Residential housing does have a cash-saving value, if financed with a fixed rate mortgage. Over time, the growth in income and rents increases the cost of housing for renters. The inflation of housing costs for renters is greatly lessened for homeowners using a fixed-rate mortgage because their housing costs are effectively frozen at the rate of their ongoing mortgage payment. Other costs of home ownership, such as property taxes, insurance and maintenance do still rise with inflation, but since the mortgage payment is about two-thirds of the cost of ownership, fixing this amount provides a large benefit. Over time, the savings accruing to homeowners from a level housing payment can be quite substantial. Applying the technique of discounted cashflow analysis, this savings over time can be evaluated.

Since the savings grow every year, the value of the inflation premium grows as the term of ownership is extended, and this premium is not as sensitive to changes in the discount rate as is the appreciation premium. The premium accruing from the savings on rent can be substantial, but ownership periods vary, and the national average is less than 7 years; therefore, if a buyer pays this premium up front by paying more than the rental equivalent value, they do not reach breakeven for several years. In the early years of the mortgage, the owner who paid in excess of the rental equivalent value actually falls behind the renter in terms of out-of-pocket cash outlays for housing. Over time, as the renter faces yearly increases in rents, the homeowners will eventually be paying less, and the savings will make up for the earlier period of deficit.

The above analysis assumes renters face the full brunt of increasing rental rates. For many apartment dwellers, this is true as landlords will raise rents every year knowing that if a renter moves out, there will be another to replace them at market rates. The circumstance is a bit different for private landlords. Most private individuals that rent out investment properties are far more concerned with the loss of cashflow resulting from the property sitting vacant than they are about maximizing income through raising rents each year. Most long-term landlords have conventional, fixed-rate financing on their properties, and because their costs are not increasing, and because they do not want to endure vacancy loss, they seldom raise rents. When they do, they do not tend to raise them to market for fear of the tenant moving out. The result of this is that housing costs are somewhat fixed for long-term renters who rent from private individuals. These renters get to enjoy almost the same benefits of fixed housing costs as homeowners. The implication of this landlord behavior is that homeowners do not necessarily see the dramatic savings over renting suggested in the calculation of the inflation premium.

The investment value for home ownership is a combination of the appreciation value and the inflation value. Both accrue to homeowners for different reasons. The appreciation value is caused by the general tendency of house prices to increase over time with the inflation of income and rents. The inflation value is a cashflow savings accruing to owners as rental rates increase while their cost of ownership is fixed. There are many variables that influence the investment value, and much depends on the assumptions behind the variables selected. Based on a typical ownership period of 7 years, and an investment environment adhering to historic norms, residential real estate has an investment value of approximately 10% of the fundamental value of the property.

Buyers who pay this 10% premium will see a return on their investment if they stay in the property long enough. Buyers who pay premiums in excess of this amount or who own the property for shorter timeframes do not see a return on their investment. Buyers in the Great Housing Bubble paid well in excess of the fundamental and investment value of real estate primarily due to unrealistic expectations for appreciation. If a buyer believes properties are going to appreciate at a 15% rate every year forever, paying a 100% premium over fundamental value is justified; however, since house prices cannot rise at that rate in a sustained manner, such premiums are ill advised.

Price-to-income ratios represent the amount borrowed relative to the incomes of the borrower. There are many variables that impact house prices, and some of the variability in prices over time can be attributed to changes in these variables; however, since most houses are purchased with lender financing, and since lender financing is linked to income, the price-to-income ratio is the best metric for evaluating long-term housing price trends. The price-to-income ratio does not need to be adjusted for inflation as both prices and income will rise with the general level of inflation. Most of the fluctuations in the ratio are based on changes in financing terms, in particular interest rates, and of course, irrational exuberance.

The Great Housing Bubble saw unprecedented price-to-income ratios because interest rates were at historic lows and the use of exotic financing including negative amortization loans were at historic highs. When measured against historic norms of house price to income, the degree of price inflation was staggering. In markets where bubble behavior is not prevalent, price to income ratios hover between 2.3 and 2.8. In bubble markets there is a tendency to maintain higher ratios, and the range over time is much greater. Any ratio less than 3 is generally considered affordable.

In bubble markets ratios of 3 to 4 are as affordable as they get. Anything greater than 4 is a strain on family budgets and generally a sign of an inflated market. Ratios greater than 5 are considered very unaffordable and prone to high rates of default because they tend to be characterized by exotic financing. Price-to-income ratios in the bubble of the early 90s in California did not exceed 6 because interest rates were higher and because negative amortization loans were not widely available. During the Great Housing Bubble, the national ratio of house price to income increased 30% from 4.0 to 5.2. This means 30% more debt is serviced by the same income. Some of this increased ability to service debt is explained by lower interest rates and exotic loan terms, and some of increase came from people choosing to take on larger debt loads due to the irrational expectation of ever increasing house prices coupled with loose lending standards which enabled the populace to take on these debts. The national trends were small compared to the frenzied activities of bubble markets in California where most markets saw their house price to income ratio double.

Buyers were never forced to buy; it was always a choice. During the market rally, greedy buyers motivated by rising prices and fueled by loose lending standards were able to bid prices up to ridiculous levels. The exotic financing was not a result of high prices; it was the cause of high prices. Lenders were keen to offer these products because they were not taking the risk, and it allowed them to keep transaction volumes high which is how they were making money. By late 2007, the market balance had shifted from favoring sellers to favoring buyers. The once greedy buyers were becoming desperate sellers: their dreams of riches from perpetual appreciation were in tatters. Many were forced to sell due to their inability to make their mortgage payments. Those that hung on were homeowners with 50% or more of their income going toward paying off an asset which was declining in value. It was not a set of circumstances to be envied.

Residential housing does have a cash-saving value, if financed with a fixed rate mortgage. Over time, the growth in income and rents increases the cost of housing for renters. The inflation of housing costs for renters is greatly lessened for homeowners using a fixed-rate mortgage because their housing costs are effectively frozen at the rate of their ongoing mortgage payment. Other costs of home ownership, such as property taxes, insurance and maintenance do still rise with inflation, but since the mortgage payment is about two-thirds of the cost of ownership, fixing this amount provides a large benefit. Over time, the savings accruing to homeowners from a level housing payment can be quite substantial. Applying the technique of discounted cashflow analysis, this savings over time can be evaluated.

Since the savings grow every year, the value of the inflation premium grows as the term of ownership is extended, and this premium is not as sensitive to changes in the discount rate as is the appreciation premium. The premium accruing from the savings on rent can be substantial, but ownership periods vary, and the national average is less than 7 years; therefore, if a buyer pays this premium up front by paying more than the rental equivalent value, they do not reach breakeven for several years. In the early years of the mortgage, the owner who paid in excess of the rental equivalent value actually falls behind the renter in terms of out-of-pocket cash outlays for housing. Over time, as the renter faces yearly increases in rents, the homeowners will eventually be paying less, and the savings will make up for the earlier period of deficit.

The above analysis assumes renters face the full brunt of increasing rental rates. For many apartment dwellers, this is true as landlords will raise rents every year knowing that if a renter moves out, there will be another to replace them at market rates. The circumstance is a bit different for private landlords. Most private individuals that rent out investment properties are far more concerned with the loss of cashflow resulting from the property sitting vacant than they are about maximizing income through raising rents each year. Most long-term landlords have conventional, fixed-rate financing on their properties, and because their costs are not increasing, and because they do not want to endure vacancy loss, they seldom raise rents. When they do, they do not tend to raise them to market for fear of the tenant moving out. The result of this is that housing costs are somewhat fixed for long-term renters who rent from private individuals. These renters get to enjoy almost the same benefits of fixed housing costs as homeowners. The implication of this landlord behavior is that homeowners do not necessarily see the dramatic savings over renting suggested in the calculation of the inflation premium.

The investment value for home ownership is a combination of the appreciation value and the inflation value. Both accrue to homeowners for different reasons. The appreciation value is caused by the general tendency of house prices to increase over time with the inflation of income and rents. The inflation value is a cashflow savings accruing to owners as rental rates increase while their cost of ownership is fixed. There are many variables that influence the investment value, and much depends on the assumptions behind the variables selected. Based on a typical ownership period of 7 years, and an investment environment adhering to historic norms, residential real estate has an investment value of approximately 10% of the fundamental value of the property.

Buyers who pay this 10% premium will see a return on their investment if they stay in the property long enough. Buyers who pay premiums in excess of this amount or who own the property for shorter timeframes do not see a return on their investment. Buyers in the Great Housing Bubble paid well in excess of the fundamental and investment value of real estate primarily due to unrealistic expectations for appreciation. If a buyer believes properties are going to appreciate at a 15% rate every year forever, paying a 100% premium over fundamental value is justified; however, since house prices cannot rise at that rate in a sustained manner, such premiums are ill advised.