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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