sunil94062

Are Home Prices Still Too High?

I don't buy these arguments as the author forgets to consider the following key metrics:

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!