The Housing Market Correction Could be Over

Posted by Patrick O'Connor on 8/28/08 11:24 am

The housing market correction could be over—if rent-to-price ratios are an inaccurate gauge of valuations

Most people believe that nationwide housing prices still need to fall significantly for us to see a recovery in the U.S. housing market, and therefore the U.S. economy—but a few economic renegades are saying, “Not so fast.”

Housing market struggles

The U.S. economy has struggled as three powerful forces—the housing market correction, the credit crunch, and a spike in energy prices—have continued virtually unabated.

In our opinion, the housing market is the most powerful of these three forces. That’s because the more housing prices decline, the greater the negative impact on consumer sentiment and spending, and the greater the credit losses to financial institutions (which would likely worsen the credit crunch). On the other hand, if housing prices bottom soon, damage to consumer sentiment and spending would likely be limited, helping to heal the financial system and allowing the overall economy to recover more quickly.

So, just how much further are housing prices likely to fall? It depends on whom you ask. The traditional view is that nationwide housing prices need to fall significantly, perhaps as much as 20%. But recently, a smaller group of economists have been chiming in to say this isn’t necessarily true—assuming you believe that a key figure of housing valuations—the rent-to-price (R/P) ratio—is an inaccurate guide.

Measuring housing prices

Before we explain why, let’s review the indices we’ll be using as a guide to housing prices. The two most widely cited measures of housing prices are the Office of Federal Housing Enterprise Oversight (OFHEO) Index and the S&P/Case-Shiller (S&P/CS) Index.

We recognize that both indices have limitations. They look at only single-family homes, and don’t adjust for home improvements or depreciation. Additionally, the data each index provides is limited, as the S&P/CS Index tracks data only as far back as 1987, the OFHEO Index to 1975. Moreover, each index has its own unique limitations. The S&P/CS Index is not geographically diverse, and the OFHEO Index doesn’t include homes purchased with non-conforming loans, such as jumbo or subprime mortgages.

That said, these indices are the best we have. Moreover, the fact that they follow similar patterns long-term attests to their accuracy. Through the first quarter of 2008, the correlation of the indices’ four-quarter changes since 1987 was 0.96, and they grew at nearly identical average annualized rates of 4.5% over that time period.

So, what do these indices tell us? To start, that the past decade has been volatile for housing prices—but most of us knew that. To explain just how volatile, however, from 1998 though 2005, nationwide housing prices rose at an average annual rate of around 7.25% to 10%, according to the OFHEO Index and S&P/CS Index, respectively. Even more dramatic numbers can be seen during the last two years of the housing market boom—2004 and 2005—when the indices rose 9% and 13.5% per year, respectively.

In fact, housing prices rose so fast they outpaced rents by nearly six times over, driving a key figure, the R/P ratio, way below its long-term average. Let’s look at that figure in more detail.

Understanding the R/P ratio

The R/P ratio is one of the major indicators of housing valuations. It calculates how much it costs to rent a home for a year vs. how much it costs to buy a comparable home.

Calculating the R/P ratio is simple. You divide the annual rent on a home by the cost to purchase that home, or a comparable home. Below we use two hypothetical examples to illustrate.

Example 1: Let’s say you can rent a house for $2,000 a month ($24,000 per year) or purchase it for $343,000.  $24,000 divided by $343,000 is roughly 0.07, making your R/P ratio 7%.

Example 2: Let’s assume the housing market appreciates, so you can still rent a house for $24,000 per year, but it costs $480,000 to purchase that home. In this case, your R/P ratio is 5%, because $24,000 divided by $480,000 is 0.05.

What does it mean? Essentially, a R/P ratio of 5% (0.05) means a person is willing to pay 20 times (1/0.05) what it would cost to rent a home for a year to purchase a comparable home. An R/P ratio of 7% (0.07) means a person is willing to pay about 14.3 times (1/0.07) what it would cost to rent a home for a year to purchase a comparable home.

So, as the R/P ratio falls (because housing prices are appreciating more than rents), people buy less real estate. That’s because when the R/P ratio is low, it makes less sense to buy a house than to sell a house, invest the money elsewhere, and rent an identical house next door.

(Note that sometimes a similar figure—price-to-rent (P/R) ratio—is seen. To come up with this figure, you do the math in reverse and divide the purchase price of a home by the annual rent on an equivalent home. For example, if you can purchase a home for $400,000 but can rent a similar home for $24,000 a year, the P/R ratio would be 17. For this column, however, we’re going to use the R/P ratio.)

Why is the R/P ratio important?

The R/P ratio is important because it helps us understand if the housing market is overvalued. Because rents are generally tied very closely to supply and demand fundamentals, one rarely sees a long-term rent bubble. Therefore, a rapid increase in home prices, combined with flat rents—which would lead to a falling R/P ratio—can signal the onset of an unsustainable housing maket boom.

The falling R/P ratio

Little work has been done to estimate long-term historical R/P ratios—until Morris Davis of the Department of Real Estate and Urban Land Economics at the University of Wisconsin–Madison and Andreas Lehnert and Robert Martin of the Federal Reserve Board of Governors wrote a white paper in December 2007 called, “The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing.” According to their calculations, the R/P ratio hovered at about the same level (5% to 5.5%) from 1960 to 1995, except for a brief period in the early 1970s. From 1995 to 2006, the R/P ratio fell, and by year-end 2006 it had reached a historic low of 3.5%.

The research of DB Advisors supports similar data. To calculate R/P ratio, DB advisors’ economists took the owner’s equivalent rent from the Consumer Price Index (CPI) and divided it by the OFHEO Index and the S&P/CS Index. According to that data, rising housing prices in 2004 and 2005 drove the R/P ratio down about 23%, or 33% below its long-term average, according to the OFHEO Index and the S&P/CS Index, respectively.

This decline suggested that housing prices had become detached from their fundamental valuations and needed to correct—and that’s obviously what happened. Housing prices began to fall in 2006, and continue to do so today. In the four quarters ended 3/31/08, the OFHEO Index and S&P/CS Index fell about 3% and 14%, respectively. Since their peak, housing prices are down 4.5% to 16% as of 3/31/08, according to the OFHEO Index and S&P/CS Index, respectively.

How much further do we have to go?

The big question is how much further do housing prices need to fall? There are a number of ways to determine this, but the widely held view is much, much further.

For example, one might compare housing values to disposable income. Historically, housing values have tended to fluctuate between 135% and 150% of disposable income, according to Swedish economist Stefan Karlsson. That number reached a historical peak of 206% during 2006, then started to decline—but as of 3/31/08, was still 188%. In order to return to its long-term average, then, Karlsson says that housing prices have to fall another 19% relative to disposable income.

Other people look at the R/P ratio, arguing that it has to return all the way to its long-term average to bring housing prices back into alignment with fundamentals. As housing prices have declined, the R/P ratio has, indeed, recovered—to within 15% to 18% of its long-term average. But, it still has a ways to go to return all the way to its long-term average. If rents continue to increase at their average pace of about 3% over the next year, housing prices will need to fall 10% to 15% to bring the R/P ratio back to its long-term average, according to DB Advisors.

This would likely hurt consumer spending, leading to more losses at financial institutions and prolonging the credit crunch. But is the situation really so dire? Some economists say maybe not.

Why the R/P ratio may be inaccurate

The R/P ratio may be an inaccurate guide to housing valuations because it compares rent with the one-time price of a home instead of the annual cost of home ownership, which may be more accurate.

After all, if you think about it, the price of a home is not the same as the cost of owning a home. The latter includes a number of other factors, such as:

 the after-tax rate of interest the homeowner could have earned by investing his or her down payment elsewhere,

 a risk premium that the homeowner requires above and beyond the risk-free rate to compensate for the additional risks of owning rather renting,

 the annual property tax rate on the home minus the homeowner’s income tax rate (because property taxes are tax-deductible),

 the annual rate of the home’s depreciation or the cost of maintaining the home to prevent depreciation,

 the after-tax cost of mortgage interest, and

 the expected annual rate appreciation (minus the capital gains tax rate, if the gain on the home exceeds $500,000 for a couple or $250,000 for an individual).

A better measure

The question is how do you come up with the annual cost of home ownership? Economists, as you may know, like to do math. And one group of economists—at DB Advisors—took out their calculators and came up with the cost of home ownership using the variables above. Assuming that you probably don’t like to do math, we’ll save you the complex formulas here, and just say that DB Advisors took all of the variables listed above—inserted objective proxies (or numbers) for each variable—did some calculations—and came up with what they call the “user cost of housing.” The economists then multiplied the “user cost of housing” estimates by the OFHEO and S&P/CS indices to come up with the ratio of rents to home ownership costs—which we’ll call the R/HOC ratio. What did they find?

Pulling it all together

In the early part of the housing boom—in the late 1990s—the R/P ratio began to decline. By the early part of this decade, it had fallen below its long-term average. (As a reminder, that means that housing prices were appreciating more than rents.)

But, the R/HOC did not decline along with the R/P ratio from the late 1990s through 2004, according to DB Advisors’ data.

In the big years of the housing boom—2005 and 2006, the R/HOC ratio did fall along with the R/P ratio. In fact, in those years, the R/HOC ratio fell well below its long-term average. But, the recent reversal in housing prices seems to have corrected that overvaluation. Indeed, the R/HOC ratio has reversed virtually all of its decline.

Why? Because, the economists postulate, the steep drop in real long-term interest rates that occurred early this decade reduced the cost of home ownership and “justified” a rise in home prices relative to rents.

As a result, housing prices may not have to fall any further to be brought back in line with their fundamental valuations. Indeed, if housing prices fall the additional 10% to 15% needed to bring the R/P ratio back up to its long-term average, the R/HOC ratio would likely be driven well above its long-term average—making housing undervalued.

Impact

If the R/P ratio is indeed an inaccurate gauge of housing valuations, housing prices could end up falling more than necessary—and that could create another set of economic problems altogether.

During the height of the housing market boom, people thought housing prices would appreciate much more than they had in a past. As a result, people thought it was less costly to own a home than it actually was, and bought, bought, bought. That created a self-reinforcing momentum: the rapid appreciation of housing prices, which was originally justified by fundamentals (such as lower real long-term interest rates), created unrealistic expectations of continued appreciation, which caused a boom.

According to DB Advisors, something similar could now happen in reverse. What if people become overly pessimistic about the outlook for housing prices? What if they erroneously assume that recent declines in housing prices—which were necessary to correct the overvaluation of the boom—must continue in order to return the R/P ratio back to its long-term average? In this case, they would assume that home ownership is more costly than it actually is—and drive housing prices down further than is justified.

Given all the pessimism about the housing market today, that seems like a real risk. But, there is some good news: according to the National Association of Realtors, median prices for existing single-family homes are actually higher than they were a year ago in a third of the country’s metropolitan areas. We’ll keep watching the data.

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