I've been thinking about this since my 8/21 post, "Return to historic costs/income", attempting to better measure the idea of house prices returning to their historic relationship with income.
The blue line above is the S&P/Case-Shiller price index for Los Angeles, from 1987 through the first half of 2007. I extended it back to 1975 with the similar OFHEO data for Los Angeles. For income I used the BEA per-capita personal income for Los Angeles (magenta line, numbers in 1,000s). Its linear trend continues into the future.
If the blue line falls at the same rate as it's fallen so far, it would fall over 40% before converging on the income line. Considering its huge rise, that doesn't seem unreasonably more than its 26% fall in the 1990s.
But income alone doesn't cover buyers' ability to pay. Next step was to add average mortgage interest rates, above, from the Federal Housing Finance Board. It shows the spike above 15% in the early 1980s. But it doesn't appear to show the teaser rates used to qualify buyers the last few years. I've presumed rates will return to a longer-term 7.9% average, the average of 1975-2007, but omitting the 1979-86 period over 10%.
Above I plotted a new income line (orange) adjusted by percent above or below the 7.9% average, to see how it tracked price increases. It's better, but could fit the 1980s better and doesn't fully reflect the last few years' teaser rates.
Finally, I tried to add a "wealth effect", to represent the value of building or falling equity, lagged a year (yellow line above).
This is an experiment and work in process, that deserves a bunch of disclaimers and requests for feedback! You may have noted that the price index (left axis) is arbitrarily matched to income (right axis). There may be better data to use for income and interest rates. I presumed future interest rates will not remain below past averages. And will prices fall faster or slower? But the general pattern seems reasonable.
Tuesday, September 4, 2007
Modelling prices and income
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17 comments:
Calculated risk meets Westside Bubble...quite a beautiful day indeed!
Very bold analysis, thanks,
Compare to long term chart for DJI, S&P, Nasdaq
This is about how people deal with uncertain future!
One thing you don't take into consideration is equivalent rent. It seems to me that the "real" value of any abode is determined by how much it would cost to rent it. Therefore, even if prices are falling, if monthly PITI is below or equal to what monthly equivalent rent would be, a home would be a "safe" buy because the option of renting it out with positive or neutral cash flow would always act as a hedge against the unrealized capital loss, or a revenue-neutral alternative to attempting to sell into a stagnant market.
So I guess the next calculaton might be what rents will do, and how that has historically measured against cost of ownership. I've heard both sides of that story argued convincingly -- both that rents will go down because of the glut of unsaleable inventory, or that rents will go up because so many former homeowners will be hitting the streets looking for rental.
In any event, I think it's also an important statistics to take into consideration in purchasing a home, as opposed to trying to time the market, which they tell me is pretty close to impossible.
And of course, as has been mentioned here before, the current cost of renting is completely out of whack with cost of ownership...as much if not more than it is with median incomes.
It seems that the downward trend line is not steep enough... Bottom in 2016 seems far off but not totally crazy. I would bet that the initial part of the down is steeper, then dribbles off for years.
Historically after asset bubbles burst, prices "over correct" , or are reduced beyond what the fundamentals support.
Not be be too wonky, but see Asset Price Bubbles, Implications for Monetary , Regulatory
by Hunter where "Investors and speculators may grossly overestimate (or underestimate) future profits and dividends, but they rely on their imprecise knowledge of the future and correct, perhaps over-correct, when new information becomes available."
The correction for reduced expectation of future RE price increases is just starting. Many speculators expected RE prices to increase 20 plus percent a year for many years. Instead prices are steady or starting to fall.
An overcorrection would mean that prices fall below the long term trend line. Often the more intense the rise, the larger the overcorrection. So for example, North of Montana would blow out with a greater overcorrection than single family houses just North of Wilshire.
Great chart and great blog by the way. I would just suggest another color line addition for a further overcorrection below the long term trend line for a 9 month period in year 2016.
Also since Bubbles are psychology manifestations, I think that the retreat to the norm will be faster. The speculative psychology and financing are dead. The retreat will be very responsive in time to external shocks such as reduced liquidity, tightening lending standards, increased documentation requirements, and the perception that the RE game is over for the foreseeable future. Price trends are also psychologically self -reinforcing and gather their own momentum on the downside as fast (or faster than on the upside). In other words, I would time the price retreat to the mean in about late 2011, not 2016.
By the way, the overcorrection time would also be the optimal time to buy.
Assuming the bubble started in 1998, it's been growing 9 years. So a 9 year correction (2016) would actually be pretty quick.
But I agree with the other commenters that there should be an over correction prior to recovery so your slope should be steeper to hit that low on the 9 to 10 year mark.
The scenario you present might play out for average condos and very small lots but I don't see demand for larger SFR (lot size 7k+) diminishing to the point of a 40% drop. There are many other dynamic conditions which influence real estate prices.
Would you please explain why you believe average income should directly correspond to median property values on the Westside, going forward? Don’t you think our market is subject to some greater international influences than in the past? Would you please delineate a set of conditions to qualify the assertions you use?
Thx
Ah, international influence, the last hope of those who don't want to see their home value drop.
I really don't think that international influence is that significant. Who are these mythical international influencers? Investors? They follow a herd mentality. I've learned that from a decade of stock market investing. People bought peapod and pets.com stock because dotcoms were hot, not because people were flocking to the internet to buy groceries and cat toys. Any internationals who bought Los Angeles properties as investments because real estate is hot will be the first to bail.
Or perhaps they're wealthy folks looking for a pied a terre in L.A. In what scenario does this account for a significant portion of the marketplace? And what sort of properties would they be buying? I could see maybe studio to 2 BR ocean-view condos, maybe, but not a house in Sunset Park or North of Montana. That'd be a big investment for someplace you'll spend at most a few months out of the year in.
And as rental properties the prices right now make no sense at all. The vast majority of rental properties I've seen on the market represent a worse investment than putting your money into a CD at 5%.
How, pray tell, does this international influence play out in your mind?
© AP (May 2007)
8. Los Angeles
Median home price: 584,800
P/E: 4th highest
Affordability rank: Least affordable
Housing price trend: 3.2%
(compare to the Case-Schiller index)
Anon,
I see what you are saying however I think you are missing something. You said:
"please explain why you believe average income should directly correspond to median property values on the Westside, going forward?"
I believe that average/median household income will NEVER correspond to median property values on the westside. They never have and they never will. The westside commands a premium (even the biggest bears will tell you that). So naturally, the majority of owners in the area will be above median earners. Since you conceded that smaller lots and condos could take a big dive, we can focus exclusively on the "high end".
It does not seem impossible for a $3m house to fall by a large amount because even if it fell by a third, it would still be valued at $2m. A $400K downpayment is needed for this at a minimum as well as an income that would easily be in the top 5% (probably more like top 2%+). Then there would be the issue of $25K per year property taxes. And this is all on a property that already fell by 33%!! Surely this could be within the realm of possibilities, right?
Truth is that none of us know, but many of us feel that all time highs across the board when looking at price/income ratios combined with the fact that high end properties in SM have fallen significantly in the past means that big drops are indeed possible.
Anon, please explain why you believe average income should directly correspond to median property values on the Westside, going forward?
Actually, this is the S&P/Case-Shiller index of price changes, "capturing re-sold sale prices to form sale pairs", not a median-price index.
I agree, an index of Westside income and house prices would be more accurate. However, in the 1990s Santa Monica (low-end north-of-Montana specifically) showed a greater rise (3x) and fall (1/3) than LA as a whole. Most of the same reasons of exclusivity applied then too.
As we have established earlier,
North of Montana teardowns
on the standard 7500 square foot lot
were
300k in 1985
up three times to
900k in 1989
then down 30% to
600k in 1995
then up more than three times to a peak in 2006 or early 2007
and have now come down.
Can anyone here comment on whether there were any other neighborhoods that experienced such a sharp run up in the 1985 to 1989 bubble and again in the 1995 to 2006 bubble?
Venice, for example I think missed out on part of the bubble in the 1980's but participated fully in the 1995 to 2006 bubble
In the last bust, Beverly Hills took a 50% cut in prices. When we bought our house in Mar Vista in 1999, it was at $410,000 -- priced at $40,000 less than they had paid for it in 1990. In 1989, everyone said the westside was safer, etc. but that's not what I saw. The drops were equally extreme. Admittedly, the Northridge earthquake contributed, having done an inordinate damage in Santa Monica, as did the Malibu fires, but the westside is in no way immune. I am still worried about a sucker punch when people realize that stocks are valued much like houses have been - based on a run up that has been financed by credit in which companies have been buying back their stock. It makes their earnings look better without increasing their core productivity. I really really really hope I am wrong.
And by the way, the work you have done with these analyses is absolutely remarkable.
Thanks for the MV and BH info - and the compliment - dlp!
Great start on the graphs! But I can't help but continue to point out the limited supply of homes in Santa Monica... Northern Santa Monica in particular. Also, SM has a per capita income that is more than twice that of LA county. We've also been seeing a steeper rise of late in per capita income...
Someone mentioned teardowns N. of Montana coming down in price this year... I don't think we've seen that yet...
One other thing: SM businesses generate over $5 billion in annual payroll, which greatly aids in funding the miniscule inventory of pricey homes the city has.
So a 40% drop could happen, but it's going to take some other forces to go that steep (still love your site though)!
Thanks, rosebud. I'd like income and Case-Shiller-like price stats for Santa Monica or the Westside, to compare with LA in general. Can we assume SM incomes are rising at a greater rate than for LA?
In the '80s-'90s north-of-Montana values rose more and fell more than for LA as a whole. True again?
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