by Calculated Risk on 2/26/2009 04:22:00 PM

Yesterday I posted two graphs based on the Capital Assistance Program house price scenarios. The first graph was the change in nominal house prices, and the second was a house price-to-rent ratio (assuming rents are flat for the next two years).

But what if rents decline?

Here is a story from the Guardian in the UK: Steep fall in rents as unsold homes flood the market

A glut of unsold properties hitting the ­lettings market since the beginning of the year has pushed rents down by as much as 25% across Britain.
...
Average rents dropped to £795 a month in February compared to £950 in May last year, a fall of 16.3%, according to property search engine Globrix ...

It estimates that the number of new properties for let has jumped by 88% over the past year, with the biggest increase occurring since the start of 2009.

... FindaProperty said that the number of rental properties advertised on its site almost doubled between September 2008 and February 2009 ... average rental prices fell from £872 a month last year to £830 in February this year, and that landlords are offering lures such as free satellite TV and free weekly cleaner in a desperate attempt to secure new tenants.

Rents are declining in the U.S. too, although this hasn't shown up in the BLS' Owners Equivalent Rent.

Here is a graph that shows the price-to-rent ratio under three rent scenarios (using the "more severe" economic scenario). House prices are based on the Composite 10 index (used by Treasury) and are assumed to decline 22% in 2009 and 7% in 2010 under the "more severe" scenario.

Click on graph for larger image in new window.

This shows three scenarios for rents in the U.S. over the next two years: Flat, a 10% decline in rents, and a 25% decline in rents.

As I noted yesterday, with the "more severe" scenario and flat rents, the price-to-rent ratio will be slightly below the normal range. If rents fall 10%, this metric would be in the normal range, and with a 25% decline in rents house prices would be too high.

With the largest bubble in history, I'd expect house prices to overshoot and the price-to-rent ratio to decline to the bottom of the normal range. This suggests even a 10% decline in rents would make the "more severe" scenario too mild.