The Housing Price-Rent Ratio

Paul Krugman writes:

http://krugman.blogs.nytimes.com/2007/12/28/housing-how-far-is-down/: [T]he housing-rent ratio... [is] comparable to the PE ratio on stocks... it fluctuated in a relatively narrow range until this decade, then took off for the wild blue yonder.... [I]s there any fundamental reason why this ratio shouldn’t go back to historical norms?...

Well, one thing has changed: interest rates, including mortgage rates, are lower, in large part because of huge capital inflows from China and other countries.... But is this enough to justify prices anywhere near current levels? I don’t think so — for three reasons. First, the math doesn’t work.... Second, the average is misleading... in “flatland”, where new housing can easily be built, real prices never rose much; the big rises have come in the “zoned zone,” where land and permits are constrained — and those rises... make no sense even given a maximum allowance for interest rates. Third, we won’t always get lots of free money from China.

So I come down to the view that the price-rental ratio will have to move most if not all the way back to historical norms. And that’s a long, long way down...

"A long, long way down" means, I think, "a fifty percent fall along the coasts."

I would cut that in half for two reasons: not 50% but 25% along the coasts, and much less in the interior. First, the likelihood that savings interested in being invested in the secure-property U.S. will be ample over the next generation is high: we will sell political risk insurance to foreign individuals and governments for quite a while yet. So real interest rates are likely to be lower in the past. Second, the zoned zone is not growing--and America's population still is. The gap between heartland and coastal values is likely to grow over time, and that anticipated capital gain should push up prices now.

Comments

[Jeff]

Nice post, Brad. I know that West Coast housing prices HAVE to fall -- in my town of Corvallis, Oregon 75% of the homes for sale are between $300,000 and $500,000 -- way beyond the means of most people here.

Few homes have sold recently, probably because people are waiting to see how low prices will fall -- in addition not being able to qualify for a mortgage.

But as a homeowner, a 25% fall sounds better to my ears than Krugman's 50%.

[Nicholas Weaver]

As someone who's calculated all this for myself ( http://www.icsi.berkeley.edu/~nweaver/buy_v_rent.xls ), actually a drop of 20% makes things pencil again, 25% definatly so.

That is, if you look at SELF rent, where you get the mortgage interest tax deduction. But thats still a pretty big bloodbath.

50% is delusional, there is no way prices in any market I've run the numbers on would fall 50% except in a really REALLY weirdly bubbled market, as long as you can still get a 30 year fixed conforming mortgage.

[Ken Houghton]

So you're joining with Krugman's initial suggestion (ca 17 Dec) that 30% is about the limit of a drop, and not the full implication of mean-reversion?

Nicholas Weaver's spreadsheet appears to (1) assume annual appreciation of 3% for all property, (2) assume no PMI cost, despite an initial scenario that appears to require it, (3) assume an implicit real cost of only 0.5% for the downpayment, (4) assume a stable property tax of 1.20% on the initial assessed value, and (5) assumes a second-highest-bracket tax rate of 28%.

Other than noting that the latter is presumptively inaccurate (if the rate is constant and the value of the property is increasing, the tax would as well, no?), I note those only because they appear to be implicit in containing the level of decline. (I assume HOA is "Home Owners Association," which implies that the property considered is a condo or a co-op.) Otoh, none of those assumptions would necessarily skew the conclusion by more than the normal back-of-the-envelope margin of error.

[Slocum]

"Second, the zoned zone is not growing--and America's population still is. The gap between heartland and coastal values is likely to grow over time, and that anticipated capital gain should push up prices now."

A comforting thought, I suppose, if one owns a home the the bay area, but I'm not convinced there is anything inherently fixed about the size or number of 'zoned zones'. The greater the difference in values, the greater the financial incentive to gentrify previously 'unzoned' areas. This has already been happening in non-coastal cities like Denver, Minneapolis, Chicago, and Indianapolis (and smaller college cities like Boulder, Madison, and Ann Arbor).

[khr]

"the likelihood that savings interested in being invested in the secure-property U.S. will be ample over the next generation is high: we will sell political risk insurance to foreign individuals and governments for quite a while yet. "

What makes you think that political risk is lower in the US than in such places as Switzerland, Japan, the Eurozone, the UK, New Zealand and others ?

Especially if you take into account the risk of currency depreciation ?

[B Clark]

I think a nominal drop of 20 to 30 percent will happen. But with inflation, and over time, that means the real drop is well over 35%, and could approach 50% - *over time* - like 6 to 10 years.

[B Clark]

Brad, when you say 25% do you mean real or nominal?

[Lord]

If past is prologue, half of the adjustment is in prices and half in inflation, so perhaps you agree after all.

[Ed]

"First, the likelihood that savings interested in being invested in the secure-property U.S. will be ample over the next generation is high: we will sell political risk insurance to foreign individuals and governments for quite a while yet. "

Wasn't this factored in to the prices of homes in the past? If so, then how does it mitigate against a return of housing prices to historical norms?

[Dave Johnson]

The boomers are starting to retire and many will want to sell their houses for smaller quarters, or to buy RVs, etc.

[wcw]

Now, I don't think prices fall 50% either, but even a nominal 50% (to say nothing of a mere real 50%) on the coasts rolls prices back in the range of 4 years of appreciation.

Now, 4 years is a lot, but it really isn't the end of the world. It's a hiccup. Predicting a hiccup is a stretch; predicting there will under no circumstances be a hiccup is a larger one.