, and not rents.
The price-rent ratio for the U.S. and many regional markets is now much higher than its historical average value. We used a model from the finance literature to describe how the price-rent ratio can move over time. We found that most of the variance in the price-rent ratio is due to changes in future returns and not to changes in rents. This is relevant because it suggests the likely future path of the ratio. If the ratio is to return to its average level, it will probably do so through slower house price appreciation.