Shambling Towards Affordability (December 2008 Edition)

Based on their historical relationships with rents and incomes, San Diego home prices are now reasonable.

There. I said it.

The long-term price-to-income and price-to-rent graphs tell the tale:

Neither ratio is at its all-time low, but both are firmly in the middle of the range that prevailed for two decades before this latest bubble blew the valuation metrics sky-high.

The price-to-income ratio would have to fall 15% from December’s level to equal its all-time low hit in 1997. The price-to-rent ratio actually hit its low in the prior cycle, in 1986. It would have to fall 22% from here to hit that level. Of course, given the exaggerated bubble-time overshoot to the upside, it’s reasonable to believe that valuations could overshoot to the downside and set new lows.

On the plus side, these charts use the December Case-Shiller release (the most recent), which as I’ve often discussed best reflects November 2008 pricing. Home prices in the real world have dropped a bit further — and the ratios gotten a bit better — since then.

Here are the same charts with conforming 30-year fixed mortgage rates overlaid:

These charts aren’t supposed to serve as timing indicators or to give buy and sell signals. They do not take account of external factors such as unemployment or foreclosures. They don’t account for potential changes to future rents and incomes. And they aggregate the whole county into a single number, ignoring important distinctions between different sub-markets.

What the charts do provide is a broad-stroke view of how expensive San Diego homes are, in aggregate and compared to history, when measured against the region’s average rents and per capita incomes. And these indicators say that while San Diego real estate as a whole is not dirt cheap, it’s perfectly reasonable.

That alone has been a long time coming. Just for some perspective, here is the price to income graph with a blue dot placed over the month that I launched the Econo-Almanac:

Another way to measure valuation is to compare rents and incomes not with home prices but with monthly payments. While this provides some good context, I do not favor this valuation technique. For one thing, mortgage rates are artificially low, with the Fed monetizing into a mortgage market that was already underpricing long-term inflation risk to begin with. But that is just a subset of the general problem with this approach: rates change, and if you are trying to determine long-term sustainable levels of affordability, you have to consider the path of rates over said long-term, not just during a given month.

On top of that, the data suggests that monthly payments haven’t historically made for a good valuation metric. I wrote about this in the last update of these charts:

It is pretty clear that for most of the history displayed on the charts, the payment-to-income and payment-to-rent ratios hewed pretty closely to mortgage rates themselves. Typically, the monthly payment ratios would move up when rates were moving up and down when rates were moving down. It wasn’t until the recent housing bubble, when the payment ratios shot up while rates dropped and then languished at generational lows, that this relationship broke down.

But the recent bubble is an aberration in which home prices rose not due to low rates but to an extended period of incredibly reckless mortgage lending. Looking back beyond this risky-lending-induced bubble, there just isn’t much historical data to suggest that homes should necessarily be more expensive when mortgage rates are low and less expensive when rates are high.

The point can be further illustrated by comparing the recent bubble peak to the early 1980s, when double-digit mortgage rates prevailed. If monthly payments are a good valuation metric, then these charts suggest that the overvaluation of the recent bubble was not nearly as large as that seen in the early 1980s. This is ridiculous, of course. The recently burst bubble absolutely blew away prior booms in terms of magnitude, as a quick glance at the bubble aftermath depicted in this long-term foreclosure graph easily demonstrates.

All that said, monthly payment levels do have an impact. They feed into the rent-vs-buy decision, for instance, which in turn influences demand for housing. So they are worth looking at — they just shouldn’t be looked at in isolation.

And with that long pre-amble, here are the new all-time lows for the monthly payment-based metrics:

Here are the same charts with interest rates overlaid:

The payment-to-income ratio is 3% below and the payment-to-rent ratio 6% below their respective all-time lows, both hit in the 1990s downturn. So by this metric (for what it’s worth, which per the above is questionable) San Diego homes are cheaper than they’ve been since this data began.

But even by the superior price-based indicators shown earlier in this article, San Diego home prices are now reasonable. So despite everything else, the San Diego housing market has that going for it. Finally.