Valuing The Housing Market

Everybody is talking about the housing bubble, but there is no agreement as to whether it even exists. Part of the problem is that there are as many ways of assessing house values as there are experts. Some of the most popular valuation methods can be divided into three categories:

1. Affordability Measures
2. Measures based on renting vs. owning (House Valuation Calculator)
3. Measures based on housing as an investment

In addition, looking at the past behavior of the housing market can provide some context. This list shows growth forecasts and more importantly the length and depth of previous declines in house values for a large number of metropolitan areas.

Affordability

There are several organizations that publish data on housing affordability, but the National Association of Realtors' Index is the most widely used. An Index value of 100 means that a family earning the median income has exactly enough money to buy a median-priced existing home. Higher Index values mean that housing is more affordable, values below 100 mean that families do not make enough money to buy a home. The NAR assumes that this family makes a 20% down payment, has a traditional mortgage, and spends 25% of their income on housing.

The April 2006 reading of NAR's Index is 108.6, indicating that housing is still generally affordable. However it is useful to put this number into historical perspective. The last time the nationwide Index was 100 was in 1986 and housing hasn't been as unaffordable as it is now since the early 90s. Housing prices decreased sharply in the late 80s, which improved the affordability index. Click here to see how your metropolitan area fared in the late 80s.

Housing markets in various parts of the country differ widely. NAR provides regional indices covering the Northeast (91.5), South (121.1), Midwest (155.1) and West (69.4) respectively. On the coasts, housing has become quite unaffordable for a typical family while prices in the South and Midwest are still within reach. We do not have historical data for the four regions, but it is very likely that housing affordability in all four regions is at a multi-year low.

Three factors determine the value of the Affordability Index: incomes, housing prices, and mortgage rates. If housing prices and incomes stay the same and mortgage rates continue to climb, housing will become less affordable than it is now. To stay as affordable as it is now, incomes would have to rise or house prices would have to come down. In our view, housing prices are more likely to change than income levels.

Housing Values vs. Rent Levels

Housing prices can get out of sync with incomes, but it is also possible for the cost of ownership to get out of line with the cost of renting. An interesting report from the Federal Reserve Bank of New York analyzes housing prices in relation to rent levels.

The central premise of this analysis is that in an efficient housing market the net cost of renting should be the same as the net cost of owning a home. The Federal Reserve Bank's paper supplies a formula to calculate a theoretical housing price based on typical rent levels. Try our House Valuation Calculator to check the theoretical value of your house.

The calculation includes property appreciation (over and above inflation) as well as the tax benefit of deducting mortgage interest. For reference, from 1975 to 1995 house prices outpaced inflation by 0.5% per year. Since 1995 they gained on average 3.6% per year over the inflation rate. If your calculated value is less than the value of your house, prices are too high relative to rents and in an efficient market hosing prices would have to come down or rents would have to go up.

We encourage you to change the mortgage rate in the House Valuation Calculator and leave everything else the same. This illustrates how house prices depend on interest rates. The higher the interest rate, the lower the value of the house.

Residential Real Estate as an Investment

The mortgage tax break only applies to an owner who lives in the house. A person who buys a house as an investment generally pays taxes on rent income and deducts operating expenses. Because of the different tax treatment, an investor values a property differently than a person who intends to live in it.

As mentioned in the previous section, buying residential real estate for its price appreciation has not been a good strategy outside of the last decade, which was characterized by unusually low inflation and unusually low interest rates. Therefore a real estate investment should generate positive returns based on its cash flow. The House Valuation Calculator provides a number of valuation ratios an investor may consider. One of the more useful  ratios is the Price to Net Earnings (=rent income - cost), which can be compared to P/E ratios for stocks.

Most investors will require a reasonable return on equity. While your house may be reasonably valued if you compare it to renting a house, it may be too expensive for an outside investor who doesn't get the tax breaks home owners are eligible for. The market value of your house depends in part on what type of buyer you could sell it to.

Conclusion

Different methods of assessing the real estate market tend to yield different results. In an ideal world we would test all the valuation methods to see if any of them can reliably identify over and undervalued housing markets.

Unfortunately this analysis is more difficult to do for with real estate than for stocks. We have at least 50 years of fairly solid data on stocks that we can use to test ideas, but reliable data on the housing market goes back at most 20 years. Because the housing market changes slowly this is not enough for a statistical test of the various valuation methods.

However, some very general notions are likely to be true in all markets:

• Lower interest rates increase demand for houses, higher rates decrease it especially for the more expensive houses. Demand will drive prices to some extent.
• Affordability of housing drives migration (data). People move out of the very expensive areas. Furthermore, companies generally consider the cost of living, among other factors, when choosing the location of new facilities. This is bound to correct some of the extreme valuations.
• As with all other markets, psychology plays an important role in valuations. The two points above, and many other factors, should impact real estate prices in the long run. For the short term, however, market psychology will probably play a more important role. After five years of very strong real estate returns there is a tendency to believe that this will continue indefinitely. In reality, periods of significantly above average performance are usually followed by periods of lackluster returns. The transition occurs when the majority of market participants switch from expecting strong returns to expecting below average returns. Unfortunately it is very difficult to predict when this will happen, but when it does prices fall or at least stagnate for long periods.

We believe that the real estate market as an investment is probably less attractive now than it has been for many years. No doubt good opportunities still exist, but rising interest rates surely create a headwind for any real estate investment.