New Math on Homes

Mike "Mish" Shedlock
April 3, 2006

The New York Times is writing about New Math on Homes. Let's tune in to the latest "It's different this time" thinking.

Gary and Margaret Hwang Smith spend a lot of time musing about real estate.

It is not just that the couple, economics professors at Pomona College, have put so much of their money in the game, having bought a home in Claremont, a college town in Southern California, a real estate market that has been described as overpriced by most and a bubble by some.

Rather, they said, applying economic tools to buy a five-bedroom 1922 Craftsman home sharpened their thinking and guided two years of research into whether there is a bubble. They concluded that not only was the Los Angeles region not in a bubble, but many markets that others were calling overpriced, like Chicago or Boston, were probably underpriced.

Their findings are at odds with other surveys that use the relationship of home prices to income to determine whether home buyers are overreaching. Homes in Orange County, Calif., were fairly priced, the Smiths found. Some cities like Dallas, Indianapolis and Atlanta were screaming bargains. Homes they surveyed in San Mateo County, south of San Francisco, were, however, overpriced by about 54 percent.

In a paper the two presented at the Brookings Institution this week, "Bubble, Bubble, Where's the Housing Bubble?" they said that even though prices had risen rapidly and some buyers unrealistically expected the trend to continue, "the bubble is not, in fact, a bubble in most of these areas."

They argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.

Their bottom line was: "Buying a house at current market prices still appears to be an attractive long-term investment."

Richard Peach, a vice president at the Federal Reserve Bank in New York who studies home prices and their relation to income, echoed that view, saying, "This is an important paper."

The value of the Smiths' research may be its practicality. It concentrates on the how, more than the why, in laying out a method to determine the underlying value of a home. They offer a way for real estate agents, financial planners and prospective homeowners to understand how much is too much to pay for a house.

Karl E. Case, a Wellesley College economics professor who has been studying real estate prices for more than 25 years, calls the paper's method "absolutely the correct way to think about it."

The Smiths say a prospective homeowner needs to ask, Should I buy or should I rent? That the value of a house is tied to the rent it can command is not a new idea. Other economists have advanced the idea and some have advanced the notion that a bubble can be measured with price-to-rent ratios that correspond to price-to-earnings ratios for stock.

But a price-to-rent ratio does not go far enough, according to the Smiths. Investors like Warren E. Buffett value a stock by looking at its intrinsic value - that is, how much return one would get on the stock over time. For stocks, that is the cash the company generates and, in some cases, gives back to shareholders in the form of dividends.

The intrinsic value of a house is the rent that it can generate. "It's not that houses are like stock," Mr. Smith said, "but if you think about them as you do stocks, you start thinking about it correctly."

The problem is that there has not been a good way to compare rents with homes. Indexes that try often end up comparing apartment rent with prices of a single-family home. A result, the Smiths said, is inflated price-to-rent ratios that are displayed as evidence of a bubble when one may not exist.

The Smiths solution was to look for "matched pairs" of similar houses, one rented, one owned, but both in the same neighborhood. They did this in 10 cities in which they could find enough real estate data and matched pairs. Once they had established what rent was for a certain house, they used software they created to compute the flow of rents over time, factoring in the outflow of mortgage payments, maintenance costs and taxes. Then they had to determine what those future payments would be worth today, which economists call the net present value. If the net present value is a positive number, the house is worth the price. If the result is a negative number, the buyer would be better off renting it.

Several economists, like Mr. Case and Mr. Shiller, quibble about the assumptions the Smiths make in doing their calculations - for example, homeowners spending only about 2 percent of the house price a year on maintenance or that everyone can obtain a mortgage interest deduction.

I find it interesting the number of complete fools hopping on the "no bubble bandwagon." The 2% maintenance figure is of course questionable, but I am very surprised that no one questioned the key assumption that house prices will rising 6% a year from now until eternity.

It simply does not wash. Here is something that does. Long term prices of houses simply can not rise above people's means to pay for them. That is a simple economic fact. Here is another simple economic fact: Family incomes are falling. The negative savings rate and rising foreclosures are more proof of stress in the system. Real wages have fallen for 4 consecutive years and that includes some pretty fat bonuses of the Wall Street fat cats at the top end.

The fact is that home prices are several standard deviations above norm in terms of affordability in many locations. Gary and Margaret Smith are simply making the classic mistake of projecting into the future what has happened over the last 10-20 years as if it that period is the norm. That is the same type of mentality used to justify the Nasdaq bubble in Spring of 2000.

At 6% appreciation a year home prices would double again in 12 years. That nifty 3 bedroom shack in California now priced at $800,000 would supposedly go for $1.6 million in 12 short years. That $750,000 condo in Florida supposedly would be going for $1.5 million 12 years from now. Sorry, I do not think so. Who could afford to buy them? Buyers are already stretched.

Did the Smith's factor in property taxes? Did they factor in the possibility of rising federal taxes? Did they factor in the possibility of a ball breaking recession? Did they factor in global wage arbitrage that is working to suppress wages in the US? Did they factor in possible effects of a baby boomer retirement?

What did they factor in other than an absurd and unfounded belief that home price will continue to appreciate at a 6% clip from now until eternity?

The Smiths are in fantasy land. There is no economic justification for their key assumption. Proof will be coming up shortly when bubble area prices drop 40% or more, and the non bubble areas stagnate at best.

People are always looking for reasons to justify their purchase. It happened with the Nasdaq bubble and it is happening again in the echo bubble in housing. Their study, a 60 page PDF, is impressive in length but unfortunately their key assumption is as flawed as dot com "click count" analysis was in 1999.

Mike Shedlock "Mish"
email: Mish
http://globaleconomicanalysis.blogspot.com/

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