House Prices Finally Approaching Fair Value...

As goes housing, so goes the rest of the economy.  So where do things stand?  After two years of precipitous declines that have taken prices down almost 30% from the peak, house prices are finally approaching fair value (which is perhaps 10% below today’s level).

That doesn’t mean that house prices will only fall another 10%, however.  On the contrary, given the tendency for prices to overshoot, it would be startling if house prices stopped at fair value.  More likely, they’ll drop at least 10% below fair value before they finally trough.  Although the rate of decline is likely to ease over the coming months and years, therefore, prices will likely keep falling through at least 2011.  And there’s at least 20% downside left.

Below, a review of the most revelant data:

First, the big picture.  Here is how house prices have behaved over the past 120 years, adjusted for inflation, courtesy of professor Robert Shiller.  The house price line is on top.  Prices are indexed against the 1890 price (left scale), and the chart is updated through the end of Q4.  This analysis suggests prices still have to fall about 10%-20% just to get back to fair value:

Here’s the same chart superimposed on the economy by the New York Times.  A Barry Ritholtz reader has updated it to reflect the projected decline.  Importantly, this version is a couple of quarters out of date.  The latest value (end of Q4 2008), as calculated by Professor Shiller, is 137%, not the 155% shown in the chart.  Prices have kept dropping since December, moreover, so the actual current value is probably closer to 130%.

Given the modest long-term upward slope of this chart, fair value is probably somewhere in the 110%-120% range (again, indexed against 1890, adjusted for inflation).  So this suggest we’re still about 10% above fair value.  However, note what happened to prices from 1910 to 1940.

And now for some more recent data. 

The Case Shiller index for January 2009 showed house prices still falling 19% year over year.  The rate of decline is finally peaking, which is good news.  But it is hard to see how it will turn on a dime. 

Thanks to a near-30% drop from the top, house prices have now fallen back to 2003 levels.  But they are still well above the average trend-line for the last 20 years (100% in this chart).  And they are even farther above the pre-bubble trend line of the mid-1990s, which excludes the bubble of 2001-2007.

Housing P/E finally returning to a more normal range

“Housing P/E” measures graph house prices against rents and incomes.  These are the closest thing we have to a price-earnings ratio for housing.

Both measures show that prices are still high but are finally closing in on average levels.  After a bubble like this, we would expect prices to significantly overshoot.  But the absolute values are finally beginning to look encouraging.

Bear in mind that, as with corporate earnings, rent and incomes are cyclical: As the economy deteriorates, rental rates will drop (as they are now).  The same goes for incomes.  All else being equal, this will make house prices look more expensive than on these charts.

Price to rent (source Northern Trust) is closing in on fair value.  Note that the date lines in the chart below are one standard deviation ABOVE fair value for the periods in question.  The mean for 1987-2008, which includes the bubble, is 110%, which is about where we are now.  The mean excluding the bubble, however, is another 10%+ below today’s level.

Price To Income (source: Calculated Risk) Closing In On Fair Value.  The trough value for the previous housing decline was 10%-20% below today’s level.


Housing Affordability Index at record high…but not particularly meaningful

The National Association of REALTORS and other housing promoters now point to the “Housing Affordability Index” as a measure to suggest that houses are already undervalued.  Thanks to low interest rates, this theory goes, houses are more affordable–so prices will soon start rising again.

The NAR’s latest “housing affordability” calculations are below.  But before you get excited, recall the NAR’s track record (In 2007, the NAR said house prices would keep right on rising despite the levels in the charts above because houses are always a great investment and that house prices never go down).

Also recall two things: First, the NAR’s housing “affordability” index does not take into account the tighter lending standards that most banks have implemented in the past two years (making it harder for would-be buyers to get loans).  Second, just because you can theoretically “afford” a house based on your income doesn’t mean that you can go out and buy one.  Imagine, for example, all the homeowners who would love to buy a house that’s much cheaper than the one they have but can’t because they can’t sell their own house.

In any event, here’s the NAR’s Housing Affordability Index through Feb.  See the third column from the right:

Inventories are still too high and will continue to put pressure on prices.

Contrary to what your real-estate agent told you three years ago, house prices are subject to the law of supply and demand.  Thanks to our construction frenzy of two years ago, today’s tighter credit standards, and our ongoing refusal to let in more immigrants, there’s still a lot more supply of houses than demand for them.  This situation will continue to put pressure on house prices until inventories approach normal levels.

As these charts from Calculated Risk show, absolute inventories of new and existing houses for sale have declined in recent months.  This is good news.  The drop in new houses in particular is back to the trend level (but not below it).

Alas, inventories aren’t everything.  The pace of sales has slowed, so declines in inventory have almost been matched by reduced sales velocity.  There was an uptick in sales velocity in February, which everyone got excited about, but it’s important to put this uptick in a long-term context:

The reduced sales velocity means that the number of months it will take to work through the existing house inventory is still well above normal.  For existing houses, for example, we now have 10 months of inventory, versus the 4-5 months that would be more normal:

The bottom line

Thanks to the precipitous declines of the past two years, house prices are finally approaching fair value. But they likely still have another 20% or so to fall (nationally), and they will likely continue to fall for at least two more years.


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