In an efficient housing market, we should expect a house to behave somewhat as a bond or dividend paying stock would with the par value / selling price of the home changing to reflect the market rates that apply to the asset and the expectations about future rates. Since homes are largely purchased with borrowed money and capital should move to the optimal risk/return relationship, we should expect this relationship to exist, in some form.
Now we might argue that the housing market is not efficient and while this may be true over short and medium time horizons, no market can behave inefficiently (gross over/under valuation) over longer time horizons and certainly not forever.
Let's use a simple example:
Bob's house could sell for $1,000,000 today.
It could rent for $36,000 per year.
The gross yield is 3.6% - similar to what could be earned on a 10 year government bond. We can use high quality bonds as a proxy for the rate of return we should expect on a house - government and agency bonds are very liquid and very safe.
Let's assume that for whatever reason (inflation expectations, competing returns, currency devaluation, etc) the yield rises to 5% and the rent stays the same. What will Bob's house be worth in the new environment? House Value * 5% = $36,000 or House Value = $36,000 / 5%
The house would be worth $720,000 in the new return expectation environment.
This may bring up a valid question: What if rents rise with inflation? Good question, keeping in mind all that is required to move the bond market is EXPECTATIONS about inflation and not inflation itself, so the idea of rising rents correlating with expectations about inflation may be questionable. Rising rents require rising wages and there can be a significant lags between inflation expectations and wage increases.
Assuming rents rise over 10% to $40,000, let's use the example above where return expectations are now 5%. House Value = $40,000 / 5% The house would be worth $800,000 in the new return expectation environment.
These examples are grossly oversimplified with many unaccounted factors. We can crunch the numbers all day long but what I have intended to show is that in a rising rate environment we can expect house prices to fall to meet expectations about the return required on an investment. What we have experienced since 1982 is a falling rate environment where 10 year Government of Canada bond yields have fallen from over 16% to under 4%.
Assuming $40,000 annual gross yield:
House Value at 4% = $1,000,000
House Value at 16% = $250,000
Can interest rates fall from the current level? Are they more likely to rise? Will they stay the same? What about inflation expectations? What will the market's reaction be to inflation expectations?
If you want the current level of house prices to be maintained then you should be hoping for inflation expectations to remain low, that rates stay low, and that rents keep pace with incomes for a very long time. This probably would not bode well for economic prospects and consequently incomes and rents but alas you cannot have your cake and eat it too!
This chart shows home prices correlated to mortgage rates. You can see that when mortgage rates were much higher, home prices were much lower and that when mortgage rates have been lower, home prices have been higher. There is a lower bound to mortgage rates but no upper bound so you could say that the risks are lopsided.
Disclaimer: I am not pretending that we should value all homes like a bond or stock since clearly there are other factors at play such as densification, gentrification, decay, depreciation of structures, among other potential rewards and risks (real estate is not fungible). Additionally, rents can rise and fall unlike bond coupons which remain constant until maturity. The dividend discount model may be a good way to value a home based on cash flows but it can get pretty complicated and we must assume growth factors which is tricky at best.