The Unfortunate State of the Current Housing Market

I just finished reading the latest edition of one of my favorite publications, Grant's Interest Rate Observer, Vol. 26 No. 18, dated September 19, 2008.

In a piece on the desirability of investments in certain mortgage structures, Grant's discusses the state of the current housing market. 

The piece references three metrics for determining home price valuations.  The first is the recent transactional value of home prices relative to GDP.  According to this metric, home prices are undervalued.  However, I do not believe transactional value relative to the economy is a good indicator of valuation any more than I believe the dollar trading volume of a stock relative to its equity market capitalization, though it may be a good indicator of sentiment.

The second indicator referenced is the ratio of rental income to home prices.  Since 1960, rents have averaged 5% of home prices.  At the end of the second quarter, rental yield to home prices was 4.0%-4.1%.  If rental prices do not rise, home prices have to fall 18%-20% so that rental yields are back to long-term trend.

The final indicator cited was incomes to home prices.  Similarly, home prices would have to fall another 18%-21% for houses to be back to their long-term trend relative to income.

What is perhaps most striking is that generally, asset markets do not deflate to trend.  They usually over-shoot to the downside so that they become cheap.

I do not believe the decline in home prices has stopped, nor do I think RTC II will halt the decline, though it may mitigate the downdraft. 

Perhaps home prices will not fall another 20%, given that rentals and incomes may rise and RTC II may cushion the fall.  However, what happens to the financial system if home prices fall another 10%?  Or 15%? 

If home prices have further to go to the downside, there are more asset impairments within the financial system, and economic growth will be anemic at best and in contraction at worst. 

I use 7.5% as a normalized profit margin, which is above the long-term average of 6% (and down from the peak of 10% last year).  Thus, my approximate normalized earnings estimate for the SP 500 is $75.  That gets me to a normalized multiple of 16x, which is not cheap.  It's as if investors believe this is a normal economic environment.

Given that investors are valuing the market as if the credit crisis isn't really happening; given that the market has fallen 25% from its peak, which is less than the average post-World War II decline of 30%; and given that I keep hearing from the talking heads and the powers that be this is the Greatest Credit Crisis Since the Depression, this is not a good environment for stocks.

Thus, the bear market in equities will continue. 

Comments

[pochovilla:]

Let's make this easy. Your child has just graduated from college with no student loans, no credit card debt and you bought him/her a late model car for graduation. He/she starts out with a job at $50K in a city with a cost of living index at 100%. You get to make the rent vs buy analysis. What do you use to make your recommendation?
1. Recent transactional value of home prices relative to GDP
2. Ratio of rental income to home prices
3. Housing / rental affordability based on income and "wisdom factors"?

Housing prices are destined to fall and will probably remain flat for many years with few exceptions.

2008 Sep 24 06:50 AM

[REal broker:]

Given the fact that America does not produce much of anything anymore, I expect unemployment to continue to grow. I've been in RE for over 30 years now, and can tell you that there are only 2 factors that effect price appreciation. First is rising income and then there is easy credit available. It will be a very long time (if ever) until you see either rising income or easy credit again. Also keep in mind we have more homes than people to fill them thanks to the glut in construction over the last several years. RE as an investment was WAY overbought over the last generation. Bottom line expect RE prices to fall MUCH more in the coming years, don't be surprised if you see home values at 1980 levels in the near future!!

2008 Sep 24 08:51 AM

[San Diego L...:]

Keep in mind that each city (market) is different for real estate trends. In San Diego California, condo vales in a number of neighborhoods have in the past two years dropped over 50%! For a good take on this and a few charts, visit: www.brokerforyou.com/b.../

2008 Sep 24 12:42 PM

[joof:]

There has been a clear volume rally over the spring and summer in several markets that had fallen hard....inland and coastal CA and to a lesser degree AZ. Inventory levels have fallen in many cases to below 5-6 months sales - or to a level that begins to indicate stabilization and even some potential for price increase

Much of the rest of the US is months behind this cycial turn


The questions - is this sales volume sustainable, will more inventory hit the market, or is this a sucker's rally?

2008 Sep 24 05:37 PM

[henarl:]

I purchased a house in Lincoln, NE ( not a hotbed of real estate appreciation) in Dec. 2005 for $540.000 and was lucky to sell it for $450.000 in Aug. 2008 after 8 months on the market. That same house in southern CA would have cost $1,500,000 in 2005 and about $750,000 now. So, whereas it lost 17% in NE, it would have lost 50% in CA. The current loss in real estate does depend on locality but it has more downside to come everywhere.

2008 Sep 25 12:08 AM