Tuesday, September 25, 2007

When Will Housing Prices Recover?

Today, September 25, 2007, the National Association of Realtors reported that sales of existing houses had fallen again, for the sixth straight month. Sales in July 2007 fell to a seasonally adjusted annualized rate of 5.5 million, down more than 12% from last summer. The NAR reported that prices of homes sold had actually risen 0.2% from a year ago. But another source, the S&P/Case & Shiller Index, reported that home prices were down 4.5% from July 2006 to July 2007. Most other data indicate falling home prices.

A question on the minds of all homeowners, home sellers and home buyers is when will prices stabilize and recover? Of course, no one knows for sure. Predicting the weather is much more certain in economic prognostication. There is, however, an investment technique that may provide insight.

Many money managers subscribe to the notion that assets have predictable values that can be discerned from historical information. For example, bond traders posit that interest rates will generally be higher the longer the maturity of a financial instrument. Thus, a 30-year Treasury bond should usually have a higher interest rate than a 2-year Treasury note. This phenomenon is called an upwards sloping yield curve. The yield curve can also invert, with rates on longer term debt becoming lower than rates on shorter term debt. That was the case for much of the last few years. Treasury markets traders sometimes employ trading strategies based on the idea that the anomalies in the yield curve will disappear eventually and the yield curve will revert to its normal upwards sloping shape. This strategy is called a reversion to mean, because it posits that the yield curve will eventually revert to its mean (or average) relative values.

The concept of reversion to mean can be employed with other assets. Let's look at housing. Housing prices, over the last century, have increased at a rate of about 1% per year, net of inflation. For most of this time period, the rise in housing prices was gradual. In some periods, like the Depression of the 1930s, prices fell.

However, from 2001 to the end of 2005, housing prices rose about 30% net of inflation, a rate vastly in excess of the historical mean. This eye-popping rate of increase is why housing prices were in a bubble, and why the bubble eventually had to burst. Growth in household incomes, which has been virtually negligible, couldn't begin to finance prices increases like these. The creativity and recklessness of the financial markets was strained to the limit to devise new and increasingly implausible mortgage loans. But even the stupidest of teaser rate option ARM mortgage loans eventually became untenable when used to finance prices increases wildly beyond the growth in buyers' true ability to pay.

Housing prices have fallen about 7%, net of inflation, since the 2005 peak. Thus, they are about 23% above 2001 levels, net of inflation. If we assume that housing prices had risen at their historical average rate of 1% since 2001, we'd have a total increase of 6% (after inflation). Current housing prices, however, are about 17% above that level.

The implication of this analysis is that if you buy a house at today's prices, you may not see any increase in value, net of inflation, for about 17 years. This conclusion is dependent on a number of variables, such as the rate of growth of the U.S. economy, growth in individual and household incomes, the availability of credit for home mortgages, government policies toward housing, so on and so forth. And it is based on national average figures, which may not entirely apply to many individual housing markets. But if we assume that housing, like other assets, adheres to a predictable pattern, returns from owning a home, after adjusting for inflation, will probably be modest for over a decade, and perhaps for much longer.

During the first 40 years of the 20th century, housing values meandered. From 1989 to 2000, housing values, net of inflation, showed losses rather than gains. There's no reason to think that another 15 or 17 years of no net gains after inflation aren't possible. Stocks, by comparison, have risen around 2% t0 3% a year after inflation. That's why putting your retirement money in a diversified portfolio containing a significant stock component is likely to work out better than betting the ranch on, well, the ranch.

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