REAL ESTATE PRICES...HOW FAR IS DOWN?
by Christopher Fox
August 10, 2005
On July 29th, Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco gave a speech at the Portland Community Leaders Luncheon titled “Views for the Economy and Implications for Monetary Policy.”
In her speech she speaks about Inflation, Risks to Economic Growth and the Bond Rate Conundrum. Then her speech turns to the housing market. Here are her words:
Housing
Whatever the source of the conundrum, clearly low long-term rates have contributed to the continuing boom in the housing market. The share of residential investment in GDP is now at its highest level in decades. The question on everyone’s mind, of course, is whether this source of strength in the economy could reverse course and become instead a source of weakness. Put more bluntly: Is there a housing “bubble” that might collapse, and if so, what would that mean for the economy? To begin to answer this question, we need to know what we mean by the term “bubble.” A bubble does not just mean that prices are rising rapidly—it’s more complicated than that. Instead, a bubble means that the price of an asset—in this case, housing—is significantly higher than its fundamental value.
One common way of thinking about housing’s fundamental value is to consider the ratio of housing prices to rents. The price-to-rent ratio is equivalent to the price-to-dividend ratio for stocks. In the case of housing, rents reflect the flow of benefits obtained from housing assets—either the monetary return from rental property, or the value of living in owner-occupied housing. Historically, the ratio for the nation as a whole has had many ups and downs, but over time it has tended to return to its long-run average. Thus, when the price-to-rent ratio is high, housing prices tend to grow more slowly or fall for a time, and when the ratio is low, prices tend to rise more rapidly. I want to emphasize, though, that this is a loose relationship that can be counted on only for rough guidance rather than a precise reading.
Currently, the ratio for the country is higher than at any time since data became available in 1970—about 25 percent above its long-run average. Of course, the results vary widely from place to place. For Los Angeles and San Francisco, the price-to-rent ratio is about 40 percent higher than the normal level, while for Cleveland the ratio is very near its historical average.
Reversion to the Mean
Economics borrows a tool from statistics called “Reversion to the Mean.” It’s a simple concept that explains how prices of goods will at times deviate from the long-term mean price to the upside or to the downside.* But the real value of this concept is in using it to predict future prices because what this tool shows us more times than not is that the elasticity of the deviation is generally equal on both sides of the mean.
In other words, if the price of something increases by 10 points above the mean price, then we find that eventually, the price of that something will fall below the mean by about 10 points for a total of 20 points.
Now, what I find very interesting about Janet L. Yellen’s comments regarding the current level of the price-to-rent ratio is that she tells us how high above the long run average it has become. “About 25 percent above its long-run average.” She also tells us that this ratio varies from place to place “For Los Angeles and San Francisco, the price-to-rent ratio is about 40 percent higher than the normal level.”
Surely Dr. Yellen has heard about the “Reversion to the Mean” concept, yet after she tells us how high the price-to-rent ratio has gone, she fails to tell us that we should expect to see this ratio drop 25 percent below it’s long-run average. Or 40 percent below the long run average in Los Angeles and San Francisco.
Given this data from Dr. Yellen, we can now surmise the answer to our question of how far is down for the housing market? The price-to-rent ratio should fall approximately 50 percent from its current levels, or 80 percent for Los Angeles and San Francisco.
Let’s see if these numbers work in my hometown of North Scottsdale.
My new landlord (who happens to own four rental properties) is refinancing and recently had an appraiser come by the house I am renting. He told me that he was going to appraise the house at about $550,000. Let’s assume my landlord decides to lock in a fixed rate and he chooses to go with the current 30 year 5.75% loan. His monthly mortgage payment, not including insurance or any maintenance costs comes to $3,209 per month. My monthly rent payment is $1,900.
So a quick calculation of 3,209 divided by 1,900 gives me a price-to-rent ratio of 1.69.
Let’s assume that the price-to-rent ratio in North Scottsdale is somewhere between 25 percent and 40 percent above the long run average as Dr. Yellen suggests in her speech above. I’ll pick 30 percent just for the sake of running the calculation.
If 1.69 is 30 percent above the mean, then a reversion past the mean, with a final destination of 30 percent below the mean would allow me to expect that the price-to-rent ratio should drop by 60 percent which should be a .68 price-to-rent ratio.
With this new price-to-rent ratio, I can now work backward to determine what the new value of my rental house will be assuming that my rent stays the same at $1,900.
$1,900 X .68 = $1,292.
$1,292 is what the new mortgage payment should be if the price-to-rent ratio drops to .68.
Plugging the $1,292 mortgage payment into a simple mortgage calculator on the internet at 5.75 for a 30-year fixed mortgage gives me a new property value of $220,000.
So now we can see exactly “How Far Is Down” for any particular rental property.
In this case I should expect to see my current rental house drop in value from $550,000 to $220,000 based on historical mean reversion characteristics.
The real problem lies not in the fact that the rental house I live in will only be valued at $220,000 but rather how fast it falls and what happens when the landlord decides to sell.
This house will become the new comparison for the other houses in the neighborhood and we can expect to see those house values come down also.
Christopher Fox
*For a simplified explanation of Reversion to the Mean, click on the link.
© 2005 Christopher Fox |
