Tuesday, December 18, 2007

Housing prices: We're in for it as it is!

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.
  • Income.
  • 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.


Anonymous said...

I don't know how you would do it but, on the income side, you'd also have to account for the increasing income inequality as well. In other words, people in the top 5% or so are not going to buy 95 extra houses to make up for all those who can no longer afford one. Over-simplified but you get my point; especially when real wages are falling for most people.

Anonymous said...

Using the NAR housing affordability measure as a proxy for future demand across all markets is too broad brush. This approach overstates affordability in some of the markets with the most egregous mismatches between demand and supply. Put another way, affordability should be applied locally to arrive at local shifted long term demand curves.

Of course, I am implying that HPA has to decline more dramatically than 15% in some markets.

Anonymous said...

I was thinking the same thing - given that home ownership rates are in the high sixties, it seems to me that 33-percentile income would be a better numerator for affordability of existing stock. Perhaps 66-percentile is a better numerator for new supply?

At any rate, I'd suggest a simple regression as a first step. How well does NAR affordability predict prices 1-, 2- and 3-years forward?

Sivaram V said...

Here's a newbie thought... why not look at valuation similar to equities?

For equities, a commonly used crude way for valuation is to use the price to earnings ratio. A similar thing for housing would be home price to rent. See what you see with that ratio. I have seen some writers look at that and I am thinking that is a better measure than looking at building permits, home prices, incomes, etc, in isolation.

Accrued Interest said...

I think in theory, rental rates is the perfect way to measure it. I'm not convinced rental rates on "typical" apartments have much to do with "typical" houses. I mean, in many neighborhoods, houses of that type are rarely rented.

To Anon on income inequality: I think there is something to this. The NAR data is based on median income (as opposed to total income) which gets at your point a little.

Another problem I don't mention in the post is that its not unreasonable for consumers to decide to put more of their budget toward housing. So that would allow for home prices to rise faster than income.

And affordablility is obviously a local issue. I think if you could take a given area, figure what percentage of homes were purchased with exotic mortgage plus what percentage were purchased by speculators, you'd know where the biggest declines are coming.

James: I'll look at a lagged regression when I have a chance.

Anonymous said...

We see across the globe that economic decisions are based, perhaps in great part, on "psychology". I don't know how to put psychology in the equation, and I also don't know if the invisible hand is supposed to take care of 100% of psychology. I do believe that deflationary environments depend on psychology: prices are going down so I will not buy now. If enough people, on the margin, believe that, then it is a self-fulfilling prophecy.

I happen to know a tiny bit about the real estate market in East Hampton NY, one of the most affluent resorts in the US. If you go to the local newspaper's website www.easthamptonstar.com you can see recently recorded deeds with prices and addresses.

A house recently changed hands at 20 Conklin Court or Circle for over $2,000,000. Just to begin with, the house is very definitely on the wrong side of the tracks. It has no cachet whatsoever. And then there's the question: who paid that amount of money?

Either prices generally are going to catch up with housing, or housing is go back to a CPI like appreciation.

Anonymous said...

Use auto-correlation (i.e. lagged HPI), probably something like a year, and then normalize income by population growth. This gives a decent model log-model of house prices. You can also throw in a seasonal component, but that's only minor.

Anonymous said...

I have a couple methodological points concerning this discussion. First, OFHEO HPI only tracks a specific subset of real estate transactions, namely same property purchases channeled through FNMA and FRE. Thus a broad spectrum of transactions are not addressed, especially upward distortions in home prices are underestimated because of conforming limit restrictions on GSE loans. Therefore your HPI vs income charts are skewed. Second, I’m not certain if N.A.R. followed the revisions of C.A.R., but C.A.R., in 2006, changed their methodology for calculating affordability. The numbers for affordability in California had been coming in at awful levels by 2006 which was I think part of C.A.R.’s motivation (though they claimed it was just accounting for changes in how people bought homes.) Single digit affordability in some areas was becoming common, and trying to sell something that almost no one can afford, well, let’s just say it dampens the enthusiasm. Not to mention it riles the legislature and agitates regulators.

The CAR methodology was changed in Q2 2006 in the following ways:

1) 20% down payment assumption replaced with 10%
2) 30 year fixed rate mortgage replaced with ARM
3) 30% of gross earnings devoted to housing expenditures increased to 40%

As you can see these changes dramatically increase the perception of “affordability,” and if you’re an old-fashioned risk manager should set off alarms. As I said, I’m not certain if the National Association did the same thing, but certainly for California and anywhere else these changes were implemented I would exercise meticulous caution in using the Association numbers.

As an example of how much these changes impacted the HAI see the following:


I see that you read Calculated Risk so you are already aware of the copious charts and data there, but thought I’d point it out for those not familiar. Well worth reading currently and digging into historically if you want to understand what is happening with housing.

Unsympathetic said...
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Unsympathetic said...

If you want a price index, use a weighted average of case-shiller indices rather than OFHEO. OFHEO only covers "mortgages have been purchased or securitized by Fannie Mae or Freddie Mac." - as copy-pasted from their info page. The upper limit on these loans is $417,000.. homes in this data set may appreciate, but the major pain won't be here, because 10-20% swings would only take you up to 500k or down to 300k. When you include the massive number of 500-1500k McMansions, which is the main group for which I think prices will fall a great deal, you'll get a vastly different trendline.

20 years ago for affordability sounds about right.. that's when 20% down was still in vogue.

I'm in the camp of a 30% nominal drop, before factoring in whatever stupid hyperinflationary move Ben the Bearded uses to attempt to stimulate the economy.

Anonymous said...

Here is another way to look at this problem.

We can divide the housing market into three groups.

1. Areas with a lot of historic growth but are declining slowly or not at all during 2007. We can assume this group will stagnate but not drop significantly. Since I live in the Silicon Valley, I would include San Francisco/San Jose in this category. Other possible candidates include Hawaii, NYC etc.

2. Area with a lot of speculation where housing prices have fallen significantly. We can assume that there will continue to be downward pressure on this group. As a data point, I was at an auction for homes in the Stockton/Sacramento area in Sept. All the homes were eventually sold, mostly at 25~30% discount from peak prices. If I had to guess for this area, I would say that prices would drop another 20% for this area as there were rampant speculation prior to 2007. Other candidates include Las Vegas, FL. etc.

3. Areas that were not touched by the housing boom. This may actually account for a large swarth of America. For this group, we can assume the normal inflation rate of growth.

If we take a small representative sample of each types, figure out how big a pie they represent, we should be able to do a deep dive to each locale and come up with a better picture of the aggregate.


Accrued Interest said...

As to the psychology... its entirely possible that housing prices over shoot on the downside in the next year or two. In other words, we could do perfect analysis and figure that the "fair-value" price is 10% below current, and yet still wind up with 20% declines.

As to analyzing the numbers locally, that's really how you'd have to do it to get an accurate number.

I've been thinking that we may see national home price declines that are relatively modest, maybe 5% in real terms. But this won't be the relevant number for banks liquidating sub-prime foreclosures. First, a soft market probably increases the discount banks take at auction. Second, its my belief that a lot of the no-doc loans were really speculator/second homes in disguise. So those buyers may walk away from a "flip" that isn't complete, and the house isn't in condition for anyone to move in. That's got to hurt the resale!

Anonymous said...

I think if the liquidity crisis improves and normal mortgages start flowing again (no crazy mortgages anymore, please), the market will flatten out and stay flat, until affordability improves.

Large nominal declines are unlikely, simply because people cannot sell when their mortgage is under water.
I think in an environment of declining nominal prices, supply will quickly dry up, except for distress sales.

Accrued Interest said...

EJ: I'd agree with you except that I think investment and foreclosed properties will result in more forced sales than in past cycles. I mean, we saw significant negative real HPI in the early 90's, but I think this time will be worse.

I think to say we'll see 20% nominal losses is hard to swallow. But like 10% isn't. If we need to see 20% real declines, then it will take a while, as EJ suggests.

BTW, great comments every one. Haven't had "my Haiku on how the world is ending" comments yet! I thought a post on negative HPI would really bring out the crazies.

DAB said...

I disagree that there is a supply component of the equation that is favorable for home prices. To the extent that people are not now leaving their homes to sell and cash out as they did in the past, that reflects price intercept on the supply curve, not a change in supply.

My belief in the South Florida market had been that my price was probably supported since the entire nation had to go to hell before it fed into that market. Demand had been coming from people cashing out in the Northeast and even the supposedly less affected areas of the mid-west. Then it all did go to hell. Fortunately for me I was able to get out with a profit when I had to move for job related reasons. I was also one of the few people in the real estate market down there who had seen the last boom and bust. What people buying there did not realize was that the 80s saw almost as big a boom in real estate and the resultant bust took from 1990 to 2002ish to straighten out.

Because I had seen the last bust, I was never one of the ultra bulls and knew I was only on for the ride...

Anonymous said...

I'm partial to looking at price/rent ratios myself. More locally, I happen to be renting a very new apartment (completed in 2005) and there's a new condo complex a couple of miles away that is in the process of going up (that is a very close match to my current rental). The last time I dove deep and did the price/rent analysis (figuring in things like taxes, unbundling utility costs, etc.) it wasn't a contest - renting clearly made much more sense.

The interesting question is whether that calculation will hold over the winter (the complex has two buildings up with a third coming, and even the first is nowhere near selling out, so I'm expecting they will get desperate sooner or later).

Anonymous said...

Good post and discussion of the supply and demand variables. However, I think you are being too optimistic, at least in the near term.

I think you have underestimated the impact of subprime on the purchase side of the mortgage market. Tanta had a post up recently that described how in the good old days, subprime was primarily a refinance mechanism for failed prime borrowers, not a purchase vehicle for marginal new buyers. I suspect the impact on marginal purchase demand was large in 04-06.

I suspect you have also underestimated the new home supply due to the impact of cancelled purchase contracts (CR has posted about this). Also, while the start rate has come down, for builders that are long too much land, building houses on it is the only hope they have of creating liquidity, so some of them will keep building (longer than economics would dictate they should) until the banks cut them off.

Why are you focusing on trended stats rather than looking at a distribution of the value of ratios over time to take out the impact of the start date? It seems to me there are many housing ratios (OO vacancy rate, price to rent, price to income, home ownership rate - just a few that come to mind) that are well into the 2nd if not 3rd standard deviation of observed historical values. I think it is very hard to make the case that prices were not extremely stretched by historical metrics.

Finally, we need to factor in the pyschological aftermath of a bubble. Armies, governments and banks are always fighting the last war. Lending standards are not just going back to 2003. The securitization market is not going back to business as usual. By the time this is all over, the Fed, Congress, bank BOD's etc, will make sure that, by God, THIS WILL NEVER HAPPEN AGAIN (for evidence see SarBox) and they will overshoot on the side of conservatism with underwriting standards and regulations (for example real, documented DTI (including T&I), at much lower levels, is going to loom large and lenders will no longer use FICO as a measure of debt capacity) - so demand is going to settle, at least for a period of time, at a level below where it was before the bubble started.

Anonymous said...

you should rename this blog the justify the status quo blog... its really gone down hill lately

Anonymous said...

5:12 PM: “Large nominal declines are unlikely, simply because people cannot sell when their mortgage is under water.”

This is incorrect. In states where mortgages are non-recourse like California (with the exception of non-purchase money mortgages) buyers can walk away with no deficiency judgment or personal liability. There can be tax implications, but this is a matter of calculating costs and risks of further loses rather than an obstruction to under water people selling or simply walking away. Furthermore short sales (sales where the asking price is below the mortgage and lenders agree to the sale) are tolerated by banks in declining markets to mitigate the losses of further value erosion or foreclosure costs. Foreclosure and REO is expensive and lenders are motivated to avoid them therefore short sales are increasing and likely to continue to do so. A further dangerous factor in this most recent real estate boom is the proliferation of ARMs and teaser rates because resets can be quite simply unaffordable. Defaults and foreclosures then ensue regardless of whether homeowners are under water or not. Being under water is thus somewhat of a non-issue other than perhaps from a behavioral finance perspective (unwillingness to realize a loss) or the importance of credit standing to an individual.

To figure out the likelihood of people selling homes short or simply walking away I would look at cost to rent vs cost to own and the likelihood of price declines. As long as rents lag the carrying costs of ownership there is enormous incentive to abandon ownership. In addition, with the heavy leverage employed in real estate, a 10% nominal decline can do enormous damage to someone with only 5, 10 or 20% equity. What incentive is there for this person to stay in their home? Especially if that equity is part of their life savings or part of a retirement strategy. If the importance of ownership per se outweighs the risk of going upside down or losing 50-100% of one’s equity then that person will likely stay. However, I suspect there are many to whom such an outcome is viewed with a motivating distaste. There is little, and perhaps in some cases no incentive to stay in a high carrying cost situation with declining equity when cheaper alternatives exist in the form of rentals and one has little to lose by leaving other than a temporarily damaged credit rating and wounded ego.

Obviously those with substantial equity are not accounted for in the same way, but it would be dangerous to underestimate the number of properties exposed to an incentive to sell at a loss or simply walk away. If anything, the most dangerous aspect of the housing and credit bubble so far is the degree to which its hazards have been consistently underestimated.

Anonymous said...
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Accrued Interest said...

DAB: I think you are technically right about secondary market supply. Practically though if fewer secondary homes are on the market, then all else being equal, prices should be higher. Or vice versa.

I supposed in my post that I thought effective supply would be around 2006 levels, but demand would be a good deal lower. So I'm agreeing in principal with the comments that mitigate any positive supply effect.

I think DAB and JS's comments about Florida and California suggest that there is a limit to "unwilling to take a loss" effect. If we get into a very hot market (especially with a large number of speculators), all bets are off. Because there you may have so much foreclosures or other sellers who don't care what price they get.

I know there are still people out there who think that any large nominal price declines will be limited to these hot markets. While I do think that what happens in SoCal will be totally different than what happens in Kansas, the sub-prime/speculator effect is everywhere. Maybe just some places more than others. I think almost all markets will suffer real price declines.

Anonymous said...

Haven't had "my Haiku on how the world is ending" comments yet!

The end of the world!
Punish the speculators
unless bail-outs cheat.

or maybe

My father's sister
Reads Accrued Interest nightly
Status quo auntie.

Accrued Interest said...

Brian: I've read that from Tanta. Its a lot like high-yield bonds used to be just fallen angels. Anyway, if you assume sub-prime originations actually go to zero, I don't think the basic analysis changes too much.

To all who suggest price/rent, I agree 100% with the concept, I just haven't found a data set that I think works. In the Baltimore area, a 4 bedroom house in a nice suburban neighborhood probably goes for $500-800,000 depending on where it is. Houses like that aren't often rented, and even where they are, it isn't like anyone is keeping long-term stats on it. Now if you owned a house like that and could find a couple rental listings, then you could do your own calculation. That's perfectly logical. But trying to extrapolate that nationwide seems fraught with data problems.

As far as people just choosing to walk away... I believe that will happen quite a bit, especially in formerly hot markets. But I'm assuming that kind of behavior when I'm estimating foreclosures. Again, I think effective supply falls but more like to 2006 type levels not enough to prevent negative HPI.

Accrued Interest said...

Thanks James... now things feel normal.

BackOfficeMonkey said...

Most homes are sold in the spring/summer so a dummy variable for seasonality should be included.

Thinking about the driving forces of housing demand for the past half a decade it seems like HPA speculation was a big driver in many areas so maybe another variable would be risk premiums.

I think you are taking out of samples of the population when you are comparing 1960s-80 to 1990-00. MBS weren't even trading let alone subprime loans.

Anonymous said...

While it might make long-time home owners more able to trade up into a larger home ...

But few can do that unless they can sell their current home for a good price.

In the Baltimore area, a 4 bedroom house in a nice suburban neighborhood probably goes for $500-800,000 depending on where it is. Houses like that aren't often rented ...

That used to be so in the suburbs of Chicago, too. But not any more. Since this summer there has been a very ample supply of such homes for rent. Ironically, you could still say that they "aren't often rented," as the asking rents are clearly above what the market will bear, and they just sit empty. One large, lovely 4-bedroom home in the $500k+ range that was put out for rent in July asking $3,000/mo is still vacant though asking was dropped to $2,300 in Sept. and then to $2,000 in Nov.

In the last few months there has been an avalanche of $350k+ homes onto the Yahoo foreclosure listings for Arlington Heights and Palatine.

mOOm said...

The alternative approach is to use the discounted sum of implicit future income from the asset which includes rent avoided and capital gains minus maintenance, taxes etc. One question is what discount rate to use... the calculation can show what level of required price appreciation is needed to justify current prices.

In the long-run without locational constraints - i.e. unlimited equally accessible land I'd expect house prices (for a fixed quality and size house) to rise at the rate of inflation in construction costs. With constrained land they could rise at the rate of nominal income growth in the long-run. Changes in size and quality though might result in houses rising near or at the rate of income growth even when land wasn't constrained.

Anonymous said...

"To all who suggest price/rent, I agree 100% with the concept"
[AI 8:09 PM]

I strongly disagree. Can't give you numbers, just 35 years of renting and looking at home prices.

There is a premium people are more than willing to pay for their own home. Part of it is because they think thats the best deal they're going to get, e.g. Why would they lend me money if its more than I can afford?[dau. in law commenting on her 30-year fixed].

Its also nesting. The local school is a big concern, so the home's got to be in the right neighborhood, and its got to be a home, not an apartment.

Can't tell you how to quantify it, but homeowners will take a great deal more grief from a HomeOwners' Association than they ever would from a landlord.

Stability. When you own your own home, no landlord can ever force you to move unexpectedly because there's a local boom and they want to put the house on the market.
Aside: For the owner-occupied homes, I think this desire for stability undermines the idea a homeowner will walk if they're underwater. I suspect some will, but generally they'll be as sticky as home prices used to be.

Anonymous said...

From FormerlyknownasJS:
"In states where mortgages are non-recourse like California (with the exception of non-purchase money mortgages) buyers can walk away with no deficiency judgment or personal liability."

Personally, I think this is the MAJOR reason that the housing crash is so bad in the US. Why anyone would want to lend money to someone to buy an asset, when they can just hand you that asset if it falls in value, I don't know. It's like selling a free Put option. So the banks are going to get a TON of real-estate put back to them.

You wouldn't offer free Puts to anyone on stocks, so why do it on housing?

If the bank was able to chase you for the difference in the house value and your mortgage, and get access to other assets of yours, chasing you into bankruptcy if necessary, then you would NOT have had a housing crash nearly as bad as it is, as people would make more effort to keep paying their mortgages.

Anonymous said...

First of all, I agree with this:

Second, its my belief that a lot of the no-doc loans were really speculator/second homes in disguise. So those buyers may walk away from a "flip" that isn't complete, and the house isn't in condition for anyone to move in. That's got to hurt the resale!

Second I draw attention to this quote from the FT:

“A lot of bad US news is already priced into the financial markets, which should ensure that risk aversion does not rise into the year end,” he says.

I vehemently disagree with that. Yes, I am a permabear, but I am also an ultrabear. There are just too many negatives bearing down on the potential homeowner at this time:

Taxes are going to go up. I know that if you have a private shrine in your home to some weird genetic amalgam of Alan Greenspan and Grover Norquist, this statement makes your blood boil, but it is true.

Fossil fuels are going to go up. I recommend once again www.theoildrum.com for intelligent analysis of peak oil.

The war in Iraq is very, very expensive and it is the ultimate tar baby.

The American wage earner has been emasculated (economically) by wage earners in other countries. Income will decline or remain flat.

In sum, I don't think anything even remotely resembling all the bad news has been factored into the financial markets.

Finally, I think the price/rent ratio is the one to focus on...as everyone seems to agree. In the last analysis (and we're getting to the last analysis pretty fast), if your payments on a house exceed what you can rent it for, you either have to live in it or abandon it. If you live in it, you have to have the income from someplace else, other than rent, to support the payments. So, you either have to rent yourself or rent your house. The house on the wrong side of the tracks in East Hampton that I mentioned? Well, one thing about it is true, ineluctably true: it can't support itself through rent.

Let's say that you "only" borrowed $500,000 to buy it (recall it sold for over $2,000,000). The takes on it are probably manageable, somewhere around $8,000/yr. The payments on the mortgage are about $30,000 per year. And you have to keep it up. You're facing a nut of at least $40,000 per year. It can't be rented in the summer for that, and it can't be rented year around for that. Either that house is owned without any appreciable debt at all, or it is owned by someone who has the income to invest over $2,000,000 in what is basically a tract home in an undesirable neighborhood that produces negative income. To me, it doesn't add up.

Anonymous said...

Forget FHASecure being helpful -- nobody can qualify.

See Housing Wire, which reports that only 266 people have qualified for the program in the two months since it was introduced.


DAB said...
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DAB said...

There is one other huge wild card in the home price equation. Employment. That is one reason the Palm Beach County prices have fallen off a cliff. There is no local job market there to speak of. Thus, when the support of prices evaporated from other parts of the country there was nothing to keep people there.

An economist I saw give a presentation last spring basically dismissed housing as much of a threat to the US economy based on employment. At that time he reported that subprime was 20% of the market and 20% of subprime was in trouble and it was not likely to get worse. So 4% of the market was and would be in trouble. Now we know that at least 6% of the total mortgage market is in trouble, that number is rising, and it includes loans that were not initially cast as subprime.

However, his point still stands that if people are in their homes and have jobs they are not too likely to lose their homes. So he could not paint as sanguine a picture today, but the overall picture is not too bad yet. The key is he focused on the unemployment rate. Since it does reflect the margin, and was (and is still) low, it is supportive of downward stickeyness.

My question then gets back to the following: is unemployment the meaningful figure? What about total employment, which has been in decline for years? I will admit that what the hell these people without jobs are doing has been a mystery to me for a while ever since they started being reported on several years ago. 50 year old dudes just sitting around their houses knowing they don’t have the money to retire or do that forever. Some of those people had to be waiting out not having jobs based on their home price appreciation. When do a mass of them run out of money, not be able to find jobs (since the employment picture has been lousy for years, the low unemployment rate masks the anemic number of jobs created in the “jobless recovery”), and have their housing situation be thrust into trouble? I do not believe these people can be reabsorbed into the labor market at this level of unemployment.

In any case, partially due to the problem mentioned above of owned houses not necessarily being comparable to rents and also for other reasons, I have never been a particular fan of home price to rental ratios as much of a barometer. Only when the multiple gets historically large do I think it tells you anything, and then is only an indicator.

Employment is the key to home prices.

Anonymous said...


You're getting too many comments! I apologize but I haven't read all of them.

I just wanted to point you to Jeremy Grantham's Q1 2005 Quarterly Letter "Canary in the Coal Mine" where he discusses house prices in various countries worldwide. He emphasizes Income to Price ratios and mean reversion (as any follower of his quaterly letters might expect).

Thought you might find it interesting in order to help develop your own methodology.

The link requires a free subscription.


Sivaram V said...

PRICE-to-RENT Thoughts

Accrued Interest: "To all who suggest price/rent, I agree 100% with the concept, I just haven't found a data set that I think works. In the Baltimore area, a 4 bedroom house in a nice suburban neighborhood probably goes for $500-800,000 depending on where it is. Houses like that aren't often rented, and even where they are, it isn't like anyone is keeping long-term stats on it."

I agree that is is hard to get long term data for that (especially before the 80's). I also think price-to-rent probably only provides insight for the middle class and working class categories. I would agree that upper class doesn't usually rent or at least probably doesn't rationally price owning a house vs renting. I know working class people, like me, would likely compare the cost of renting to owning a house before buying a house, but wealthy people probably only consider owning a house and their decision is likely on the size of the house rather than against renting. One of the reasons there was a huge bubble in housing was because it was cheaper to own a house than rent in the last few years (this is why working class and working poor switched out of renting to owning).

In any case, just saw that Paul Krugman dug up some old posts from CalculatedRisk showing a house-to-rent chart:


(krugman blog entry: http://krugman.blogs.nytimes.com/2007/12/18/predicting-the-house-price-fall/)

I think we need to look to the 60's and 70's to see what is a reasonable price-to-rent ratio. Based on the 80's and 90's, I guess the US average should be between 1 and 1.1 but we really need the number from a longer period of time.

Anonymous said...

In reply to some of the comments:

While I believe that regular homeowners will ride out the downturn (if they can continue to pay the mortgage), I agree that investors will be quick to abandon properties that are under water.

That leads me to think we may be close to a bottom.
After all, how many of those investors are still left?
Haven't they all bailed yet?
Are there still speculators left who are waiting for their ARM reset?
Is there still a big overhang of foreclosures of failed investors?

If not, we only need to deal anymore with regular homeowners who are facing an ARM reset they can't afford?

Anonymous said...

In looking at supply and demand I think you must take into account homeownership rates. They are not static. There is ample evidence that the drivers that lead us to historic highs are gone. Add to this decreasing prices which will drag HO rates lower and higher interest rates. I disagree with you assumption of lower rates. Even if the fed lowers lenders are now starting to price the true risk. While st rates may go from 5 to 3 a 30 year fixed will probably go from 6 to 7 over the next year.

I think you have to look at more people renting, younger people staying at home longer and more cohabitation. If HO rates decrease which you have previously alluded to http://bp0.blogger.com/_pMscxxELHEg/R1bveDRwQnI/AAAAAAAABS4/k3gYiV5CPGA/s1600-h/Homeownershiprate2.jpg
the effect could be tremendous. If HO rates drop 4% over the couple years we're talking about a decrease in demand of 4,000,000 units. This could happen fairly quickly as the gains in HO over the past 5-10 years are ferreted away by a slow economy and rethinking of ownership.

BackOfficeMonkey said...

Dab, employment should be correlated with income. It is a very important variable but throwing it in the regression is gonna cause the problem w/ multicollinearity.

On rental rates - real estate markets are fragmented. Discounting the cash flow will work if certain real estate are just investment property and market actors can arbitrage the price of home compared to its future cash flows thus should be mean reverting. However many people buy home for personal reasons and not for an investment. Two different populations.

Anonymous said...

Your first mistake is to assume interest rates wil stay low. You simply cant shower a market with liquidity for a decade plus and have no inflation. Only in the US of A. Perhaps you should run your mosdel assuming flat to declining real wages, rising interest and see where the affordability index comes out. the housing distortion began in 1998 so the comp would have to be wfore that. I think the early 70s is probably a good barameter before the i rate spike. you will not that the averagew price was apox 2x income. today that multiple is 6x and interest rates are the essentiually the same. a 20% drop wildly understates the adjustments that havce to occur in the major markets like NY LA etc. These markets are up 100s of percent and people are carping about a 10% move. delusional.

bobn said...

Another Haiku:

The World is Ending;
House prices fall forever;
No end is in sight;

where "forever" seems to me to be at least 4-5 years given the oversupply already in place and the resets of subprime, alt-a ARMs and the resets/recasts of Option ARMs. The Option ARMs are especially explosive when the switch happens from neg am at a low rate to fully amortizing at a higher rate. (See Tanta UberNerd posts for the grisly details.)

Anonymous said...

Couple thoughts to share:

The current RE situation has a considerable number of homeowners at or near negative equity caused by excessive refi activity or using lending products that required very little or no down.
Feldstein in his speech at Jackson Hole noted that 40% of mortgage holders in 2005 did a home refi.
I doubt that looking at past RE boom and bust cycles will be great indicators as to events unfolding in the coming years. Negative equity will continue to capture greater number of homeowners as the market deflates this will also be true in markets that did not experience high HPA as homeowners in those markets used the credit cycle for cash out refi purposes thereby putting them in or near negative equity positions.
The crisis is more then supply imbalance or affordability issues but a significnat over use of credit products for both refi and new home purchase that has created a significantly large percentage of homeowners with negative equity in a falling market.

Anonymous said...

Krugman has his own version:


Anonymous said...

Here's the short link:

Anonymous said...

You might find it useful to subscribe to craigslist apt rental RSS feeds for all the cities they cover. (I do it for a couple local areas).

You won't be able to get data to populate a spread sheet, but you will be able to get an idea of what the rental market is like. Plus, you will see that there are plenty of single-family homes up for rent.

Just looking at rents for my town vs. sales prices and thinking back to what they were in the late '90s, I can tell you that there's a long way to go if that's the determining factor. But it's much better than it was a couple years ago.

I suspect that times will not be fun for renters looking to stay renters or owners looking to sell. A couple of years ago it was a paradise for both.

Anonymous said...

Here's an example (I've left out the location to protect the innocent): "No outside maintenance! Freestanding cluster home in private association of **************************. Dramatic 2-story LR w/atrium window. 1st floor MBR Suite w/luxury Bath. Open and light-filled spaces. 2nd floor Loft, 2 Bedrooms and Hall Bath. Elevator leads from spacious 2-car Garage to 1st floor. Huge storage area and bonus rooms on lower level. Close proximity to ******* Parkway and 10-minute drive to ********** Village. Partially furnished or vacant. Term flexible, pets considered. 2 months' security. Also for sale @ $729,000. Rent with option available. $2,900/month."

Maybe I'm way off base here, but my rule-of-thumb is that with a conventional mortgage (20% down, 30-year fixed), after all expenses (interest on princiapl and downpayment, insurance, maintenance, etc) and tax deductions, a house will cost you ~10% of it's purchase price/year.

In this case, then, to own the house would cost $72,900/year or $6,075/month. BUT, you could rent the place for $2,900/month. So the gap seems enormous to me.

Anonymous said...

The assertion that 'speculators will be gone completely' seems badly false. Perhaps 'reduced greatly.' But I can assure you there is plenty of 'smart money' talking to HBs about starting distressed Co-invest funds.

I'd also use the OFHEO CQI index, not the HPI. People don't need an 'improved' house but they certainly don't tend to buy ones that are worse than what they already can afford.

Accrued Interest said...

I found the following on Credit Slips, which is a blog run mostly by bankruptcy lawyers, on the subject of non-recourse mortgages...


"In CA, purchase loans on 1-4 units homes for owner occupancy are non-recourse, meaning the lender cannot come after your assets if you default. The house is collateral for the loan.

However, as mentioned above, many people refinanced, or took out home equity lines and then they lose that protection. Still, I have never heard of a deficiency judgment foreclosure in CA. All foreclosures are done on the courthouse steps, so any debt is wiped out."

So it sounds like the truly non-recourse loans aren't too common.