Maybe, all along, we have been under-valuing houses?

And the new, higher prices are the more accurate ones?

There is yet another twist to the "housing bubble" question and it is consistent with my own strong "environmental" bent. The gist is that historically, in a "cowboy economy" (thank you Ken Boulding!) we had no sense that there were any limits to growth. Now we do. The hysteria over "peak oil" is the strongest and most recent manifestation. We know we are living on "spaceship earth" (thank you Bucky Fuller!) and not on a limitless plain in which we could pollute one spot and just move on. There is no there there to move to. This is it.

So maybe, all along, we had been under-valuing houses? Maybe the current surge in prices reflects something closer to their "true" value? Follow me? I will spell it out in more detail if I need to. But Is suspect most readers here get it.

Comments

[Robert Wacker]

The "we had no sense" is about the only thing that you said that made any sense. Home price increases have been spurred by lower-rates (50 yr lows) and then by speculation. Value is based on cash flows. Rents (i.e. cash flows) are not moving much. Thus in the long run "true-value" is the present value of rents (annuity) plus growth plus tax benefits minus expenses divided by rate of return. Let me put it this way. Let us say two houses on the block are the same. One is selling for $800,000 the other can be rented for $2,000/month. What should you do? Well let’s see the interest on the mortgage of an $800,000 house is about $3,500/month. That does not include up-keep or paying off any of the loan (or tax benefits). So let’s see here what is the proper valuation? I can pay $3,8000 a month and hope that interest rates never go up, or inflation kicks in and I make more $, or I can eventually find a greater fool. On the other hand, I could rent and invest the difference in capital that will have long-term growth benefits. There are other ways to look at valuation but I suspect that most readers here get it. The most basic rule in long-term investing is that eventually all assets return to the value of the cash flows (plus growth).

Oh and these housing numbers are not random; they are from your neighborhood.

[David Sucher]

Robert, my comments on real estate relate to the Seattle context. "Perception of scarcity" is a very real element in the Seattle housing market.

Btw, do you own a house/condominium? Or do you rent? I have a suspicion that differences of opinion on this issue have a strong correlation to whether one owns or rents.

[Dustin]

It is an interesting idea that you’ve hit upon... The first time I saw Robert Shiller's chart, I remember thinking... "Maybe the 70's and 80's had it all wrong..." Using the chart, it is possible to begin after WWII and draw a straight line growth from 1945 (or so) until today that doesn't seem so ridiculous.

I would argue that the average home that is put on the market has improved over the past 50 years and that this improvement would be in excess of inflation. I would actually be surprised to see numbers that pointed the other way... Both old and new homes have become bigger and amenities like heating systems, washers/dryers, higher quality windows, etc, have become standard features. And then, when you add scarcity of land, it seems pretty clear that an index of home values should show a growth over the past 50 years...

[Roger]

David,

For your comments to be correct, that means that owning real estate is a privilege of the quite well off--at some point, the cost of entry will simply preclude "the little man" being able to buy anything.

Do you think that's accurate?

As a homeowner, think there's a bubble-ish sort of thing going on. How many people making $100K+ a year can a single city support? What happens when none of the people who are needed to run the actual city can afford to live close enough to it to actually work there (especially true as gasoline continues its price rise)?

No one is going to work for $10 an hour in Seattle if it costs them two hours worth of wages to park and two hour's wages to fuel their car. And no one is going to spend six hours a day on a bus from Monroe or beyond.

Please remember very easy credit and exotic financing play a huge part in this price run-up. To buy a $500,000 house even a few years ago would have required $100,000 cash and an gross income of $137,000 a year to support the $3200 payments (figured at 7% interest, and Seattle-level taxes and insurance, with a max monthly of 28% of gross pay).

An interest-only ARM with an initial rate discounted to 5%, plus 5% down plus moving the gross pay requirements up to 33%, as many lenders do, means only $25,000 out of pocket and a required gross income of $91,000 a year. Still high, but the requirements are 75% lighter in the up-front cash and a third lighter for the salary.

Funny thing is, $500,000 homes are no longer uncommon but having a combined household income of $130-$140K is still pretty rare.

[David Sucher]

Roger,
I do not track your comments at all and I am at a loss to know how to comment.

[Kevin Bryan]

David,

Forget the US in the 70s and 80s. There are *numerous* examples of housing bubbles crashing, all around the world, over the last few centuries. Sydney has dropped 15% this year alone. Home prices in Japan are still up to 50% off their highs in the 80s. Home prices in HK are still not at their level from 15 years ago. Going back further, a number of areas in Europe have seen housing price drops of a large magnitude.

Housing in the US, long-run, is not scarce. The areas where the largest bubbles are forming, in fact, have seen decreases in population (or else very small growth): SF, Boston, NY, etc.

There has not been a large jump in the number of people preferring to buy vs. rent. The change in demand has been almost entirely speculative - that is, driven by buyers of "second homes", usually for investment purposes. Housing in many areas has become a pyramid scheme market.

LR, I think it would be good for Seattle (and other places) to see housing prices fall dramatically. How do the expensive cities plan to draw new talent? Where is the next Bill Gates moving to - Boston or Salt Lake? NY or Austin? San Diego or Tampa?

[David Sucher]

Kevin, I think you are just a bit off about the Seattle market. It is hardly driven by second homes for investment purposes.

[Brian Miller]

Claiming that SF is a declining population case is true only if you look at the City itself isolation.

[Richard Wacker]

David,

Valuations are not opinions, art maybe. I own and I use to have income property. I sold the income property and kept the house. I also own a winter home in southern OR. I have owned my main house for years and don't owe much on it. I have invested in real estate in various forms for 20 yrs. I have sold all of my investment positions. Part of investing is knowing when to sell and when things are about to turn. I have very much liked reading this blog in the past. I am afraid that you do not get what Shiller is talking about and you seem to be in the not so rational camp. You sound maybe like you have recently purchased or invested in property. Understanding cycles, costs, cash flows, and -as you point out- perception is very important. However, there are basic macroeconomic and finical pinnings at work here. Perceptions change with the financial winds and unless you know what to look for you will get stuck. There are a lot of professional investors out there. They do not move with the novices that Shiller writes about. They tend to eat them for lunch or dinner. In fact novices (maybe like yourself) are often "contrary indicators". The numbers are already stating to look bad for the market. Hopefully it will be a soft landing that won’t trigger a recession next year. Maybe low rates will prolong the inevitable. I expect to lose 20-40% of real-value opportunity with my main house but I can afford it because of what I have made on my other investments. Speculators and investors will not want to lose that much and many will sell their inventory. In fact condo inventories are already building. Some people will be forced to sell. Perceived value of property will not prevent the “invisible hand” from correcting the market. When real estate is over priced and people pay too much other sectors of the economy get hurt. This leads to job losses and a slow down and eventually a drop in real estate prices. This is your invisible hand. You can monitor housing inventors they will give you some idea of what the market is doing. You should also ask yourself about other bubbles and valuations. Why is the market “undervaluing” Bank of America? Is it because they hold to many ARMS mortgages and Wall St is worried they will see loses? The real bubble to worry about is in the bond market. Nobody is talking about it but the Federal Reserve is worried. If that bubble goes say goodbye to low rates for long time and housing prices will drop (housing is just over priced but not a bubble). We are living in interesting and uncertain times. Not good for investing in over-priced assets. You can invest in deflation of the housing assets too. If you are worried about not being able to pay you mortgage or lose money you can hedge your position with housing options too. You should talk to a professional about how to hedge if you are worried or if you want to trade on the down turn. If none of this makes any sense just ask yourself. What is the marginal cost of building a house.

[Redd]

Home valuations are done when the city coffers are in need of capital.

How do determine value? A person or there home is only worth as much as someone is willing to pay him/her or for a house like there neighbors.

Home valuations go up during a buyers market. Why? appreciation is rising, the mayor and city council see potential dollars for them to spend on special intrest programs. They see it as leaving money on the plate.

When the housing bubble deflates, and only in certain areas, valuations are done less often. An area becomes less popular, you have less new residents moving in. Another example, everyones valuations are going to go up as long as people moving from the coasts move in to an area where the tax levy is lower. They have more money to spend, and have to otherwise take a tax hit, on a new home. So if it is a trend for people to build $800K homes, everyone pays or benefits, depending on what side of the coin you are on.

[dissenting]

While your comment that the true cost of housing should be higher than the historical average may be correct. However, this would not help show that there is no housing bubble unless there is a causal relationship between realizing the costs of sprawl and the cost of housing. I highly doubt significant market effects of environmentalists concerned with sprawl. Housing starts are high, so there appears to be no recent regulatory restriction on producing homes.

It appears you are desperate to justify current prices. Sure, there is a chance that prices are justifiable, but given the repeated history of bubbles their is a high probability the prices are not justified. During the dot-com bubble, people made arguments about the "new economy" and the exceptional nature of the Internet. Here, you are making an argument about the exceptional nature of the housing market. An argument that has failed many times in the past. And you make this argument with very little evidence that the housing market is exceptional. At least the Internet was something new.

Rather than attack other people's motives for questioning housing prices, perhaps you should evaluate your own willingness to bend over backwards to defend the high prices.

[Richard Wacker]

Redd,

Interesting but I think you should read up on asset valuation and cash flow. It might save you some pain in the future; if not by making a mistake then by understanding how most of the financial world functions. Assets have underlying value based on cash flows. When assets are "over-valued" then the current purchasing cost is greater than the discounted cash-flow plus growth. Think about what Time Warner paid for AOL. Just because Time paid $182 billion for AOL it does not mean that the true value was correct. In fact it was off by almost 100 billion dollars. Why because the cash flows and growth provided by AOL was not what TIME thought.

The same analogy can be used for housing. Do you need me to explain how or can you figure that part out?

You can ignore what the city tells you about what the value is. They will just say what houses are selling for not what the true financial value is.

[Roger]

David,

My obtuse and probably uneducated prose was trying to point out that:

a) You have to have somewhere within a city for the people on the lowest rungs of the economic ladder to live;

b) If housing costs and the costs of commuting to work both rise, you can end up with a situation where those people cannot actually afford to either live in the city or live close enough to commute affordably--how do the affluent get their lattes, or their garbage picked up, then?;

c) the standards by which banks lend have loosened considerably--in my scenario, today the cost of entry is but a quarter (or less!) of what it once was and the monthly payments in the early part of a interest-only loan are 2/3rds what they'd be in a conventional mortgage. And yet, the costs are still astronomical;

d) the people taking advantage of c) are likely to be people on the financial edge anyway, counting on appreciation to provide their safety net; and

e) housing costs have far outstripped income growth, as far as I can see.

I was trying to point out that if your theory is correct, "entry level" housing as we conceive of it today is an aberration, and home ownership is really only the perogative of the well-to-do--definitely not the middle class.

[Roger]

Also interesting to me that the main form of mortgage before the Great Depression was...interest-only loans.

[redd]

Mr. Dick Wacker, no matter how condescending you are, you only have highlighted my point. Value is determined by what someone is willing to pay. Let's say you want to sell all of your Star Wars collection. Well it's estimated value is worth $20,000. Well you aren't going to get shit unless someone gives you that much cash. Using that same analogy, if you go insure your collection, are you going to insure it for it's value, or what you paid for it?

Stock values have nothing to do with home valuations, but since you are bringing up the comparison, your error was made because you believe the fact that Time Warner overpaid for AOL does not mean AOL wasn't worth that. It obviously was, someone paid that much for it.

Can you go to a persons door that is selling a home and tell them you will pay them what you think it is worth? Well, you can, but a professional that did a PROPERTY VALUATION and PRICE COMPARISON told the seller that everyone else on earth will pay you X amount of dollars. X= What the home is worth, even though you think the home is "priceless".

So if you buy a house being sold by AOL you can bet it is overvalued.

[Richard Wacker]

Redd,

Apples and oranges… The value that is the purchasing price of an asset is not necessarily the “true-valuation” of an asset. If it was our business cycles would be much softer and Time Warner share holders and Tony Blair (http://www.sundaymirror.co.uk/news/fullnewsbottom/tm_objectid=15880889&method=full&siteid=106694-name_page.html%22) would be a lot happier. I am sorry that you see people who question assumptions as condescending or should I say condo-sending??? No seriously, questioning assumptions is key to seeing were things can go wrong. I question my assumptions and I hope others will too.

I wish I had time to walk you through the last business cycle but I don’t. Here is an abridged version. A rough model for asset valuation is by looking at present value of future cash flows (in the case of real-estate that would be rent; this has dropped since 2000) plus tax benefits (this has increased since 1997) plus present value of future growth (this has grown since 1999 but now it looks like it is going to drop) minus costs for upkeep minus opportunity costs. There are other methods too but this one will work. So at the end of the dot.com bubble the market collapsed and a lot of people lost jobs. To prevent a worse down turn the federal reserved lowered interest rates and after 9/11 they lowered rates to record lows. They were basically giving real money away. According to IS-LM models this is a massive stimulus to the economy and can cause inflation over time. It also stimulated the bond market (some people now worry that the bond market is frothy). Mortgage rates dropped to record lows which caused the real cost (affordability) of housing to drop because your monthly costs (mortgage payment) dropped. People started to purchase more and demand increased. While sales prices increased by 20%/yr housing was still affordable because of low rates. Now people started to see the growth in sales $ and started to jump in- 40-50% of new jobs created since 2002 have been in housing or housing finance. People were in need of employment and there was the growth sector. At the same time new exotic mortgagees on high risk credit lowered monthly costs even more. This drove prices up more and increased speculation. People saw the present value of future growth opportunity as being large and speculated. Others saw that the cost of construction was far less than the sale prices and built (think Boston in the 80s). In the long run this speculation and building is what will cause prices to drop (maybe only in real not normative value.. when people are over burden and growth opportunities are not there properties will be dumped and the cycle will end). Up until the point were sales prices are equal to the "true valuation" things are good; unfortunately we left that behind 1.5 years a go. While all this is going on there is a huge increase in building, a trade imbalance with Asia, currency issues with China, deflation in Japan, and massive twin deficits in the U.S. The Federal Reserve is now worried about inflation and asset bubbles that can seriously hurt the financial system in the US (think about what happened in Japan). Our economy though larger is now less diverse than any time in the past 20 yrs as service industries and now housing replaces manufacturing and agriculture. While we are likely to have low rates (10-yr bond) for some time, as the Federal Reserve increases short-rates they are basically shrinking the economy eventually something will have to give. Usually what happens is that an asset class losses value (i.e. the growth component is cut.. if it is bad than the cash flow component is cut too). Some think it will be the bond-market that will go. This will cause mortgage rates to go up. While real-estate prices are sticky, in the long run markets are efficient (this means that business cycles and new construction will eventual cause prices to drop towards the marginal cost of construction). Certainly tax laws, pension investing, and the bond market has helped housing but now irrational expectations of growth and fear of being left behind have taken over. When Time purchased AOL they thought the future growth opportunity was worth a lot because for two years prior it was. It turns out they were off by $100 billion. A lot of people now hope future growth in housing is worth a lot because it was over the past 3 years: eventually they will be wrong. Assets are over-valued when people don’t realize what their assumptions are and what events can make those assumptions turn out to be bad one.

Here are my assumptions..

Original assumptions (2001)… Housing was undervalued because…. a drop in interest rates and changes in the tax system… Interest rates are low because of the Federal Reserve, savings rate is ok, excess liquidity in the market, high savings rate in Asia, lack of growth opportunities, and undervalue of the Chinese Yuan. Low rates make purchasing is cheaper than renting.
New Assumptions… Housing is over valued, inflation is picking up, Fed raising rates, oil prices high, unsustainable lack of diversity in jobs, china is revaluing currency, likely bubble in bond market, government running massive deficits, consumers spending way to much, zero savings rate, lots of building and speculation could mean that bullwhip effect will happen. While prices have double over the past 4 years, monthly mortgage payments have not increase much more than the rate of inflation. Exotic and fraudulent loan practices are increasing risk; eventually this will cause rates to go up. There is no real housing shortage since rents are low and land is plentiful. Excessive # of people are taking ARMS and are deep in debt. People are taking to much equity out of their homes. People are behaving irrationally, contra-indicators are all over the place (think about who is speculating, realty tv shows, magazine covers.. not good signs.. these are the people/things that drive prices/value beyond “real/sustainable values”). New bankruptcy laws will change reality and psychology of market. All of these observations and assumptions that I have made say to me that the risk is greater than reward. Eventually there will be a slow-down, jobs will be lost, and people will move on to other investments. Because the Federal Reserve has pumped so much $ into the system they have no choice but to keep raising rates. Bankers (say at Morgan Stanley) and economists “(say at every major university) now worry that our out of control spending and lax monetary and credit policy could cause the dollar to collapse. Interest rates are very low right now but how long is that going to last? Does it need to last for the market to adjust (people are over leveraged at historically low rates)? Those are the big questions. To me it does not look good. Many people have mortgaged their futures; hopefully we have not mortgaged the countries ability to quickly rebound. It is a flat world out there.

Feel free to attack my assumptions…

After the fall-out from bad loans given to over inflated "values" you can expect the government to regulate how property is "valued" for loans. While comparables make sense for valuations when there is no cash flow involved, price comparisons are a joke from a financial stand point when you are trying to determine the “true value” of an asset... So tell me about appreciation wise sage... Why do prices go up and down...??? Now that is condescending..

[miss representation]

What is clear a sign of bubble activity is you have several people on this thread aruging against generally accepted (I won't argue 'fundamental' since I'm not that much of an absolutist) standards of valuation and investing. And when I say 'valuation' I mean strictly in terms of looking at real estate as an asset class that does not differ substantially from any other (since, again, there is little historic evidence that investors behave differently on a downslope with real estate than any other class).

Doesn't anyone remember the armchair quarterbacking of the late 90's when we were told P/E ratios were antiquated, and anyone who said Amazon was overvalued at $400 obviously was simply angry because they missed buying in at $50 -- BTW, trading closed Friday at $42, and Amazon is considered one of the stronger companies to come of out of Internet Bubble. Who remembers MarchFirst? A company with a market cap of over $10 billion, which was essentially liquidated in less than 90 days?

Real estate will come down. If your basic finanicials can support buying historically overvalued assets in hopes of a short term gain (which would require a rather large investment due to the short time horizon, and that's embracing quite a risk premium), then real estate is a viable option -- and there are plenty of far more attractive financial vehicles, exlcusive of buying inventory outright, that will benefit from the run up with less downside risk. Considering that some European bourses are up 25% on the year, I can't say it's the smart money. ANYONE who takes out an interest-only mortgage this year (and who could not support it if their ARM swung up 150 basis points -- not an unlikely scenario with Greenspan still stumping for increased rates) can only get out with their finances intact is because of blind luck. An interest-only mortgage in this market is like buying Amazon at $400 on margin.

[David Sucher]

A home purchase is not only or even mostly a real estate purchase.
Anyone who thinks it is ought to rent.

[miss representation]

You are trying to have it both ways David, and doing it badly. It is either an act of faith, driven by a desire for personal placemaking and detached from rational economic analyses -- though anyone who argues that most economic decisions are largely rational is also somewhat delusional -- or it is the best investment opportunity since tulips, and anyone not in on the action is a fool. I hope you see the wide gap between those two positions: the former barely acknowledges the financial dimension of the decision (perhaps even to one's own detriment) and the latter sees nothing of value in a house beyond one's ability to exploit price differentials. Rational economic analyses can temper the worst extremes in either direction, since it can correct bias by taking into account other criteria. After all, considering quality of life is a component, and being rational about the potential downside of an interest-only mortgage on quality of life five years out is not looking at the asset purchase as strictly an investment vehicle.

[David Sucher]

"Both ways?"
I have no idea what Miss R. means. Lost me.

[miss representation]

So maybe, all along, we had been under-valuing houses? Maybe the current surge in prices reflects something closer to their "true" value? Follow me?

A home purchase is not only or even mostly a real estate purchase.

It seems like in the first case you are aruging that value is measured only in dollar terms, and in the seconding you are seeming to dismiss anyone who analyses home buying as an economic activity. If in the first case you are trying to move the discussion out of the realm of the financial, you should find terminology that doesn't have a whiff of late night infomercial, or present us a barter system for obtaining housing.

It's not like everyone woke up in 2002 and said "Whoo! That's some internet hangover! But you know? You know what is real important? A home. Castle. Pride of place. Blah, blah, blah" and then everyone ran out to nab their 40 acres.

Most people want to own a home. But the sharp uptick in purchasing habits is clearly driven by speculation. You, who knows a thing or two about economics, willfully ignores that economic anaylsis can encompass a broad array of values; other criteria can be weighed when observing trends, but since most of the purchase behavior at this stage is in absence of those criteria (home ownership to provide long-term housing security, for instance), the current discussion focuses on bubble economics.

In order to prove your point at all, you would need some metrics that show that new patterns of housing development would reflect valuation (in economic or cultural terms) that would make sense in the context of macro-economic or environmental changes (where scarcity of land or other resources would provide a stable long-term valuation to justify the purchase cost). But housing -- excepting perhaps Miami or NYC (both hemmed in by geographic need), and Portland, OR, as the hippy outlier -- has followed the same depressing pattern it has for the past 50 years: find cheap land even further from existing services and tax laws, building bigger houses on useless plots (too big for efficient distribution of services, to small to farm in any way), and wait for the SUV drivers to show up.

[Mr. Right Now]

There is a frightening parallel between the late '90s bubble rhetoric of the "new economy" defying all the old valuation fundamentals and the currently vogue and ubiquitous arguments about the exceptionalism of the housing/real-estate market. Paradoxically, I would agree that the current real-estate climate is exceptional and cannot be understood in historic terms. In the past, people were generally unable to secure loans from banks if the couldn't afford the home they wanted to buy or if their credit was bad. Now it seems that just about anybody with a pulse can get a zero down interest only loan. Maybe the banks have been emboldened by the bankrupcy legislation K street was able to buy. But if all those people who are now rushing into massive mortgages for fear of being priced out of the market or missing the boat suddenly are left owing more than they have in home equity, there could be widespread bankrupcy. And with the new bankrupcy legislation, it's not hard to imagine that a whole class of indentured servants might be created.

As a caveat, I'm a renter.

[David Sucher]

Faith -- in fact gleeful faith -- in the housing bubble is almost exclusively found among renters.