No reason to be optimistic about house prices

By Felix Salmon
September 8, 2010
David Leonhardt has delivered yet another excellent housing column, full of sharp insights and careful thinking. The key concept in the piece is the distinction between the idea that houses rise with incomes, on the one hand, and the idea that they rise with inflation, on the other. If house prices generally rise with inflation, as Bob Schiller thinks, then they have quite a ways further to fall. On the other hand, if they rise with incomes, then they've already mean-reverted.

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David Leonhardt has delivered yet another excellent housing column, full of sharp insights and careful thinking. The key concept in the piece is the distinction between the idea that houses rise with incomes, on the one hand, and the idea that they rise with inflation, on the other. If house prices generally rise with inflation, as Bob Schiller thinks, then they have quite a ways further to fall. On the other hand, if they rise with incomes, then they’ve already mean-reverted.

I think that Leonhardt is right in thinking that houses are more likely to rise with incomes than with inflation. Houses sell for whatever buyers can afford; the key numbers here are the total monthly outlays, on the one hand, and income, on the other. If mortgage rates remain steady, then house prices, once they start clearing, are likely to rise in line with incomes.

But on the strength of that premise, I’m not nearly as bullish as Leonhardt, for three big reasons.

Firstly, mortgage rates are not going to remain steady: they’re going to rise. A $2,000-a-month mortgage payment at 4.5% will buy you $530,000 of house. At 6.5%, it will buy you $368,000 of house. That’s a 30% decline.

Secondly, as the home sales figures showed, houses are not clearing right now. And insofar as they are, they’re only doing so because of trillions of dollars of implicit federal subsidies being pumped into the mortgage market via Fannie, Freddie, the FHA, and other state-owned agencies. The government has prevented home prices from dropping to their natural level. Which might be sensible policy, but also means that you can’t take today’s prices as market-clearing.

And finally, incomes are the final shoe to drop in this recession. We’ve had a nasty fall in GDP, and in the stock market. We’ve had a large rise in unemployment. But we haven’t had any kind of decline in real wages — quite the opposite, in fact. Leonhardt says that “housing does not rank with unemployment, the trade deficit, the budget deficit or consumer debt as one of the economy’s biggest problems.” But what effect does he think that those big problems are going to have on incomes, over the long term, in a world which is globalizing inexorably and where Americans in general get paid far more than their peers doing similar jobs in foreign countries?

On top of the big reasons, there are smaller concerns which should worry anybody thinking about buying a house right now, including the massive shadow inventory of homes which would be on the market if the market were only a bit more normal. And then there’s this, from Leonhardt’s conclusion:

The ratio of median house price to income is about 3.4, compared with a prebubble average of about 3.2…

If you can imagine staying much longer than a few years, you should take some comfort in the fact that the bubble seems mostly deflated. Sometime soon, prices should begin rising again. They may not quite keep up with incomes, but they will probably outpace the price of food and clothing.

Keep those ratios in mind: if you’re spending something in the neighborhood of 3X your annual income on a house, you’ll probably be OK. But that’s certainly not the kind of ratio that I see here in New York.

And yes, housing is undoubtedly a better investment than food and clothing, but that’s not saying very much. Remember that food and clothing have been falling in price, steadily, over the course of decades. Even if houses just kept pace with inflation, they would probably outperform food and clothing.

As David Merkel says today:

We all become worse capital allocators when there is no safe place to put excess funds. It tempts people to stupid decisions.

Buying a house constitutes a monster allocation of capital to real estate, at a time when the outlook for house prices has never been foggier. I’m far from convinced that it makes sense right now.


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“No reason to be optimistic about house prices”

I am optimistic. I think prices will fall, so that I can finally afford to buy in NYC.

Oh, wait, you think rising prices are a good thing? Why? For whom?

Posted by TSTS | Report as abusive

For people who want to sell their homes…you know, like most people who own homes want to have happen?

Posted by REDruin | Report as abusive

tO WIT….you want housing prices to go down BEFORE you buy. You want them to go UP once you own, so you get more money when you sell.

Posted by REDruin | Report as abusive

Felix, I think you are right and the other econo-analysts you discuss are also right.

New York real estate does not look to be a good buy to me, by any valuation metric. New York had a huge run up and very little in the way of a correction.

On the other hand, in many other parts of the country, the decline has been dramatic and has taken prices down all the way out of bubble territory.

A lot of the smartest macro investors out there are gold bulls. This includes Soros, John Paulson, Marc Faber and recently Michael Burry. When those guys line up I want to get the heck out of the way! What is the story? Some are looking at gold as an alternative currency and if the world were to jump on a large scale over to gold from dollars, inflation would occur. Deflationists look and the declining credit-money and ignore unsustainable deficits, arguing always that there is no alternative to the dollar. But isn’t there? The amount of gold held in the world is now around 160,000 metric tons. This would mean a present value of around $6 trillion. A little more appreciation and it can start to be a viable substitute.

Hyperinflation everywhere and in every circumstance involved a jump to a hard currency. We always think central banks were total idiots to let things get out of hand just by printing and printing but that is not how it works. In Weimar Germany, citizens woke up one day and decided Pounds or Swiss Francs were better than Marks and it was basically over instantly. Sure the central bank made it cute by **later** adding a bunch of zeros but that 75% or whatever initial fall due to switching by citizens was the big collapse where most value disappeared. And that big collapse was out the government’s hands. It was pure psychology. Please note that Weimar Germany was in deflation until nearly the end, with the government running huge deficits and many buying up bonds.

I am not calling major inflation a likely outcome but it certainly possible, and homeownership, especially homeownership with a low interest mortgage, is a beautiful hedge.

Bernanke’s anti-deflation bias, and his ability to monetize without limit, should be taken seriously. Worldwide historical incidences of substantial inflation outnumber substantial deflation incidences by perhaps 50 or 100 to 1.

Posted by DanHess | Report as abusive

TSTS, good point!

Posted by FelixSalmon | Report as abusive

I am having a little difficulty calculating your mortgage numbers. I believe a $2000 payment would amortize a 30 year mortgage of around $395,000 at 4.5% or of around $316,000 at 6.5%. In other words, you could borrow 20% less. If you assume a 10% down payment and ignore stuff like taxes, PMI etc. then you would have had to have about $43,000 for a down payment at the lower rate. I think you have to assume the same down payment (since higher rates shouldn’t really negatively affect what you are saving for the house) then you would have to buy a house that cost around 17.5% less to have the same payment. If you assume a higher down payment then the reduction in price is less to get you even. Perhaps I am missing an assumption in your numbers.

Posted by JohnOmeara | Report as abusive

Spot on. It may be that house _payments_ move with wages rather than inflation, because monthly payments as a percentage of monthly income is the way Americans work out their housing budgets. At least, if you had the data to back up such a conclusion, it would make sense.

And, TSTS, sure, I get what you’re saying. But you have to acknowledge the massive trouble it makes for everyone when such a huge portion of homes in this country are under water in nominal terms–the great strength of the American economy is supposed to be worker mobility: the ability of everyone in Pennsylvania to move to Tennessee in the 1970s or what have you. That can’t happen with so many people shackled to their homes. Our labor force ends up looking more like Europe, even as Europe looks more like we once did. So the penalty to our competitive advantage is huge.

Posted by ckbryant | Report as abusive

Felix, there may be different advice for different situations:
- A cash buyer may be better off waiting in some places, because prices could go down if interest rates rise.
- A buyer with $2000 a month for a mortgage payment and plans to stay may be better off buying now because if interest rates rise his monthly payment will shoot up and his ability to buy that house will diminish. He doesn’t care what happens to the price if he is not selling soon.

An important thing to note: an interest rate rise from 4.5% to 6.5% does not mean a 30% decline in prices, but purchasing power. Never has there been that tight a correlation with prices. Falling prices pull buyers out of the woodwork and drive sellers away. Further, many buyers are not mortgage buyers.

If as you predict interest rates soon go from 4.5% to 6.5%, mortgage buyers should buy immediately and cash buyers should wait.


The amount of house that the $2000 mortgage buyer can purchase is now at $530,000 but it will drop thirty percent in your scenario. At the same time prices will drop something less than that due to cash buyers and a dearth of sellers. In this scenario, the amount of house the mortgage buyer can buy is at its peak presently.

Posted by DanHess | Report as abusive

Keep in mind, Mr. Hess, the amount of House you can buy is at its peak only in terms of interest rates. if house prices fall further, that’s not a true statement…you’ll be buying the maximum amount of house now, only to find yourself underwater almost immediately as house prices drop further, and the effective amount of ‘house’ (as opposed to the cash value of house) is going to go up yet more. That’s Felix’s main point…house prices have further yet to plunge.

As house prices plunge and interest rates stay low, you’re going to get the same amount of house for less, or be able to afford a bigger and better house for the same. If house prices have further to fall, you’d be crazy to buy now, even if interest rates do start to go up. Those costs will simply be taken into consideration for the willing to buy market, and force house prices down further yet.

I.e. You want to buy House X. A 4.5%, it’s worth 500k and for the sake of argument, a $2k a month payment. INterest rates pop to 6%…but nobody is going to pay more then $2k a month for the house. It’s value plummets as a consequence, as willingness to pay forces value to adjust to interest rates, instead of interest rates forcing payments to adjust to them.

All a question of demand.

=+Bob D.

Posted by REDruin | Report as abusive

Bob, I’m not sure you understood my point.

Suppose interest rates rise from 4.5% to 6.5%. A mortgage user’s ability to buy has dropped by 30%. But prices almost certainly will not drop by 30%, because prices have never ever followed mortgages that tightly (cash buyers enter, sellers exit). Perhaps they drop by 15%. (Note that historical interest rates have bounced wildly all over the map, but house prices have not followed. Indeed in the last fours years houses price moved opposite interest rates!)

Buyer A can have 15% more house now at $2000 per month (30% more purchasing power, 15% higher prices). Buyer B can have 15% less house later (30% less purchasing power, 15% lower prices). If A is planning to sell soon, he will suffer but if he just stays and enjoys the larger house and the cheap fixed mortgage he is an absolute winner over B.

Suppose they both hang around for the length of their mortgages. It is easy to see that A has done far better; for the same payment he has enjoyed 15% more house for 30 years and after that high living he is 15% wealthier house-wise.

Posted by DanHess | Report as abusive

Pace Felix and the commenters, I’m with Calulated Risk here. As he says, ‘[p]rice is what you pay for something. Interest rates are related to how the item is financed.. Imagine just one buyer gets a special interest rate. Would that lucky buyer be willing to pay more than all other buyers for the same property? Nope.’

Perhaps CR goes too far in order to underline his point. True, ownership includes a fixed-income component, and if spreads remain constant this component will increase in value with lower rates. However, everything else for which you pay (in a word: location, location, location) does not. So the result even with this concession is the same: ‘there is little relationship between house prices and mortgage rates.’

That said, you don’t fight the Fed and you don’t fight the tape. Betting on further house price declines strikes me as doing both.

Posted by wcw | Report as abusive

You all seem to be looking at these matter mainly from a financial standpoint, and ignore the 800 pound (weight, not currency) gorilla in the room: 70 million baby boomers have begun retiring. In other words, a major part in the population of home owners will be putting their real estate property for sale in the next 5 years.
This will create a big, steady supply of homes on the market, except in certain specialized markets in the sunshine belt.
There is no way the US government can sell enough bonds to finance measures that would counter affect such ebb in real estate. This is the worst possible time for such efforts. Those ideas should be shelved, and reality accepted, for better and for worse.

Posted by yr2009 | Report as abusive

Felix, spot-on on the real problem:

So how about proposing a solution instead of continually bringing up the same problem at the root of all our economic woes? We either have to (1) make American labor “competitive” by having workers living on China/Mexico-competitive $50 per day wages and no health insurance or (2) make foreign wages uncompetitive through taxing or tariffing offshored labor and goods.

I know which one will lead to a revolt, and which one is a political non-starter. So we have to choose, and our only options are violence by ordinary Americans due to massive overseas job displacement and non-survivable wages with massive deflation across all sectors of the economy, or (2) genuine old-fashioned protectionism. I think the latter is more likely, because option 1 is almost unthinkable.

It will result in the time-honored clash between chaos on the streets, and chaos on Capital Hill–the populists vs. the corporatists. And many more of us are net debtors who will be suffering under option 1. Unfortunately, right now, the corporatists have managed to split the populists among party lines. When these two groups finally realize that on the truly essential issues, they are aligned, then real change is possible.

Posted by TaxLawyer | Report as abusive

Assuming a proportional downpayment, the 30-year amortization on a $300k home at 4.5% interest is almost identical to a $240k home at 6.5% interest. Thus if all homes were financed on 30-year fixed rate mortgages, with the mortgage held for its full term, then an increase in interest rates from 4.5% to 6.5% would suggest a 20% drop in housing prices.

Of course that isn’t the case. As others have noted, the average tenure in a house is around seven years. Even families intending to own for a longer period probably don’t average more than 10-15 years in a property. Thus prices ought to be less sensitive to interest rates than that. As Dan Hess points out, your cost of long-term ownership is likely to RISE with interest rates, even if prices fall. For this reason I believe it is a good time for people in highly stable situations to buy.

Good point by yr2009 about prices being driven by supply and demand, though I seriously doubt that all 70 million baby boomers will put their houses on sale “in the next 5 years”. (Perhaps over the next 25 years?) The only counter to that would be immigration.

In conclusion, this is a bad time to be a short-term owner, but long-term owners can take advantage of the situation to reduce expenses, reduce taxes, and hedge risks.

And yes, the NYC housing market remains ridiculously expensive. I don’t know how anybody can afford to live there, let alone buy.

Posted by TFF | Report as abusive

It’s kind of odd to read this discussion. I hope that most first time buyers took advantage of the tax credit and now we have satisfied that demand.

Otherwise, I can’t imagine there are a lot of people with equity looking to trade up right now. Actually, I can’t imagine there are a lot of people with equity.

Isn’t this what’s stopping up the market? If there is no reason to move why would you? A few years ago you moved to cash out but now what?

Posted by silliness | Report as abusive

As to boomer demographics, I see no reason to believe there will be net selling going on. My neighborhood has a number of homes that are owned by empty nesters who like their nice, larger family-sized homes. Perhaps they won’t sell at 60 but 80. Heck, our house has 5 bedrooms and 3 baths and the previous owner held it until her own death at 92, long after her husband passed.

If it takes 20-30 years for many boomers to let go of their homes then this is a non-event. Long before then the boomer echo (children of the boomers) which is just as numerous a cohort, will have gone through household formation. In fact the boomer echo (think Chelsea Clinton’s age) is already at the beginning of that stage.

Posted by DanHess | Report as abusive

MR. Hess, I’m just making the point that demand is going to be fixed via how much it can afford. If I’ve got only $2k a month to spend, those houses are going to sit unbought until their price comes down to affordable levels. Housing prices might not perfectly reflect mortgage rates only if incomes offset increases and demand is high enough to support them. If demand slacks and incomes are constant, housing prices have no choice but to fall into compliance…which is the situation happening now.
Good point on boomer demographics. My own parents have lost probably $75k on their house in the last two years…selling it and moving into a condo that wouldn’t require maintenance is now basically out of the question. Felix’s point of hurt mobility is very true.
I’d also like to point out that the biggest reason Europe doesn’t have our worker’s motility is the language barriers. Lots of Europeans speak multiple languages, but certainly not all of them, and certainly not the majority of the ones that prefer the term ‘labor’ to ‘professional’. Lots of autoworkers moved from Michigan to Texas to work, and long ago from Kentucky to Michigan…you won’t see it happening from Germany to France or Spain, and vice versa. Professional, high-end people, sure.
Lastly, there is only one solution to the whole problem with foreign goods, and its simply to choose not to buy them. That is it, it really is that simple…and that impossible. We’d rather save a buck for ourselves then overpay so someone else gets a job here. That’s just the way it is.

==Bob D.

Posted by REDruin | Report as abusive

Real-estate ‘talking heads’ continue to ignore the issue of local taxes as part of total cost of ownership. I know a family who is buying a $250k ‘mansion’ in a depressed real-estate area in New York State, but they are going to have to scramble to pay the $1000 per month taxes (plus a $1200 per month winter heating bill). Cities and schools have not cut back spending to match the decline in property values. And those high fixed cost are going to continue to keep the home ownership market soft until incomes rise dramatically.

Posted by graceracer | Report as abusive

Real estate taxes are simply a way of apportioning the costs of a town’s services among the residents (and businesses) in the town. They really have nothing to do with the health of the real estate market.

If you buy a mansion in a depressed town you’ll pay much more than your neighbors and thus higher taxes than if you buy a median home in a more expensive town. Where I live, the taxes on a $250k house would be a quarter that much. Of course the house would also be a quarter the size. TANSTAAFL.

Posted by TFF | Report as abusive

So what are we saying here? Real estate will never be a good investment again. Yea right. Quality real estate will always be in demand and in short supply. That is the very thing that drives up prices – demand and short supply. Real estate taxes are the only “wealth” tax in our society paid by the average citizen, and for good reason. Even back in the time of Adam Smith people realized that real estate was in high demand and in short supply. That is why it was taxed – to help supress prices.

Posted by 123456951 | Report as abusive

Real estate in ‘specific areas’ goes into high demand and short supply. We are not in short supply today, and there IS no high demand. ‘Quality’ real estate changes with the years, and high quality ten years ago is a boarded up abandoned home today. In Adam Smith’s day, we had tons of immigrants coming in, and so yes, there was always a demand for more homes. In this day and age, we are overbought and overbuilt, and keeping out the new blood that would drive the market.
And real estate is taxed as a fairly equitable way to pay taxes (although no farmer will agree with it, hehe), not to suppress prices.
==Bob D.

Posted by REDruin | Report as abusive