Fair Value: Why Should Home Prices Stabilize?

After the weekend housing discussions, I received a few emails, asking: “Why do you think the worst of housing is behind us? Why can’t we fall another 33%?”   

The short answer is, Prices certainly can fall much further; it is possible. However, I am making (what I believe is) a higher probability argument due to fair value. My basis for saying the worst is likely over are prices: We are off 33% from the peak, and as of the end of Q1, were ~5-15% over fair value by traditional metrics.  So a return to fair value — even a 15% drop in 2011 — still means the worst is (was) behind us.

If houses were to careen far below fair value — they were about 40% overvalued, so in theory, they could overshoot 40% to the downside — then my valuation thesis would be wrong. There are lots of ways house prices could drop much further: If jobs and income plummet from here, home prices will be too high. If interest rates spike, prices will adjust downward. If the mortgage deduction were to be eliminated, prices fall also. IMO, these are smaller possibilities — say 20-25% chance — then merely mean reverting towards historic relationships with median income, cost of renting, and home equity as a percentage of GDP.

Jobs, Income, cost of renting, the mortgage tax deductions, desire for specific school districts, and myriad other factors have typically provided a relationship between home prices and fair value. Assuming that these traditional elements continue to have force, then prices may be less likely to careen past fair value the way equities do when they mean revert. Psychology has an impact, but the insanity seems to be more tempered with Houses than it is with stocks, likely to due the transactions costs and time lag of buying and selling real estate versus instant stock transactions.

The ultra low rates and abdication of lending standards are why prices went into orbit. Lending standards have tightened, but rates remain low. These headwinds are why I expect future appreciation to be modest at best over the next decade.

For some context, consider these three long term charts: >

US Median Prices of Houses Sold


Source: Economagic

Interest Rates Conforming 30 Year Fixed Mortgages


Source: Economagic

US Home Ownership Rates

g6901170640212142463646921093225.gif Source: Economagic

Previously: A Closer Look at the Second Leg Down in Housing (June 24th, 2010)

Cost of Home Ownership (February 23rd, 2010)

Originally published at The Big Picture and reproduced here with the author’s permission.

2 Responses to "Fair Value: Why Should Home Prices Stabilize?"

  1. Thinker   September 14, 2010 at 3:47 pm

    I think that the number of jobs created would be the major factor affecting housing prices. However until the economy recovers, I would propose a housing stabilization program where the government would receive first rights home equity in return for making part of the monthly mortgage payment for those facing foreclosure, with the government disposing of its housing shares in 10-15 years (disposing over a period of time to minimize price disruptions on the housing market) by having the homeowner to either refinance or sell the home then. The current foreclosure rescue plans are too indirect, they involve some write offs on the part of the lender and also give away government money. Under my plan, there would be no government giveaways, the burden would be on the homeowner (by not building equity) and the banks possibly having to writeoff some mortgage balance in 10-15 years time. In return the homeowner gets to stay in his home for 10-15 years (as long as he or she does not default) and the bank to receive monthly mortgage payments for the same period of time. At the end of the period, the homeowner would either have to refinance his mortgage or sell his or her home and the government would get its money back with any remainder first going to the bank and then the homeowner. By reducing the number of homes being foreclosed, new housing construction employment will increase, housing prices stabilize and possibly even increase. How would this be funded? By selling T-bills, since investors seem to be flocking to the safety of government dent and rates are low. Of course, the government would have the authority to halt the program if T-bill rates started moving up sharply in response to the program. A modest increase in interest rates over current rates would be okay.

  2. Its So Obvious   September 19, 2010 at 3:20 pm

    I’m so frustrated with the government mucking up the natural course of the housing market and its absurd interventions to prop it up with inflated home prices on the backs of ALL taxpayers. To be fair why not tax only homeowners the cost of maintaining the status quo as they are truly the only ones directly benefitting besides the banks and investors obviously. All of those who rent and wish to be a homebuyer should not be asked to pay for this support when it workng against there best interest, since lower prices would enable more would be buyers to qualify and more people to rent as rental prices become more affordable. As a real estate appraiser and broker for 16 years I know something about this business.