Are Home Prices Still Too High? 27 comments
Michael Steinberg
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The Wall Street Journal, in “Home Prices Declined at Record Pace in October”, reports that the Standard & Poor’s/Case-Shiller home price index fell 2.2% month over month and 18% year over year for October. Some of the metropolitan areas fell more than 30% year over year. Prices peaked in mid 2006, but are still 58% above early 2000.
The value of homes to a large extent depends on where consumers are anchored. Those that bought during the bubble endear the Federal Reserve’s view that we are in a deflationary spiral. Those that were priced out or too cautious during the bubble still see inflated prices. Funny, how the Fed only sees the danger of asset price deflation, and never recognizes the inflation in asset prices. Anchoring plays a large role in a person’s view of economic value.
It’s old news that the Fed and Treasury are trying to prop up housing prices by every free market means possible. Most of their methods are truly bizarre. After socializing Fannie Mae (FNM) and Freddie Mac (FRE), the Fed wants to purchase up to $500B of their MBS in the free market. At the same time the Treasury won’t explicitly guarantee the GSE debt. Wouldn’t it be cheaper and more effective for the Fed to buy directly from the GSEs? All this to create a shortage of guaranteed high quality agency MBS theoretically pushing conforming mortgage rates to the mid 4% range. The Fed apparently believes that low mortgage rates are the answer to everything. History warns us that the Fed never believes that consumers consider the long-term value in asset purchasing decisions.
All of the Treasury’s previous attempts at free market mortgage modification have failed. I believe this is because mortgage investors are viewing the long-term economic value of housing based on more than temporary measures by the Fed. “Lite” modifications have failed because mortgage investors, banks and servicers have not matched payments with borrowers’ ability to pay. And investors only want to take true write downs if they can completely exit the transactions through foreclosures or short sales.
The purposeful failure of free market mortgage modifications will lead to the feared “cram-downs” by bankruptcy judges if enabling legislation is passed during the next Administration. Judges will determine the comparative economics of the NPV (net present value) of foreclosure versus modifications. This fear should rightfully strengthen the mortgage underwriting process.
Let’s look at a few general methods of measuring the economic value of residential real estate. The first is affordability. The mortgage payments and operating expenses should not exceed the 30% to 40% range of the buyer’s gross income. Operating expenses include real estate taxes, insurance, utilities and any condo or HOA dues. The range should also consider other debt and credit score. The old rule of thumb was the purchasers should not consider homes costing more than three times their annual income. This means a couple earning $60,000 should not pay more than $180,000 for a home. With operating costs greatly inflated, the Fed’s interest rate lever is much less a factor on affordability.
The second general valuation factor is rental return on the property. The Fed considers owners’ equivalent rent rather asset value in calculating housing inflation. But, the Fed did not consider negative rental returns an indication of a housing bubble. The last general valuation factor is appraisals. I consider appraisals to be the least dependable indication of economic residential housing values. In many instances, prior sales are more of an indication of emotional values rather than economic values. The rent versus buy calculation provides a much stronger support level.
The Fed and Treasury believe that they can create equilibrium of supply and demand by freeing up mortgage credit and lowering rates. If they can tempt enough buyers to enter the market based on artificially low rates, they believe a floor in housing prices will be maintained. I say they’re wrong. Housing prices will have to fall to their economic value based on expected longer term interest rates and inflated operating expenses. The free market was tempted by artificially low interest and got burned not too long ago.
What good is it to buy a house because you can afford the mortgage payments, only to find out that you will have to sell it at a loss later?
Disclosure: Author is long FNM and FRE.
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This article has 27 comments:
Baby boomers actually will now start getting out of the houses that they have and trade down as that's the only real asset they have to keep them going in their golden years.
That means LOTS of second-hand home supply in the market going forward.
Stock prices have crashed to almost 2001 levels.
I dont see why house prices are still at 2005 levels.
So yes, there is a lot more to go... remember Japan's case of 70% decline.
Maybe the US is not as bad, but I can definitely down 50% from peaks.
So I agree, there is no need to rush into get a house on "bargain".
I originally anticipated that we might see an increase in rental rates with the current downturn but it appears that many of those losing homes to foreclosure are moving in with family and/or friends as opposed to renting a home or apartment. This has resulted in a drop in rents which contributes further to the decline in home values for the reasons you have stated above.
I agree with you that home prices are still inflated and do not see the market of 2004-2006 returning again. Due the to anticipated return of high oil prices I see exurban areas and rural areas surrounding Metropolitan areas will see limited returns to growth if any. People should and will seek housing that is close to employment and hopefully they will seek housing that falls within the traditional cost structure of 33% or less of gross monthly income, ideally this would be in the 25-28% range.
McMansions are and should be a thing of the past. Poor quality construction covered by fancy finishes dominated the 2000-2006 housing market and will plague it for the next 20+ years. New housing will need to be more functional, more energy efficient, built at a higher density per acre and it must be more affordable.
The following only prolong the pain:
- Foreclosure moratoriums
- Artificially lowered interest rates
- Tax Credits for buying a home
- Loan modification programs for people who bought something they
could not afford to begin with
The resolution of this crisis will come about through fundamental societal change in the way we live our lives because high oil prices will return within 24 months and as a result:
1) New homes need to be more energy efficient
2) Living space will be smaller per residential unit reversing the trend
we have seen over the last 3 decades
3) People will need to live closer to where they work
4) Homeownership by percentage will decline for the next decade and
possibly beyond
5) Good public transportation will attract new business and residents to
the Cities, Counties and States which commit the resources to it.
6) Zoning laws which currently force segregation of residential use from
commercial and retail uses will be abandoned in favor of more mixed
use development.
7) Society will benefit from these changes.
*Most people purchase with the intentions of staying in their new home
and do not have a period of time in mine to later sell.
Secondly, is it better to pay a landlord $1,500.00 monthly, on a second floor, or higher, have no yard, no garage, no basement and last but not least, NO WRITE OFFS? WITH FUEL PRICES,TAXES, AND WATER BILLS GOING UP EACH YEAR, SO WILL YOUR RENT AS WELL.
IN CONCLUSION, IF YOU ONLY CAN COLLECT AN AVERAGE OF 1.5%-2% IN BANKS WITH YOUR MONEY, AND YOU CAN'T TRUST BROKERAGE HOUSES, RESEARCH FIRMS, STAR MINE EXPERTS, T.V. PERSONALITIES, AND CEO'S IN GENERAL WITH MARKET MANIPULATION, SCAMS, IN THE STOCK MARKET, THEN OWNING A HOME IS THE ONLY THING LEFT FOR AMERICANS TO INVEST IN.
SINCE MOST 1 FAMILY HOMES IN NEW YORK HAVE GONE DOWN AN AVERAGE OF $100K ALREADY OR 20% MINIMUM, AND INTEREST RATES FOR MORTGAGES ARE AT AROUND 5.25%,
THEN IF ANYONE HAS THE DOWN PAYMENT, AND CAN AFFORD TO PURCHASE NOW, THEN THEY SHOULD. ANYONE INCLUDING YOURSELF, MR. STEINBERG WHO AGREES WITH YOUR ARTICLE,
SHOULD PURCHASE A CRYSTAL BALL AND HANG A SIGN OUTSIDE YOUR LIVING QUARTERS, THAT READS 'PALM READER'.
A) A $500K house, $100K down, $400K financed with fixed 30-year @ 4% = $1,900/month payment.
B) Same house purchased for $300K, same $100K down but now only needing a $200K mortgage, let's say financed using a 30-year fixed mortgage at 11% = $1,900/month payment.
Although the resulting monthly payments are identical, the inputs are very different indeed. Your risk is obviously lower putting less principal at stake. The lower rates argument is merely another desperate attempt by those trying to prop up real estate (i.e. keep it still up in bubble territory). People have figured out this realtor payment spin...
Also, a generational demographic shift is about to put added downward pressure on house prices; see the following article for an indepth analysis on the upcoming boomer-shift:
www.informaworld.com/s...
1. In building a home, one uses various commodities, including one non-replacable commodity - Land. Commodities over time go up in value, as it costs more and more to replace them. Thus the value of a new home is traditionally more than an older home, as it costs more to create. And for logical reasons most folks love to buy new, especially if they can afford them on a monthly basis using a mortgage;
2. We have over the years technologically advanced building techniques and these advances have been 'mandated' by our ever changing Uniform Building Code ("UBC"). These advances also have the effect of increasing building costs, which is further translated into "value";
3. The homes we build these days have an estimated useful life of more than 60 years. This out-strips the useful life of relatively modest homes we built in the 1950's some with out-houses for sanitation, wood-burning furnaces, no insulation, poor ventilation and meager plumbing – and which in some parts were expected to last just a shade above 30 years. The virtue in building homes that will last these 60 years is that they can house folks for that long. Thus any computation we do of "value” has to recognize this powerful attribute.
The NPV calculation that the author asks us to make, must be over this 60-year horizon, coupled with the terminal value of the land (which "value" will also grow over time as the commodity portion of the home depreciates as it is "consumed"), and mostly discounted at close to the risk-free rate of money. I posit we use our 30 Year treasury as the proxy for risk-free, and this is around 2.25% today. I use this risk-free rate as the discount factor as opposed to the opportunity rate of interest for all risk-capital, as making and providing homes for our citizens is the exact thing that society at large benefits from and thus we should promote them as the safest kind of asset. Safer than even our faith in the US Government's Treasury (where "notes" can be printed willy-nilly and thus the value easily "compromised", as is now the case).
4. To my view there is materially nothing unsound, if we compute value by studying all of the three methods - (a) replacement cost, (b) discounted cash flows and (c) comparables. I also posit, (and this has been empirically evidenced) that over a decent time horizon all asset values converge to their respective replacement costs. The time to "buy" them is, when, because of market irrationality one can buy below replacement cost and one "sells" when they are materially above replacement cost, and again where this has happened only because of irrationality. In perfect equilibrium things should always have a value equal to their replacement costs. But this rarely happens as we have an economy where sentiments ebb and flow and value is dynamic. The US economy has been as close to theoretical equilibrium as far as I can tell. Not so in many parts of Europe and certainly not in any emerging country - China and India for example. We in the US right our wrongs ever so fast - most of the time. This is to be desired and is GOOD.
I think the DCF is far less accurate a measure for value as we cannot accurately predict cash flows for 60 years forward (and doing a DCF for 5 years or 10 years is equally inaccurate, on a 60 year asset life).
Comparables are the least valuable. It is bizarre that folks at Banks (and Sheila Bair at the FDIC inclusive) put maximum faith in comparables and this is what is reported by the Schiller index. It is exactly the wrong index to be worshipping or evangelizing.
In summary, this author and the readers here should learn to compute replacement cost. Permanent values do not have much to fall to my view for rational reasons. They may swing for irrational reasons.
And for my area - SF Bay Area, I can report that in many parts home prices are now well below replacement costs (unless one believes that timber and copper will be given away for free, and that too forever!). I wouldn't bet on that!
Demographics is the name of the game, and there are too few post-boomers chasing too many homes. (These comments also apply to Retailers, and for the same reason.)
Prices WILL stabilize at replacement cost in each area of the country, once excess inventory is worked off. In rust-belt cities and no-growth towns, prices will keep dropping until homes get destroyed by vandals or the effects of sitting empty.
In places like Chapel Hill, NC (where I bought 4 years ago when this Recession became apparent), prices have been remarkably stable.
In other places, like Maui - which had huge price inflation, prices have another 10 to 40 percent of collapse to go., (depending in part on the re-emergence of Japanese buyers).
I think most people expect inflation to rage as soon as the current crisis ends,
house prices will be the first to rocket up.
Finding ways to increase worker productivity that drive incomes up and employing transactional efficiencies that drive down the costs of buying/selling should have greater importance--example: title searches--rates are absurd for the actual work done.
sunil9406 - To your thorough discussion I would add that replacement cost is not a support level until there is demand. In addition, replacement cost is not a fixed value but can vary as prices rise (thereby increasing potential support) oir as prices fall, as in a depression. As far as land values are concerned, you are generally correct, but not always so. I have been to places in upstate New York where now vacant land sells for less today than it did as farm land after the Civil War. There are those who think that more distant suburbs may lose land value if transportation costs make long commutes less desirable.
Jonathan Christopher and andyn - I agree with your posts that demographic pressures have some negatives for the housing market over the next decade. It is only a question of whether economic activity can overcome this headwind.
Jimmy 46 - Your thought that housing prices will rocket up with inflation should recognize the possibility of stagflation. There have been times when housing prices have failed to keep up with inflation, most recently the early 1970's, the late 1970's to early 1980's and the early 1990's.
Guero and nobull - Lender initiated loan modifications may pre-empt the need for many cram-downs. Lenders will prefer to keep control by avoiding cram downs, when they might be feasible, and take a quick smaller loss of principal rather than a larger loss of principal in recovery after foreclosure, which can take much longer. Neither modification nor cram down will have a high degree of success unless the resulting modified mortgage is affordable (keeping housing costs under 38% of gross income - mortgage payment plus property tax and insurance escrow - or the 33% for mortgage only, as mentioned by tcornelison. One reason (probably the major reason) that so far many modifications have failed with 6 months (reported failure rate of 50-60%) is that the affordability guidelines continue to be violated. An additional potential problem may come from too much additional debt (besides the mortgage). I believe the guideline for that is 10-12% (of gross income) max.
I believe lenders have been ill equiped to deal properly with modifications, but will get on board with meaningful programs soon, because it can save them significant capital. Many foreclosures recently appear to be faced with as much as 50% (or more) loss of principal upon resale, with many months of maintenance and carrying costs added. Facing this prospect, a 20-25% writedown, settled in 30 days, may be preferable. In some case, the modified contracts may have a share of future appreciation incorporated.
tcornelison - I would add to your comment that a large number of vacant houses increases the rental market supply. This provides some downward pressure on rents.
I would also point out that higher end homes built in the last few years have not suffered from cheap construction. During this time we have seen extensive use of steel I-beams. compound wooden beams, engineered floor joist and rafter structures, as well as dramatically more efficient insulation methods. The problem of cheap construction is a problem in the lower 50% of the market, but that is nothing new. In the area I live (central North Carolina) recent home construction costs ranged from about $100 per square foot to $160 per square foot. Perhaps 10% of that was in land value and another 10% in fit and finish. The rest of the difference was in construction quality. By the way, there were houses up to (and over) $200 per square foot because of higher land value and luxury extravagance.
So what are replacement costs in the Bay Area and why do you think we are below them now? Are you factoring in the plummeting value of land in your equation? Just because Toll Brothers and others spent 3x what they should have for land in 2004-2005, doesn't mean the land is actually worth that.
An Excellent article. Now some are trying to put up housing prices by force. This method will not long last and especially first home buyers should be very careful. Do not try to overpay for those housing market manipulators, pump and dump traders. In addition we should not overpay rent as well. In addition to housing prices now rent also collapsing globally.
Still home prices are over priced. We will see one of the worst burst in the housing sector in Asia during next 10 years. First home buyers should wait until 2013. During this period you will see direction of the housing market.
However post baby boomers are not as strong as baby boomers. Once present baby boomers retire housing market will collapse.
When you buy house now you will have to sell your house in the future at a loss. It is happening all over the world now. Do not get caught to debt trap, mortgage trap and traps of real estate brokers, bankers and real estate agents.
We must try to learn how to value houses, employment rate, world economic situation, demand and supply etc before buying houses. House has become a trading product for some speculators and corrupt investors.
Once houses prices come down by 70% then you can think about buying houses. According to some industrial expert some house prices can come down by 70% in the next 18 months globally.
Voluntary loan modifications, like cram-downs, will cause losses to banks. Since the fed and treasury have undertaken to prop up the banks' losses by various mechanisms, some transparent and others opaque, then these losses are ultimately going to be borne by taxpayers, savers and the general public, either through higher taxes, higher interest rates, or higher inflation.
At the end of the day, there is no difference between cram-downs and voluntary loan modifications in terms of the beneficiary and the loser. In all cases the beneficiaries are those who consume more than they produce, and the losers are those that produce more than they consume.
The US government is flooding the economy with money, in large part to replace the equity lost in the financial system via the drop in home and stock prices. I think they will continue until the surplus of cash forces prices back up, accompanied by general inflation. The result will be restored equity and a lower portion of (increased by inflation) income required to service mortgage payments. I'm not saying this is right. When did that become government policy?
Luckily there are millions of new people coming to and being born in this country. Housing has declined to 2000-2001 levels in many areas, and in some cases are well below normal trend lines. And with tax breaks well below cost of renting (not to mention the pain in the rear it is to constantly move).
The coming inflation will boost asset values including, yes, real estate. Like it or not your dollar will be like it was in the mid 70's - worth less every month. T bill bubble, inflation, signs of recovery - look out. Buy that bank owned home now and get a 4.75% loan before it's a thing of the past.
If someone declares bankruptcy they should be prepared to lose their primary residence in order to pay off creditors.
Now that government owns banks, a cram down is essentially the USA defaulting on obligations. Why don't we just cram down the national debt and start America over?
Ridiculous.
The biggest expense in any low to middle income family is a mortgage. And that keeps them working, but the job market is not large enough for every working American to keep working for 30 to 40 years while the new generation comes into the work force, because many of the older generation postpone retiring and opening up those positions because they still have mortgage obligations.
Ask yourself this: What kind of idiot lends somebody money when they have no skin in the game? Of course they are going to default if it doesn't pan out for them. You says no-recourse is "bad enough" but that is what it means to be a SECURITIZED LOAN. This is what businesses do every single day when they can't meet obligations. It's capitalism 101.
What you fail to see is this: If it's not a cram down, it will be a 100% loss. The borrower will not pay. This is not Russia, but what you seem to want is 18th century England when we had debtors prisons.
On Jan 02 08:06 AM nobull wrote:
> The forced loan modifications by judges is what scares and disgusts
> me the most. Thats worse than Russia. People who jumped into houses
> with no risk had the option of walking away from a loss and sticking
> the bank with the loss with the loss. As if that wasnt bad enough,
> now they also get rewarded for it.
People who don't have jobs or are fearful of losing them are not likely to sign mortgages -- assuming that banks would even offer such people mortgages. Meanwhile, those of us who have jobs are not all earning six-figure incomes, and many of us either pay an increasing amount for our health coverage or do without. Add higher energy costs, skyrocketing college tuition, and food prices to the mix, and you wonder how housing, which is still WAY overpriced when compared to average or median income, can remain so inflated?
It can't.
What on Earth could prop up such astronomical prices? Why would you want to buy something that's taxed at an inflated value? States like NJ, where typical property tax bills alone amount to more than I pay for rent, don't seem like wise places to buy just yet.
Oh, wait -- I guess the housing bulls think that we're all going to be earning a LOT more money in the coming year or two. That's great. I could use the requisite 50% cost-of-living adjustment upward. Yes; that would fix the problem.
Whoo-hoo! We're all gonna be RICH!
I'm glad I have a house in Wisconsin that cost me $150K where the identical house in California would be twice that much.
Now I just need to get some voice practice, "Welcome to Walmart, can I get you a cart".
Prices have to come down to what people can afford, and that means housing has a long way to fall unless govt wants to artificially inflate INCOMES to match the too-high housing prices. People have become too jaded to high prices. They think $250K for a modest ranch house is cheap. It's not. We need to forget California's whacky prices and look at what a house is really worth, and what people can really afford. A middle class family, which is what most Americans are, should not be buying a house that cost more than about $150K, and they should have 20% down, and their total mtg pmt should not be more than a quarter to a third of their income. When those figures are in line again we can call bottom. Until then, the industry can spin all it likes, but people are tapped out and some are out of work. They're not going to buy half million dollar McMansions now. The industry needs to get over it and either change the way they do things or find another line of work.