Housing Prices: Bargain of a Lifetime, or Much Further to Fall?

Back in November, I read an article in the Economist with the tagline “House of Horrors: the bursting of the global housing bubble is only halfway through”.

I usually pay close attention when the Economist calls a bubble, because unlike the daily rollercoaster of stock cheerleading and fear you read in most US newspapers, the writers over there have a sound understanding of, well, economics. Armed with just that relatively simple knowledge, you can usually call “bullshit” on many of the financial world’s most pronounced hissy fits, and rake in steady investment returns while your day-trading neighbors get crushed by a bear market.

In the article I read, the Economist pointed out that the housing market responded very differently around the world to the great financial crisis of 2008.

Here in the US, prices fell about 34% from peak to trough when measured on a nationwide basis. But this figure masks some even more brutal falls: in the most prosperous  and supply-constrained areas like Manhattan and San Francisco, prices barely suffered a dent. In wilder and more speculatively-overbuilt areas like Phoenix, Las Vegas, and Miami, some neighborhoods went on sale to the tune of 75% off, with foreclosures making up over half of all property sales for several consecutive years.

In the UK, prices only dipped 10% before resuming their climb. (See this nice article on Monevator for more analysis on the UK/London side of it). And in Canada, just a canoe ride away from the brutally crushed market of Detroit, price rises have continued unabated and continue to set new records. Toronto residents usually fall unconscious when I tell them that they can currently buy a luxury 4-bedroom home with palm trees and mountain views, for less than the value of their one-car parking space.

So when you ask “are houses overvalued?”, you need to qualify the question by specifying a city and country. The situation varies greatly by location. But how can you judge the true value of a home? A pad in New York City is surely worth more than an equally-sized unit in St. Louis, because the supply and demand situation is drastically different. But how much more is it worth?

Housing economists are the ones best qualified to make this call, and the way they do it is by measuring at least these two factors:

• The price-to-rent ratio
• The price-to-income ratio

When you look at those things, and compare them to the historical average ratios for your area, you can get a good idea of whether you’re in a bubble, or a bust.

In the US, the price-to-income ratio took a huge 75% jump through the mid 2000s, but the subsequent crash brought it down lower than ever before. It now sits at least 20% below its historical average.

In Canada, on the other hand, the price-to-income ratio is at an all-time high, at least 29% above the average. In the UK, this overvalue ratio is at 20%.

Price-to-rent ratio is simply a measure of how much a house costs, versus the gross income it would collect if you rented it out. A common rule-of-thumb here is 20. If a house costs more than 20 times the annual rent, it’s possible the prices are overheated in that area. In the foreclosure project, we picked up a house that cost about 10 times its annual rent after renovations – a good buy. In San Francisco, houses cost about 30 times their annual rent – a bad buy. Over time, these things tend to revert to their historical mean – prices will fall and/or rents will rise.

Price-to-income and Price-to-rent are cool ratios, but it’s not always easy to find a big spreadsheet of the data for every city. If you just want the quick-and-dirty guideline, you can look at a chart of  inflation-adjusted house prices. Why? Because both rents and incomes tend to rise roughly at the rate of inflation over time*, and so do house prices. If you see the house prices take off at a slope that is much faster than inflation, watch out for bubbles.

Being a big fan of economist Robert Shiller’s book “Irrational Exuberance”, I visited his website and downloaded the housing price spreadsheet, using it to generate this graph of inflation-adjusted US house prices from 1890 to late 2011:

Things got a little silly in the 2000s, but are starting to look quite reasonable now.

Dr. Shiller has been watching both stock prices and house prices for many years, so throughout the 2000s, he was calling “Bubble! Giant Stupid Bubble! Hello!? Is anyone listening? Stop buying houses and stocks! Look at my graphs!”.

Most of us didn’t listen to him, but the information has always been out there for those with the knowledge to keep an eye on it. An asset bubble forms when enough people collectively say, “This time it’s different, and the [houses/stocks/gold bars/tulip bulbs] will forever be worth more than ever before. The bubble looks like a part of the graph that doesn’t belong, suspiciously similar to what we see today with gold prices.

Nobody can predict the future with anything close 100% certainty. But using a good understanding of economics to make some educated guesses, you can occasionally spot an inefficiency in the herd mentality of the world, and avoid losing a bunch of your money in the stampede.

In today’s case, the ‘herd’ is the stream of fearful young couples I hear from regularly, who say things like “I’d never want to buy a house – look how much the prices have dropped! And have you heard about what the Federal Reserve Toilet Paper is doing to the national debt and also how the European Debt Crisis caused that Carnival Cruise ship to sink and gold bars are the only safe ingredient for salad dressing these days?”.

Back in 2006, the herd told me to “buy a 2-bedroom condo in Miami for $600,000 because it’s one of the most desirable places on Earth and the prices have gone up at 30% per year, meaning it would be worth $1.2 million before the warranty on the new fridge even expired”. (I’m only paraphrasing loosely from a few real estate brochures I read during a trip I took there at the time, but you get the idea).

So in the case of US housing, I feel confident in placing bets on its gradually improving strength. The current inventory of unsold homes has dropped to about 6 months of supply at the current sales pace (down from a peak of over 12 months in January 2009), the lowest level since the spring of 2006. As the supply continues to drop and the foreclosures gradually get gobbled up, the prices will rise again.

In my own city, I see solid returns on rental properties, and a cost of owning that is lower than the cost of renting. Equally significant, many homes are available at a price that is lower than the cost of building them, assuming a land cost of zero. By definition, no new houses will be built under this price condition, meaning that as long as my city’s population continues to increase, house prices will have to rise as the supply of available houses falls.

In Toronto, however, I’d place a different bet. House prices there have risen much more quickly than income, leaving the most recent home buyers holding record levels of debt. People are competing with each other to buy houses at more than the asking price, on the fear that prices will be even higher tomorrow. Although the Canadian financial system is more stable than that of the US in 2008, any change in buyer enthusiasm, employment, or interest rates could cause a self-feeding loop of price drops which lead to more price drops, until the price ratios above revert to their historical norms. I could be wrong, but given an uncertain future, I’ll make my bets based on my best estimation of the odds.

Your own course of action should depend on a level-headed assessment of your own country and city’s housing market. Look at the historical prices and the price-to-rent ratios in both your own city, and other places you might like to live. Renting a house or apartment for now will seem like a less bleak choice if it saves you a load of money during your working years, and allows you to buy a less expensive house further down the road in a more liveable city. In the US, however, the time to buy might be within the next very few years.

* actually, I think economists would say that rents rise with inflation, while incomes rise with GDP growth, which is traditionally a few percent higher than inflation. But in theory, this would result in us spending less and less of our money on housing over time. Therefore, it’s possible that rents and housing prices could be expected to rise slightly faster than inflation, while other products like food and durable goods rise more slowly, as we have seen over the past 100 years. But either way, I think my graph is still useful. Any economists want to weigh in?