The Housing Market

The Housing Market… Why the Price-to-Rent Ratio is Signaling More Pain Ahead

by Alexander Green, Chairman, Investment U;
Investment Director, The Oxford Club
Tuesday, January 8, 2008: Issue #749

Whether you’re investing in real estate, stocks, bonds, or gold coins, you are rewarded primarily for your exposure to one thing – risk.

In the summer of 2005, I warned readers that if they were speculating in the current housing market, the time had come to cash in their chips and get out of the game. I listed a number of reasons, but the biggest one was that ordinarily sensible people were talking and acting as if highly-leveraged home purchases were risk-free transactions. After all, they kept telling me, “real estate always goes up.”

It doesn’t, of course. And now everybody knows it.

According to the S&P/Case-Shiller Home Price Index, which measures home values in 20 major U.S. cities, home prices have fallen an average of 7% since peaking in June 2006.

I would love to tell you that the worst is over. (After all, I own a couple homes myself.) But the reality is we’re only in the second inning. Real estate has much further to fall and you should govern yourself accordingly. Here’s why…

Residential Housing Market Still Feeling Pain of 2007

Last year was the most painful in decades for the residential housing market. Home prices fell, home ownership dropped, foreclosures soared, and the housing market emerged as perhaps the weakest part of the entire U.S. economy.

But housing prices are set to slide considerably further, as anyone with two eyes and a modicum of objectivity should see. Banks and mortgage lenders are raising their lending standards. That means credit will remain tight, boxing out many potential buyers. Interest rates on many mortgages are about to reset, ratcheting up the pain on many borrowers and triggering more defaults. Home inventory is still growing and must be worked off before the market gains some kind of equilibrium.

And now a new study by one former and two current Federal Reserve economists gives us another major reason to be pessimistic about home prices: the price-to-rent ratio.

An Accurate Gauge Of Home Value: Price-to-Rent Ratio

Economists feel the price-to-rent ratio is perhaps the most accurate gauge of fair home value. Most human beings are rational animals:

If home prices get too high, many will choose to rent. If rents get too high, many will choose to buy.
Unfortunately, the new study by Federal Reserve economists concludes that U.S. home prices “likely would have to fall considerably” to return to a normal relationship with rents.
The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995.

But starting in 1996 – the birth of the housing bubble – home prices soared much more rapidly than rents. In fact, by the end of 2006 they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%, a third below its long-term average.

The study concludes that to reach equilibrium, housing prices need to fall 3% a year for a decade, even if rents grow in line with their average 4% annual increase. (Of course, if home prices fall faster – and harder – equilibrium could be reached sooner.)

The Current Housing Market Has Yet To Hit Bottom

In other words, we’re still a long way from the bottom of the current housing market. And here is some further anecdotal evidence to prove it.

My brother is one of the most successful independent homebuilders in central Florida. He is an annual Parade of Homes winner. But the quality of your homes means nothing when no one is buying. Last year he laid off all but two of his employees. Next week, he plans to let the last two go. He said when he cut the price of his existing inventory below his building cost, “no one even walked in the door.”

I also know a couple of young men who have bought four homes in foreclosure eight months ago. They put plenty of sweat equity into them, getting them into primo shape and pricing them well below the market. “We can’t even get anyone to look at them,” they told me recently.

Most homebuilders know the score, of course. But friends who are out looking for homes right now tell me that many sellers remain deluded. “They just can’t get out of their heads what they could have gotten for their home two years ago,” one told me. “Only the desperate are willing to come down significantly. But most of them can’t anyway because they have no equity in the home.”

Of course, there’s another reason sellers are fighting to hold firm. Polls show the majority of Americans believe their homes will be worth more in a year than they are today.

No one has a crystal ball, of course. But as Steven Tyler famously sang, “Dream On…”

Good investing,

Alex

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