The United States Department of Labor Bureau of Labor Statistics measures the Rent of primary residence (rent) and Owners' equivalent rent of primary residence (rental equivalence).
They make this distinction because a house has both a consumptive purpose and an investment purpose.
The consumptive value is measured by rent or rental equivalence.
There is legitimate financial reason to pay more than the rental equivalence price.
The normal rate of house appreciation, not the unsustainable kind witnessed during the Great Housing Bubble, can provide a return on investment.
The source of this added value is the leverage of mortgage financing and the hedge against inflation obtained through a fixed-rate mortgage.
The investment premium, which is about 10%, is less than most people think.
The rental equivalence value is the fundamental value of real estate, and it is also its consumptive value.
There is an independent investment value that can also be measured and added to the consumptive value to arrive at the maximum resale value of the property.
Investment value is derived from two sources: the increase in property value through appreciation and the long-term savings over renting caused by inflation.
These two components can be measured independently.
Since the return on investment generated from residential real estate occurs in the future, a discounted cashflow analysis is required to determine the net present value of the future returns.
Calculating net present value sounds complex, and manually going through the calculations is quite cumbersome, but electronic spreadsheets make this an easy task.
The concept is simple: how much money would investors put money in an investment today if they knew the rate of growth and the cash value to be realized in the future.
For instance, if investors put $100 in a bank earning 5% interest, they would have $105 at the end of the year.
Net present value looks at the situation in reverse.
If investors knew they would receive $105 at the end of the year and the market interest rate was 5%, they would be willing to pay $100 for it today.
Similarly, the investment value of residential real estate is the value today of an amount of money to be received in the future either through sale or savings on rent.
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, 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.
The real investment value of residential real estate is almost universally over estimated by home buyers.
Many believe they will make a fortune in appreciation owning real estate.
Most have no idea what properties are really worth, what investments are, and how investment premiums are calculated.
These are the ones who overpaid for real estate during the Great Housing Bubble and lost a great deal of money.