Treasury Secretary Henry Paulson argues that the root of our current economic problem is falling home prices.
Just how overvalued are home prices and to what level might they fall?
There is a firm foundation to all asset prices which in most cases is generally the present value of the future cash flow that the asset generates. Stocks generate dividends, bonds generate interest and a home generates an imputed stream of rental payments that the owner would otherwise incur. In fact, the shelter portion of the Consumer Price Index measures “Owners equivalent rent of primary residence”.
This chart shows the real (inflation adjusted) “Owners equivalent rent” portion of the CPI-U for the Washington D.C. area (red) vs. real Case/Shiller Home Price Index for the Washington D.C. area (black) over the last 21 years.
The numbers (lines) are two discrete indices that are meaningless in and of themselves but describe a rate of change.
Together, a ratio of home price over rent provides some insight as to home price values in the Washington D.C. area.
Real Price/Rent Ratio:
The real price to rent ratio averaged 0.97 until January ’02. It peaked at 1.65 in September ’05 and was down to 1.26 this July. If we assume that the pre-bubble value of 0.97 describes the “correct” relationship between home prices and rents, one could argue that another 23% decline is needed in the numerator (home prices) or a 30% increase is needed in the denominator (rent).
We will almost certainly see a combination of both forces. Although real rent increases have averaged only 1% annually over the last ten years, tighter mortgage lending requirements may increase demand for rental units
As of July 31, the Case/Shiller Washington D.C. home price index has declined 15% in nominal terms (24% real) from its peak in June ’06. Prices are now at the level they were in Nov ’04.
Yet another measure of home price overvaluation can be seen in the National Association of Homebuilders-Wells Fargo Housing Opportunity Index for the Washington D.C. area. The index measures the share of homes sold in that area that would have been affordable to a family earning the local median income based on standard mortgage underwriting criteria.
Prior to 2002 the index averaged 75.8. It dropped to a low of 20.5 in the third quarter of 2006 and has climbed to 58.9 as of the second quarter of this year.
One could argue that another 28% increase in the index is needed if we assume that the pre-bubble value of 75.8 describes the “correct” index value. This increase could occur through a combination of declining home prices or increased household income. While the latter would be preferred, it should be noted that over the last five years Washington D.C. area personal incomes grew at an annual rate of only 6.8% (3.6% real).
See Home Prices and Fundamental Value from the Federal Reserve for a more in depth discussion: House Prices and Fundamental Value
Charlie Ryan
October 2008
