(Bubble) Trouble in the Real Estate Market?

Home real estate is famously subjective to value, but by one objective measure house prices have barreled far ahead of fundamental worth.


Home real estate is famously subjective to value, but by one objective measure house prices have barreled far ahead of fundamental worth.

Five years into the real estate bull market, sentiment about current home price valuations is shifting from euphoria to doubt in some quarters. In the past ten days, prominent stories in the New York Times, Washington Post, Wall Street Journal and USA Today have highlighted risks to the housing market and by association, to the nation's economy. Other commentators have dismissed concerns about a real estate bubble.

Establishing fair value for houses has always been tricky because the real estate market is notoriously inefficient. Houses change hands infrequently, sellers have more information than buyers, real-time data on prices is unavailable, and supply/demand issues can distort price comparisons among regions.

By one purely quantitative measure, there is ample reason for concern. The nation's home prices have diverged sharply from the value that homes have as shelter. In theory, home prices should be tied to the value of living in them, and for most of the history for which data is available, they do. Today, though, home prices appear to be factoring in the expectation of continued strong price gains, which would be unrealistic in light of past experience.

Today’s Home Prices = PV (Shelter Benefit) + PV (???)

The Office of Federal Housing Enterprise Oversight, or OFHEO, publishes the House Price Index, which tracks changes in home prices across the country. Another government agency, the Bureau of Labor Statistics, calculates a data series called Owners' Equivalent Rent, which measures the implicit financial value of home ownership.

By comparing changes in the House Price Index with changes in Owners' Equivalent Rent, we can tell how closely house prices track the benefit of living in them.

As the chart shows, the House Price Index has surged far above Owners' Equivalent Rent in the past five years-to a degree never before experienced since the government began collecting this data.

A Past Cooling-Off Period

As the chart shows, the House Price Index rose faster than Owners’ Equivalent Rent in the late 1980s. By the third quarter of 1989, the House Price Index peaked at a 10 percent premium to Owners’ Equivalent Rent. It took the next five and a half years for the two series to realign. During those years, house prices rose nine percent on a nominal basis, but actually fell 10 percent in real terms, after taking inflation into account. At the same time, OER rose 22 percent.

What Might Be on the Way Today

There are several ways that today’s scenario could play out.

  • We may be in for an extended period of meager price appreciation while Owners' Equivalent Rent catches up with the House Price Index. Using the historical rate of Owners' Equivalent Rent appreciation as a proxy for future housing cost increases, it will take 11 years for the two series to reconverge, assuming that the House Price Index holds constant where it is today.

  • House prices may pull back to come closer in line to the value of the shelter benefit. To come immediately back into alignment with the Owners’ Equivalent Rent series, the House Price Index would have to fall nearly 25 percent.

  • We may see a smaller pullback combined with flat to single-digit nominal price gains for an extended period.

  • Or we may be worried needlessly over a new paradigm.

A final note: the series that we’ve examined in this article are national series and therefore don’t reflect varied regional experiences. Some regions have seen muted price appreciation and will therefore not be at risk for significant price corrections. Other regions have growing supply/demand imbalances that may justify higher prices relative to housing benefits. On a national basis, however, the picture is unsettling.




June 6, 2005


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  • Do they modify the home price index to take into consideration rates' impact on avg monthly payments? If not, then the PV of future price appreciation might not be as large as otherwise suspected. The extended use of ARMs with initial low monthly payments would also then be partially responsible for the divergence between the two which could create an additional way that the scenario could play out. Rates increase, hybrid mortgages turn into higher monthly payments, buyers in this market become renters in the next and home values see a sideways or slight drop but rent accelerates rapidly.
  • Neither the House Price Index nor the owners' equivalent rent series takes interest rates or the size of mortgage payments into consideration. I strongly agree that the use of nontraditional mortgages is contributing to the divergence between the two series. -Melanie El-Sabaawi
  • Melanie - A problem in the OER/Price Index equation is that demographically stable areas tend to have higher ratios than more mobile areas. For example, it is a factor of 10 in DC, but 17 in Philadelphia (a $250,000 house in DC would generate $25,000 p.a.in rent, but a house of the same value in Philadelphia would only generate $15,000 p.a.). Happy 4th! Dick McC
  • Sure, interest rates affect home pricing. And, the supply of rental properties in some markets far exceeds the demand giving a distorted comparison between home values and rental rates. Also contributing to the price push are forces that are shifting the demand curve to the right (increasing the demand at every price point) and the supply curve to the left (reducing the supply of housing at every price point) and effectively raising the equilibrium price. The rightward shift in the demand curve for new home construction is caused by: 1. More of the population is within the prime home ownership age range (35 to 55) 2. More people are acquiring “second homes” 3. The aging US housing stock is due for replacement (the home constructed during the boom that began with the returning WW II GI’s is now 60 years old and mechanically outdated). At the same time, the supply curve is shifting left due in part because of: 1. Increasing land use restrictions 2. Increasingly restrictive (therefore expensive) ordinances on “tear downs” 3. Ordinances mandating the construction of “affordable housing” which physically reduces the land available for construction of supply to meet the demand along the rest of the curve 4. Municipal levy of “Impact Fees” on new subdivisions
  • While mortgage affordability is important, so are factors such as: a) The affordability is short-live if it's an ARM/OptionArm products b) Rise in speculative property flippers mean increase chance for surpluses to exists. This is why builders are starting to put severe restrictions on buyers to reduce the impact of surplus inventories from increasing. c) Real real-estate investors expect ~10% annual return on the property. This is to cover taxes, insurance, maintenance, and standard profit margins. Right now, for hot markets such as Southern California, the annual return is 5%. This means most investors who are renting out their property are LOSING money.