You can gain some insight into the pricing puzzle by focusing not just on home values, but on rental rates.
Housing economists have long used a home price/rent ratio as one way to gauge whether or not home prices are inflated or undervalued.
Moreover, on a very practical level, relating home prices to rents can give you a more detailed view of whether there's a financial payoff to homeowning, says Gary Smith, Pomona College professor and co-author of "Houseonomics."
A housing P/E
The use of a price/rent ratio is analogous to employing a price/earnings ratio for stocks. When a stock price is high, and its earnings per share relatively low, the P/E is high. A high P/E often indicates that the stock is too expensive and the share price is headed for a drop.
What someone is willing to pay to rent a place is that home's "earnings." And, just as in the stock market, a high home price related to the rental earnings mean homes values will probably drop.
For a specific look at how a home's P/E is determined, let's consider a home that is listed for either rent or sale in suburban Chicago.
The home has been rented for the past three years for $1,600 per month. It is currently listed for sale at $400,000. Dividing the price by the total annual rent of $19,200 gives a "housing P/E" of 20.83. According to Moody's Economy.com, the long-run average housing P/E is 16, so a P/E of 20.83 suggests that this home may be somewhat overpriced.
