Economic News & Analysis - April 10, 2012
Housing: Cheap or not?
By Brian Jacobsen, Ph.D., CFA, CFP®, Chief Portfolio Strategist

Brian Jacobsen photo


  • Housing activity may have bottomed out, but forces are at work that are keeping—and are likely to keep—home prices down.
  • The government is giving the go-ahead for banks to rent out foreclosed property.
  • Despite low mortgage rates, lack of credit availability and job insecurity may discourage potential buyers.
  • Although traditional measures like the price-to-income and price-to-rent ratios might suggest that homes are fairly valued, these numbers may not be painting the right picture.
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The housing market is a cause of constant consternation: When will it return to normal? Or, if not normal, how about close to normal? When it comes to sales and construction, it could be years (see Chart 1).

What about home prices? Prices, I think, are likely to recover well after sales and construction pick up. While it may appear that housing activity has bottomed out, forces are at work that are keeping home prices down.

The problem of “shadow inventory”

When housing activity picks up, those who postponed selling may become emboldened to put their homes on the market, keeping prices down. Shadow inventory also includes foreclosed homes that are owned by lenders, such as banks. Banks carry these properties on their books as “OREO,” which stands for “other real estate owned.” Some banks are experimenting with renting these properties out instead of trying to sell them. On April 5, the Federal Reserve Board encouraged this by reiterating that banks should make a good-faith effort to dispose of foreclosed properties, but in today’s environment, banks can rent out the properties without actively marketing the property for sale. In fact, the Fed said that banks that rent out the properties in certain areas could receive favorable Community Reinvestment Act consideration.

This seems to be designed to nudge banks to maintain properties, rent them out, and help keep neighborhoods from becoming blighted with neglected foreclosed properties. It could, incidentally, also create a whole new industry for companies that specialize in maintaining single-family residences. (It’s a lot easier and cheaper to maintain a multifamily residence than to have to hop from property to property to mow lawns, shovel snow, and take on all the other hassles associated with owning a property, which is why there aren’t more companies yet that specialize in renting out single-family houses). Banks are not supposed to be permanent landlords, so eventually these houses will either be sold to private investors or as homes, which could further keep prices from rising.

The full benefit of low mortgage rates is offset by higher credit standards

There are two popular metrics for measuring how “cheap” housing is: the price-to-income and price-to-rent ratios (see Chart 2). Based on those measures, housing looks pretty cheap. The chart below plots these two ratios, indexed such that the value as of the end of 2011 is set to one.

The historical relationship between the average sales prices of existing homes to average personal income is quite variable. The theory is that as income goes up, people can afford to pay more for homes. However, other factors can drive a wedge between income and price. For example, interest rates clearly play a role. With mortgage rates as low as they are today, a given level of income can mean a person could buy a more expensive home. Of course, that assumes the buyer can come up with the down payment. One reason real estate deals fall apart is because the property appraisal doesn’t come in high enough, meaning that the lender might not be willing to lend enough money to close the deal. Although mortgage rates are low, that doesn’t mean credit is freely available.

Job insecurity may discourage potential buyers

Another reason that the price-to-income ratio might not be a good guide to determine whether housing is cheap is because potential buyers of properties might not be certain that their incomes or jobs are secure. When the job market is chugging along normally, people might be more willing to invest in a property. Today, however, when unemployment seems like it may be permanent instead of just temporary, potential homebuyers may hesitate. As of the end of February 2012, the median duration of unemployment was 20.3 weeks. That’s down from its peak of 25 weeks in June 2010 but still well above its average of 8.1 weeks.

An alternative to buying a home is renting. That’s why the price-to-rent ratio is a popular measure of whether homes are cheap. The measure of rent typically used is the “owners’ equivalent rent” (OER), which is measured by the Bureau of Labor Statistics as part of its calculation of the Consumer Price Index (CPI). OER makes up more than 24.9% of the CPI, so it is a big part of household spending. It measures how much a homeowner would likely need to pay to rent a property comparable with the one the homeowner is living in. When rents go up, buying looks more attractive.

Based on the price-to-rent ratio, homes look pretty fairly valued. There are a few problems with this measure, though: Not only do homes require a down payment and maintenance, homes are not particularly liquid assets. So, if you suddenly find that you want to move or that your life situation changes and owning the property no longer makes sense, it’s uncertain how long it might take you to sell the property. It’s also uncertain what price you’ll get for it. The renter has the option to move when the rental agreement allows for it without having to worry about disposing of an illiquid asset. In an environment where the job picture is so murky, this option may be particularly valuable.

Are homes fairly valued?

Although traditional measures like the price-to-income and price-to-rent ratios might suggest that homes are fairly valued, these numbers may not be painting the right picture. To get a feel for whether homes are fairly valued or not, I performed a statistical analysis, considering factors such as income, rent, mortgage rates, unemployment, and the pace of home sales. For the analysis, I looked at the relationship between home prices and these factors from 1983 to the end of 1999 in order to omit the “housing bubble.” Based on my analysis (see Chart 3), home prices could have approximately 4% more to drop. Alternatively, the gap could close if rents increase or the labor market improves.

If mortgage rates start drifting up or the labor market continues to merely slog along, I don’t expect to see home prices rise much anytime soon.

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