It is finally undeniable that house prices are falling in most of the US. For those selling their home in this market, the big question now is: "How far will prices fall?" Seller instincts are to hold out, insist on a price based on recent sales (within the past 6 months to 1 year), and ride out the storm. Most sellers seem to expect a resumption of the unprecendented housing euphoria next Spring (2007).
As many readers know, I am a regular author and blog admin at Patrick.net, the top Google-search housing bubble blog. I approach the real-estate bubble issue from an empirical, data-driven, and fundamentals-oriented approach.
My first introduction to the notion that real estate prices began to outpace supportable fundamentals after reading Yale economist, Robert Shiller. Mr. Shiller has long been a solitary voice of reason among. Mr. Shiller is also co-developer of the Case-Shiller Index, upon which the CME housing futures and options products are based. Let's analyze Shiller's position:
Well over a year ago, Shiller began demonstrating that housing prices had come unhinged from fundamentals. Traditional arguments supporting sustainable housing prices include income, population, cost of building, income-affordability, and mortgage interest rates.
Before price growth began to slow in 2006, we can see that population has grown at a relatively constant rate. We can also see that mortgage rates are largely uncorrelated to real house prices. In fact, house prices rose in the early 1980s while mortgage rates skyrocketed.
A better view of just how far house prices have risen compared to fundamental price support levels is shown below:
Almost unbelievably, when house prices are set to a real-price 1890 benchmark, we see that today's real-prices (12/2006) are 100% appreciated over baseline, while data suggests that instead prices should be closer to 12-15% over benchmark, in real-dollars. (I realize at this point that some readers will immediately think that of course 2006 prices are twice 1890 prices. But remember, these are real-dollar price. Let alone 1890, $1 in 1940 would equal $11.46 in 1/07. So, nominal-prices of a house would have to have increased 11.46-fold in order for the real-price to remain unchanged. I cannot overemphasize the importance of thinking in adjusted dollars.)
That means that, overall, houses are overpriced by around 75%!
Many of those predicting a "soft landing" in US house prices are basing that prediction upon the notion that today's prices are permanently high. In other words, prices may slip from 200% of benchmark to a modest 190%-195% of benchmark.
The common argument is that, except for the Great Depression, prices have never fallen more than a few percent. Well, actually prices have fallen by more than 10% as recently as the early 1990s. But still, the floor underneath falling prices has always been sustainable fundamentals, which was 111% in 1990, and is at best 115% today in 2006.
So how do we get back to fundamentals?
This is the hundred thousand dollar (or million dollar in some areas) question. Pundits and those with vested interests are insisting upon a soft landing. In short, a soft landing means that nominal home prices don't fall, instead only real prices fall. In other words, your house's price tag won't go down, at least not by much. Meanwhile, your income will rise, rents will go up, overall inflation will creep up, eventually filling the gap.
Let's take a look to see if this is plausible:
Assuming nominal prices continue to grow by 2.5% (most in the industry are calling for a "return to normal", meaning 5%-6% annual increases, so they claim):
Your house price in 2007 is $1,000,000. Shiller says it should really be $570,000. Your home is overvalued by 75%, as measured by sustainable, long-term prices.
In 2020, your house would be worth $1,377,511 assuming annual appreciation of 2.5%, and no correction in prices (a soft landing). Shiller says, in 2020, that house should sell for $806,429. So your house is still overpriced by 71%!
The question you should be asking yourself is, "do I think inflation will be 71%?" Actually, inflation would only have to rise by a fraction of that, probably more like 25%, in order to bridge the price gap. This is because of the way that taxes, rents, and investments work on the math. But still, do you really think we're going to see sustained inflation of 25% for a decade and a half?
How much will my million dollar home sell for?
Many people in the San Francisco Bay Area are sitting in homes they assume they can easily sell for $1,000,000. In fact, the house my wife and I purchased in 1996 (and have long since sold) for $365K now boasts a Zillow-value of $1.285M! Some comparable homes sold in early 2006 for over $1.3M. Let's say those owners are "pricing to sell", and want to get out in 2007 for "only one million".
Shiller predicts that it will take until roughly 2011 for prices to fully correct to fundamentals, or the full 75%. In order for this to occur, there will need to be 20% or greater drops in house prices in some years, probably the early years. A hard landing. So those sellers would be lucky to get $800,000 for that "million dollar home".
But what about 2008, 2009, 2010? Well, if you wait all the way until after the dust has settled, you should be able to pick up that million dollar single-family home for a mere $585,000.
And does $585K really sound that out of line? I mean, a home purchased for $365K in 1996, and then sold for $585K in 2010 is very much in line with historical expectations. But that's really the key: historical expectations. Bubbles like this have the effect of distorting expectations. It was only a few years ago that normal people did not expect to retire wealthy thanks to their house. They expected to sell or bequeath their home for a nice appreciation, about 1% over inflation plus a little extra in highly valued areas.
- We are not going to see sustained ultra-high inflation of over 20%. So house prices cannot stay this high as a function of fundamentals.
- We are not living in some great new tomorrow -- a new paradigm. One would have thought after the embarrassment of "The Long Boom" or "Dow 36,000" people would have learned to be skeptical of new paradigm talk.
- Fundamentals always win in the end.
- Maybe Shiller is wrong. He has been before. But it is very unlikely that he is completely wrong. He just may have some dates wrong. Maybe we'll get lucky and the nastiness to come will stretch on until 2020 or beyond. That's something wonderful to look forward to.