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.