Home prices and fundamentals

We all know the housing bubble story and how so many economists, and business, finance and real estate professionals got it all wrong. While I was never in the business mortgage lending or forecasting home prices, I was one of those economists who got it all wrong. So, for the record, I like to spell out what I was thinking and why I was thinking it. I'm doing this for the following reasons: (1) to dispell the idea that all of this was or should have been totally obivous; (2) so that I might be less likely to make the same mistake; (3) because I think the dialog may now placing too much emphasis on bubbles and too little on fundamentals.

I'm motivated to do this in part from having just read Akerlof and Shiller's new and excellent book "Animal Spirits." Akerlof and Shiller present a compelling case. But I don't think they fully present the most rational justification for what was causing the boom as it happened, even if animal spirits had a clear role in the bust. I now believe Akerlof and Shiller are right on nearly all counts. But I'd like to spell out why some, or at least I, was fooled. I don't think I quite fit the caricature of the market participants in their book.

Also, one way to fight animal spirits underlying the current recession is to focus instead on fundamentals. A focus on fundamentals might also go some ways toward countering the present lack of confidence.

First, I never expected prices to continue their double-digit increases. Rather, I expected them to gradually level off and remain flat, at least in real terms. My impression was that the rapid increase in home prices came about from an adjustment to a new equilibrium. This adjustment seemed quite natural to me for two main reasons: (1) historically low interest rates; and (2) because mortgage lending markets, due to larger bank sizes and securitized lending (which can make sense if managed and regulated wisely), made it easier to manage risk, and thus allowed them to lend to more people with somewhat lower credit and incomes.

These two main factors were buttressed somewhat by a few secondary fundamental factors. These include, large tax breaks from mortgage interest deduction and relatively recent changes capital gains taxes, a general (and reasonable if not rational) increase in willingness to bear risk, and revitalization of inner cities like DC, which caused many extremely low-priced homes to increase in value many times over, which helped to skew upward some of the statistics (even the excellent Case-Shiller-Weis index).

The two main factors should have brought about a marked reduction in the 'price to rent' ratio often cited during the run up. This is the ratio of a home's price divided by the amount it can be rented in any given year. At the height of the bubble this ratio was reported to be around 30 in cities with the most rapidly increasing prices. The bubbleheads argued that the ratio should always return to its mean of around 12 to 15, indicating prices were more than double what they "should" be.

I saw no reason for the price-to-rent ratio to return to its mean. Interest rates had fallen steadily over many decades and were approaching all time lows. Consider that a price to rent ratio of 15 is like a real rate of return of 6.7% and a price-to-rent ratio of 30 is like a real rate of return equal of 3.3%. This didn't seem altogether out of line with fall in interest rates. And a real rate of return of 3.3% isn't bad--at the time the real rate on inflation indexed treasuries was around 1% or less.

I was also suspect of the ratios being reported. The quality of a typical home sold can be very different from a typical rental home. And with so many new homes and apartment-to-condo conversions, it was easy to see how the relative difference between the typical home sold and the typical rental were diverging.

What the bubble heads didn't do often was to cite the housing affordability index. This index relates the affordability of the median home price to a household with median income. An index value of 100 means a household with median income can just afford the median-priced home. The affordability index takes interest rates into account. Price-to-rent and price-to-income ratios, popular bubblehead stats (see, for example, NYT columns by David Leonhardt) do not. This housing affordability index remained fairly stable amid rapidly increasing home prices. Incidentally, the housing affordability index is now at a record high of about 170: homes have never been more affordable to so many.

While there is no denying there was a bubble in housing, I still believe the above fundamentals played a large role. And I think it is also interesting and important to note that today we see home price declines and foreclosures in places that did not see large increases during the bubble. Also, some of the places with the largest increases remain extremely expensive. Not all of this is born out by the statistics because the statistics tend to be of a more aggregate nature. The CSW index--surely the best index going--considers MSA's not individual cities or zip codes. But within each MSA there is surely a lot of variation across neighborhoods, with some increasing or decreasing faster than others. In Washington DC, for example, while home prices have declined, they've declined much less in the city center in comparison to suburbs and exurbs. Rather, it seems the best neighborhoods closest to the city center have declined very little while the newest and furthest areas have declined much faster. I understand this same pattern is true throughout the country. All of this led me to believe things didn't get really bubblicious until around 2004 or 2005 when mortgage lending got completely out of hand--something I had not realized at the time.

Aside about the CSW index: I'd love to see this index parsed out in following way: across all cities, sort areas by zip code from the most expensive to the least expensive. I expect a reliable index could be made using about 5% of the zip codes, which makes for 20 indexes. I'd guess the high end isn't coming down as fast as the low end, and this cut of the data should give the clearest indication of the phenomenon.

So, fundamentally speaking, where are we now? Well, on a national basis the price-to-rent ratio is nearing its historical mean while interest rates remain at near all time lows. Short-term interest rates are near zero and short-term inflation-indexed rates are also quite low.

I'll take a house my old neighborhood in DC as an example: There's a shell of good sized row house for sale right now next to the Georgia Ave.-Petworth metro. The asking price is $190K and they seem willing to take much less. I'm guessing it would take about $200K to make this a nice new home (plus a basement rental?). So let's just call it $400K and understand with construction time and such it could be a bit more than that. One would need about $80K to invest and would have a mortgage of about $1850/mo. plus taxes and insurance--let's call it $2300/mo. Note that about $350/mo of the initial payment would go toward principal and effectively count as savings with a 5.5% return.

I have a decent row house up the street (no basement rental) that I rent for $3500/month. For this rent we had a long line of interested and well qualified renters--we probably could have rented it for more but we wanted to be picky. The house isn't new and it doesn't have central air conditioning. So, to expect $3500 a month on a newly renovated row house right next to metro (but still on a quieter street) is no stretch of the imagination.

So beginning from the first month one can expect to make maybe $1000/mo over their mortgage payment on this place (we'll allow $200/mo for maintenance ), plus an initial $350/mo toward principal which will grow over time. And, over the long run, one should expect rents to rise with inflation. This means net returns increase over time because the payment on the fixed rate mortgage won't change. Even if taxes and insurance go up modestly, this is a deal that grows much sweeter with time.

Why am I not buying this place? I just don't have the time to deal with it all. But all of this makes me think we've overshot big time on the downside with respect to home prices. As the affordability index shows, there has never been a better time to buy. This is especially true if your a first time buyer and can get an $8K tax credit to boot.

Maybe prices will fall further and buying opportunities will be even better. But that's bubble-like speculating, not fundamentals. There are some really sweet deals out there right now and I'm baffled--and scared--that they aren't getting picked up faster.


  1. Thank you Patricia! It's a small time blog--more like a personal journal--but it's feels good to know a few people like to read it.


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