Real Estate: Buy, Sell, or Hold?

That's the question homeowners are asking in the midst of the worst real estate slump in decades. Our exclusive calculations can help you figure out what your house will be worth in coming years.

You can't blame America's homeowners for feeling hopelessly confused. From suburban porches and city terraces, they're gawking at a housing world gone mad. Just 18 months ago, folks on a tony Linden Lane or a leafy Boxwood Court were astounded to see the colonial their neighbors bought for $600,000 in 2000 sell for $1.5 million after multiple bids. Now they're just as bewildered to watch the same model across the street go begging for months at $1.1 million without a single offer.

The millions of Americans who believed yesterday's happy talk about housing are now paying the price, from couples who stretched to buy second homes, to true believers who drove the Florida condo craze, to executives who can't take that great new job in Charlotte without suffering a huge loss on the house purchased at the bubble's peak in Sacramento.

Now that the gilded forecasts have proved spectacularly wrong, homeowners don't know what to think about real estate's future. The dizzying rise sure didn't make sense. And the sudden slump doesn't seem any more logical. How can you make reasonable financial plans for the future if you have no idea what your house is worth?

Take a deep breath. We can't tell you what your house would fetch tomorrow. But we can help you through the fog of whipsawing prices and vacillating views to develop a clear picture of what your house will most likely be worth in five years or so. Over long periods housing, like stocks and bonds, follows a set of economic fundamentals. No matter how far prices get unhinged in a speculative craze - and we've just witnessed a blowout - those basic forces eventually regain their grip.

Many factors determine the value of a house. A family would consider the quality of local schools, the number of bedrooms, the size of the yard. Economists assessing a region look at interest rates, employment, and population growth. But over time the most reliable guide to home values is rents.

In most markets people won't lay out much more in monthly costs to own a house or condo than they would to rent a similar property unless they expect a huge profit when they sell. Indeed, speculators chasing quick profits did a lot to inflate the recent bubble.

But once the fervor fades, prices must fall to restore their normal, long-term relationship with rents. Rents exercise a kind of inevitable gravitational pull on prices. The ratio of prices to rents "behaves much like price/earnings ratios for stocks," says Yale economist Robert Shiller. "Like P/Es, price-to-rent ratios are mean-reverting." In other words, while prices soar from time to time, sending the ratio to exceptional heights, sooner or later the relationship is bound to return to its historical average.

So what are rents saying about home values today? To answer that question, Fortune worked with Moody's Economy.com to estimate adjustments needed to get prices and rents back in balance. We'll go into detail below, but the headline is gloomy: According to our calculations, prices in most markets will fall by double digits over the next five years.

Here's how we reached that disturbing conclusion. We started with the median price of existing homes in 54 metropolitan areas, using numbers from the National Association of Realtors. We then compared those prices with the annual rent on similar properties - houses, condos, and apartments with the same number of square feet as the median-priced house in each market - using figures prepared by Property & Portfolio Research, a commercial real estate research firm. That gave us a price/rent ratio for each area. Economy.com then compared the current P/R ratio with its average over the past 15 years and calculated how much it would have to decline to return to its historical norm. The average drop for all the markets we surveyed is 28%.

But that's not the whole story. The adjustment doesn't come exclusively from a fall in prices - rising rents also help close the gap. To complete the picture, Economy.com assembled a forecast of rental growth in each market; the average rise in our 54 markets is a total of 12% over the next five years. So to reach the average correction of 28%, prices need to drop only about 16%.

Of course, that's still a big bite. And in many areas the outlook is far worse. In the major Florida cities, Orlando, Miami, and Tampa, prices need to fall 28% to 34%. It's a similar story in inland California markets such as Sacramento (-26%) and the East Bay (-31%). In East Bay boom towns like Walnut Creek, a four-bedroom house that might have fetched $1.56 million in the spring may go for less than $1.1 million in five years.

In a handful of cities, our formula suggests that prices will actually rise. Home values should increase slightly in Dallas, Indianapolis, Cleveland, and a few other locales the bubble missed. In Detroit houses are so cheap - the median is around $100,000 - that even a shift in the economy from disastrous to mediocre is all that's needed to lift both rents and prices.

You can see the results for 54 areas around the country in this table. We also show the impact of the projected adjustment on a typical high-end house - one that sells for double the local median price - and indicate what that price will likely be five years from now.

We specify how much of the adjustment in each area will come from rent increases, and how much from price declines. Our forecast assumes moderate economic growth and job creation, and fairly stable interest rates. An unexpected boom or severe recession, of course, would change the picture.

One more note about our methodology. The home prices we used are taken from June data. At that point prices in many areas had already declined from their peaks. Since then, of course, we've had the subprime crisis and credit crunch, which have put further pressure on prices. So in many cities and towns, they have already started on the painful path back to rational levels.

To understand why the big price declines are inevitable, it's important to appreciate the giant chasm that opened between prices and rents, and how fast it happened. All through the 1990s the multiple of prices to rents nationwide remained between 14 and 15.

Then prices exploded for reasons that are now highly familiar. The most important was easy money. The 40-year-low interest rates that prevailed from 2003 to 2005, especially the irresistible teaser rates on adjustable loans, brought a flood of investors into the market. Lax lending standards allowed subprime borrowers, people with poor credit histories and erratic employment records, to suddenly afford to buy houses, further stoking demand.

By 2005 the Fed was aggressively raising rates to slake the coals. But the banks and Wall Street kept the party raging until late 2006 by concocting exotic mortgages that held down monthly payments for the first year or two and enabled buyers to keep paying outrageous prices. Then rising defaults forced lenders to scale back on loans to the high-risk borrowers driving the market. In July the subprime meltdown dealt the market a stiff blow by erasing the bargain rates that started the entire boom.

While prices rocketed, rents barely budged. From 2000 to 2006 they rose a total of about 10%, not even keeping pace with inflation. For a while, part - but only part - of the rise in prices relative to rents made sense. The drop in rates genuinely made houses far more affordable for millions of buyers. Between 2000 and early 2005 average mortgage rates, adjusted for inflation, declined from 5.5% to less than 4%.

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