I have been working for several weeks on a model for what the fundamentally correct price for homes. I'll tell you right off the bat that I'm not happy at all with the results.
First let's think about what factors would influence the demand curve for homes. Thinking back to micro 101, demand is a 4-part function.
- Price of the good.
- Price of other (related) goods. Here I think we're talking mostly about rental housing and the price of financing.
- Tastes and Preferences. Increasing or decreasing demand due to speculation would fall into this category.
The last 3 items form the demand curve, where the first causes movements along the demand curve. Basic price theory.
The supply of homes is a function of the marginal cost vs. marginal expected revenue. In thinking about where home prices are headed, we know supply from builders is going to be much lower in coming quarters. The variable is supply from foreclosures.
Anyway, let's start with some simple estimates of demand. Here is personal income versus OFHEO's home price index. Both are normalized to start at 1 in 1997. The gap between income gains and home price appreciation is 16%. So if you believe that home prices and income should rise at the same pace, then home prices need to fall 16%.
This kind of analysis is intuitively appealing. Its simple and logical. People can't afford to pay more and more for homes unless their income is rising as well. So you'd think that home prices should track income gains pretty well.
Unfortunately, the analysis doesn't hold up for various time frames. If we look back 15 years...
Homes look only about 7% over valued. And if we look back 20 years...
Homes are actually about 7% under valued! Given that interest rates are generally lower than they were in the 1980's and most of the early 90's, this would seem to imply that home affordability is better today than in 1987 or 1992. So you can't say that homes prices need to fall now because home affordability is worse than, say, in 2000 unless you can explain why 2000 is the right comparison date. Why not 2002? Or 1991? Or 1823? Unfortunately this problem crops up a lot in time series data analysis, and it's the kind of thing most members of the media rarely consider.
Anyway, the Housing Affordability Index calculated by the National Association of Realtors tells a similar story.
While home affordability is much worse than 5 or 10 years ago, its about the same as 20 years ago. Again, the problem is you don't know what the "right" comparison date is. Think about it this way. In 1997, the affordability index was 135 vs. 108 today. For the sake of argument, let's say a 20% decline in home prices would get us back to 135. But is 135 the equilibrium level? Why not 145 or 125? This doesn't invalidate home affordability as a statistic, but it does mean you need more to estimate what home prices "should" be.
Now let's consider something else about elementary price theory: all prices are set on the margin. I think this is the key to why home prices must fall from here.
By "set on the margin" what I mean is the price of a good is set when buyers and sellers agree on a price. But the overwhelming majority of homes aren't for sale on any given day. Similarly, most people aren't looking to buy a home on any given day. So when we estimate the price of homes, we can only use the small subset of home buyers and sellers to gauge overall home
Recently we went through a period where financing for homes was very easy. I've seen various estimations, but it sounds like sub-prime loans as a percentage of all mortgages went from about 5% in the mid 90's to about 20% in 2005-2006. In 2008, and probably for at least a few years thereafter, sub-prime lending is going to be very light indeed. I'd say that private sub-prime lending will be almost zero. I'll bet that almost all sub-prime lending will come from FHA or municipal housing agency programs. We also know that certain types of Alt-A loans, like Option ARMs won't be available, although we don't know what percentage of Option ARM borrowers could get a more standard loan going forward.
Mortgage originations involve both purchases and refinancings. But if we assume that sub-prime refinancings as a percentage of all originations is consistent with prime originations, we can assume that a decline in sub-prime originations would take 15% of all demand out of the market. How much in price decline that implies depends on the slope of the supply and demand curves. So while the 15% figure is nice, it doesn't tell us much.
Tougher credit standards will hit prime borrowers as well. Many people got piggy-back mortgages in recent years when they couldn't put 20% down. Today the market for these second mortgages is poor, and more people will be forced to pay mortgage insurance or not buy at all.
There will be secondary demand effects as well. The idea that home prices "can't" fall has been shattered. It is (was) commonly held that renting is throwing money away, while buying a house is an investment. Many families rented only as long as they had to. As soon as they could afford a house, they bought one. At least some of those buyers will remain renters longer in coming years, even if they can afford a house. Speculators are going to be absent entirely.
While interest rates are falling, I expect this to be a minor positive for demand. While it might make long-time home owners more able to trade up into a larger home, I think tighter credit standards will cause a smaller incoming class of first-time buyers. Rates would have to fall a good deal from here to make a big difference in demand.
Then we get to supply. New supply from builders is plummeting, down about 1 million units since 2005. All indications are that what is being built is mostly finishing developments already in progress, so we will probably see the housing starts keep falling, or at least stick where they are. This will be offset by foreclosures, but how many foreclosures we see is anybody's guess. Here is where the Hope Now Alliance and FHA Secure programs could make a big difference. If foreclosures wind up being spread out over a 3-4 year period that will have a considerably different impact on home prices than if they are concentrated in 2008.
Voluntary supply of existing homes, i.e., people just moving out, is likely to contract. Existing home sales is 26% lower today than the 2005-2006 average. People who bought a new house in 2006 or 2007 probably can't move until their nominal home price appreciation is zero, or until they save a relatively large amount of cash. Both of these will take time.
So you can see why I'm unhappy with the results. I was hoping for something more definitive, but I'm left with only directions. I know that demand is going to fall considerably. Bad for prices. Supply is also going to fall a good deal. Good for prices. My sense is that there will be enough foreclosures to keep supply close to 2006 levels, where as tighter credit will cause a plunge in demand.
Alright. If you stick a blaster to my head and make me pick a number, I'd say a real decline of 10-20%. 18% decline nationally puts us back to where we were in 2003, when interest rates were low, but the rise of no-doc and option-ARM and all that crap was still to come. So at least that's a semi-reasonable comparison to what demand might look like in 2008, when interest rates will be low and exotic mortgages will be rare. I'd then adjust the figure a couple ticks better because supply is likely to decline.
Again, if I have to guess, I'd say that this will happen in 18-24 months. For most of 2007, home sellers were hanging onto the illusion that nothing was wrong with the market and they could still get 2006 prices. Now it seems as though sellers are either pulling their homes from the market or marking them down to a clearing price. It will take some time for this process to complete, and pressure will build from home foreclosures, but my guess is that it doesn't take long for the losses to pass through.
Looking forward to comments, especially anyone who has access to quality data sets which would be useful.