The Reverse Ripple Theory of Metropolitan Home Price Corrections

You drop a rock in water. The ripple is largest at the center and becomes weaker as it spreads out.

In the Reverse Ripple Theory of Metropolitan Home Price Corrections (you got a better name?), home prices in the outlying areas with a lot of new construction will tend to fall most and first (the splash), as it moves toward the center of the metro area, the ripple weakens and the fall in home prices is progressively less and later.

The “less” part is probably conventional wisdom among real estate geeks. The “later” part is probably not.

Will the Periphery Bottom Out First?

Buried in Appendix C of Global Insight/NationalCity’s September 2007 issue of “Home Prices in America,” I noticed an intriguing little table barely mentioned in the text, called “Past Price Corrections.” The table is now included in recent issues, as well.

The appendix showed 79 metro area home price corrections completed since 1985. Its great stuff for real estate geeks.

Don’t miss the last two notes in Appendix C.

The more severe the overvaluation, the greater the subsequent declines tended to be: correlation = +0.25

The more severe the overvaluation, the shorter the duration tended to be: correlation = -0.31

That last note surprised me. The more a market is overvalued, the faster home prices tended to correct! That seemed counter-intuitive to me. Why would a more overvalued market correct sooner than a less overvalued market?

Anyway, let’s run with it. What if that effect occurred within a single overvalued metropolitan area as well within the history of U.S. home price corrections?

What if home prices in the most overvalued areas of metro Phoenix Arizona, my home, fell most and bottomed out first?

Most Overvalued Areas

So, where were the most overvalued areas in metro Phoenix during the recent boom?

The conventional wisdom is that areas on the periphery with lots of new homes were more overvalued, at the peak, than other areas.

The periphery became more overvalued, in my opinion, because there was a bit of a pricing oligarchy in the new home areas. The homebuilders were the oligarchy.

As the market tightened during the boom, homebuilders had the market power to increase prices in their areas more quickly than was possible in older areas where each home seller made an independent pricing decision.

When a homebuilder increased its list prices by say, $10,000, he increased the value of all the resale homes in the subdivision at the same time.

If, however, Joe Homeseller in the same subdivision increased his list price $10,000 - and the builder did not - it would have essentially no affect on the market.

In my view, prices in new home areas increased more than in other metro Phoenix areas with similarly tight markets because of the market power of the homebuilders to raise prices.

Since the peak, we have certainly seen median home prices on the periphery fall faster than in the interior of metro Phoenix.

The future will show us if these peripheral sub-markets will also tend to be the first areas to see median home prices bottom out and whether the interior sub-markets of metro Phoenix will tend to have less severe but slower home price corrections.

Hey, it’s just a theory.

The charts below compare 85086 in far north Phoenix, which includes Anthem, a newish master planned community of Del Webb (Pulte Homes), and 85051 in Phoenix, an area of homes built in the 1960s and 1970s. Charts show monthly medians for resale (not new), single family detached homes.

Obviously, the periphery (85086) started to fall first. The question is will it fall further and bottom out first?

Comments

[BelvedereResearch]

Very interesting look at things. I live in San Francisco and have noticed the same phenomenon - outlying areas like Stockton, Tracy, and San Jose (though they'd take offense to being called an "outlying area" of SF...) are getting crushed while prices in good neighborhoods of SF seem to be about flat. By any standard valuation metric, they have at least 20-30% of excess in prices, so time will tell whether it's just in the midst of the reverse ripple.

I'd offer one more possible reason for why. In the bay, outlying areas were the ones where subprime was the biggest factor as people who otherwise couldn't afford a house decided to accept a 45 minute or 1 hour 45 minute commute and "stretch" for that house. They're most susceptible to the jolt of foreclosures and abrupt halt of banks willing to lend. Factors leading to inner rings of the ripple lowering prices have more to do with the slow process of price discovery and inward diffusion of prices.

If a buyer was formerly willing to add 30 minutes to commuting to save $200K, they're still directionally willing to do so, and if Stockton houses drop, it's a matter of time before the next buyer looking at Stockton vs Concord, or Concord vs Freemont, or Freemont vs. Berkeley, etc... will ripple that price inward.

The other possible reason is level of speculation. Just a guess but I'd suspect more were speculating on new home developments out on the fringes than on 100 year old (and much pricier) homes in the city center.

[Steven R.Smith]

Excellent article.

[sumosama]

Excellent article. As an Anthem resident, the housing market is certainly the strangest in the 6 years we have lived here. Specifically, there are still homes selling at the million dollar mark while just down the street, a similarly equipped/situated reo or short sale home will sell in the high 600's or low 700's. A far cry from the go go days of offers coming in sight unseen and lotteries for lots.

[sumosama]

sorry for the continuation...

Part of the graphics for Anthem are a bit misleading. A significant part of the dropp off in both graphics comes from the closeout of the country club portion of Anthem. These tended to be more expensive homes on both a per foot and total basis. We bought one of the last new country club models in early 05. New homes were completely sold out by end of 05.

[ScottSambucci]

John,

We're seeing the same affects nationally - San Francisco, Seattle, Washington DC - the downtown and desirable areas are relatively unmoved by the current downward trends. Try to buy a home on the water in Seattle and you'll compete with 10 other bidders. But go 15 miles out, and buyers can take their pick.

Well done on your analysis! (and for using Price/Sq Foot to indicate value instead of using the standard median prices).

Hope all is well!

[BonVivant]

Excellent article. It confirms what we have been seeing the Washington, DC metropolitan area. The outlying areas Dulles, Ashburn, Woodbridge and Prince George's County started to stall and drop in 2006. It has only accelerated out there. In the desirable areas of the city and within the beltway, we are seeing some softening, but there are still buyers if the property is priced correctly.

Is this the opposite of what happened during the boom years? Did prices increase first in the center and then go out? In DC, as the high prices in the center went even higher, it drove buyers out and then further out.

[gwinner]

The conventional real estate wisdom in San Diego is that market price increases start at the coast and move inland, while market price decreases start inland and move to the coast. The reverse ripple hold true here too, at least until a tsunami of biblical proportions hits the coast.

[John Wake]

Thanks for the comments!

Belvedere Research, I agree. That's a good way to explain it.

sumsama, the charts are for resale homes not new, so I'm not sure what affect the closeout of Anthem Country Club might have had on the charts. It could go either way.

You can compare other Phoenix zip code real estate markets on my web site "Arizona Real Estate Notebook," www.arizonarealestaten....

BonVivant, "Is this the opposite of what happened during the boom years?" Probably, but once the market got tight enough in the new build areas and prices really took off out there, that news had a big impact on prices in the interior areas as well.

[vreporter]

In what is probably the most resilient market - until now - this phenomenon seems representative of NYC and surrounding areas. The boroughs and NJ suburbs are getting hit much harder while Manhattan (an island) seems to be holding ground. The oncoming cuts on Wall Street however will pose some pain in the core of the city as well. What does that bode for the 'burbs! Not well I don't think.

["Magazine-Cover-Indicator"Indicator....]

Genuinely interesting.

[redriver]

Fall further/Bottom out first/Rebound first

The only comps acceptable in Queen Creek are foreclosures.

Being based in Phoenix I will agree with the "concept" (actually the reality) that the outlying areas will be the first to rebound because that is where all the big right offs have been with the recent REO's. With Speedwagon finished lot prices of 30 cents on the improvement dollars (land is free - no joke here. Ex.: If it took $1200/Front foot to build, the finished lots went for $300/front foot), this will enable at least one old time Phoenix builder who bought some of these REO's to "begin selling new homes in the valley starting from $89,900 by year-end".

Now the really interesting phenom to watch (as mentioned) will be the reverse flow of devaluations back to the core. Flushing the toilet seems to be a good analogy. Can't wait for that calm flat water. In the mean time, its going to be very interesting.

The other point that needs to be addressed is that a great deal of the cost increase of new home construction was not caused by the usual suspects but by the cities and towns themselves. (Seeking Alpha 2/20 article 64780) Under the umbrella of "better" "quality" "livable" they drastically raised the cost of doing business. A University of Washington Economics professor completed a study last year on this very topic and found that in Seattle the city actually was responsible for over 88% of the cost increases over the last seven years! This number is lower here in Phoenix but a large number still. Larger lots=less density=more $/unit. Front porches on entry level homes. Stucco pop-outs on rear windows behind fences. 38' wide roadways. The list goes on. For us to get back to market, everything related to the run-up must be addressed.

Good article.

[Russ f/Royal Oak MI]

That theory doesn't fit Cleveland or Detroit. Houses in the inner cities crashed 1st there are not selling even for less than the cost of hte lumber and copper in them.

Oops- I forgot the copper has already been strippted

WEll they then do a kinda dead cat bounce. Like from $100-200 per property. Then just sit there waiting to be bulldozed after teh mayor gets out of his latest criminal charges and the city recovers from paying his defense lawyers and lawsuit settlement costs.

The stench was getting to be too bad even from the suburbs.

[User 138620]

John,

Do you need a membership to the Arizona MLS to search sale prices by zip code?

Thanks!

[samo]

I suspect your theory might be a bit off. I would argue that newer neighbourhoods are more likely to have bigger price swings because of a combination of (1) more supply (i.e. liquidity) being added in these areas and (2) newer homes (akin to higher relative prices for a new car than a used one with 1 mile on the odometer). The result is when the demand rises, prices get frothier at the 'margin' than in areas where there's a more solid historical data on pricing.