Shambling Towards Affordability: Year-End 2010 Edition

Submitted by Rich Toscano on February 14, 2011 - 6:32pm
It's time for some valutions.  The charts below show San Diego housing valuation ratios updated through year-end 2010.

Let's start with the price-to-income ratio.  The decline in home prices since the summer brought this ratio back down to 7.6 -- right in the middle of fair value territory per these ratios.  In fact, it's 5% below the median price-to-income ratio over this entire period (which incidentally is 8 on the nose).



The price-to-rent ratio came even closer to hitting its "fair value" at just 1% above its historical median.  (I have theorized that the higher price-to-rent ratio reflects slightly depressed rents as a result of the bubble-era building frenzy).



So compared with incomes and rents, San Diego home prices in aggregate were more or less at fair value as of the end of 2010.

Middle of the road purchase prices combined with ultra-low mortgage rates to get us back near historical lows in the payment-based valuation ratios.  The monthly-payment-to-income ratio was 39% below its historical median!



And the payment-to-rent ratio was 32% lower than its median value:



So what does this all mean?  There are really two separate questions to grapple with:
  1. What will happen to home prices?
  2. When, and under what conditions, does it makes sense for an individual to buy?
The second set of graphs, the payment-based ratios, are much more relevant to the second question.  I've argued a million times (latest iteration here, I won't drag everyone through it again) that price-based ratios are much more important than payment-based ratios in determining whether housing is fairly valued on a sustainable basis.  Payment based ratios are a relatively minor factor as far as question #1 is concerned -- but they are hugely important for question #2.

If you buy now, and you get a big mortgage (high loan-to-value ratio), you are locking in a monthly payment that has effectively never been lower in comparison to regional incomes and rents.  (I am of course referring to the county in aggregate, as some areas remain more expensive... so assume for this article that we are talking about the "typical" home as measured by the aggregate number charted above).  To the heavily mortgaged buyer, San Diego housing has never been cheaper.

But that's not necessarily a reason to run out and buy, because to the extent you intend to sell the home in the future, you have to consider question #1.  Low mortgage payments are of little consequence if you are just going to sell the house 5 years down the road.  In that case, the primary driver of how well you do in the transaction will be what's happened with home prices when you sell.

But if you are hanging onto the home indefinitely, that's something different.  In that case -- assuming that you intend to buy a house with money that is mostly borrowed -- the future path of prices is less important than the future path of payments.  Put another way, who cares what happens to the home's market price if you are sitting tight and making generationally low monthly payments the entire time? 

Of course it's possible that payment ratios could go even lower.  But catching the exact bottom is a speculator's game.  One could argue that monthly payment ratios 30-40% below the three-decade median should be "close enough."

This is why I believe it can be a very good deal to buy in some cases.  But there are conditions:
  • You have to be willing and able to stay in the house for a very long time (long enough that the lower mortgage payments outstrip the effects of potential negative price changes... I'm too lazy to calculate this but it's probably in excess of a decade)
  • You have to buy a home that is reasonably priced (while San Diego in aggregate is reasonably priced, there are still pockets of overvaluation)
  • You have to get a big mortgage (or put another way, you should put as little down as possible)
To the extent that these conditions are not in place, one has to shift focus on to question #1: what will happen with home prices?

Well, we are out of the danger zone of high aggregate valuations as far as the price-based ratios are concerned.  But unlike with payments, home prices are not actually cheap.  They are right square in the middle of their historical range.  While this removes the dangers posed by overvaluation, it certainly doesn't rule out a move into undervaluation.  It has happened in the past, and that was after housing booms that paled in comparison to the latest one, and at times that the economy didn't face the structural problems it is facing now.

My own suspicion, and this is purely a guess, is that valuation ratios will drift downward in the years ahead.  Not plunge, but drift downward.  This is based on headwinds to housing price growth I anticipate: a big foreclosure backlog, structurally high unemployment, higher rates, and the potential for a serious economic downturn (plus much higher rates) as a result of a US sovereign debt crisis.  (I know I have said that rates don't impact valuations as much as many people think, but nothing happens in a vacuum -- a sufficiently large and sustained rise in rates could certainly exert some downward pressure on valuation ratios, at least for a time).

That said, unless (until?) rates really get out of control, I don't imagine that there will be big moves down in pricing.  The scenario I envision is valuations grinding downward over a course of years, but doing so against an ongoing rise in wages and rents.  As long as the process is slow enough, valuations could drop quite a lot without having too much of an impact on nominal home prices.  (This is usually when people start arguing that nominal wages and rents will flatten or decline over the coming years... I hope that by now everyone has come to understand that the Fed isn't going to let this happen).

So, let's sum it up...
  • In aggregate, San Diego home prices are right in the middle of the road -- they are neither cheap nor expensive based on their historical relationship with rents and incomes. 
  • My speculation/guess about the future is that that negative structural factors in the years ahead will lead to housing lower valuations, but not necessarily to significantly lower nominal prices (with the potential for substantially higher interest rates being the wildcard in this forecast). 
  • Irrespective of price forecasts, mortgage payments are so historically low in comparison with rents and incomes that it makes sense to buy a reasonably priced home with a high loan-to-value ratio so long as the buyer intends to keep the home for a long time to come.

(category: )

Submitted by AN on February 14, 2011 - 10:37pm.

Nicely put Rich. Thanks for updating those graphs. I share you sentiment exactly.

Submitted by SD Realtor on February 15, 2011 - 7:22am.

Looks like you may need to start a new site. Housing is getty kind of boring. Or just convert this one to a full blown site for political rants.

Submitted by livinincali on February 15, 2011 - 8:07am.

This is usually when people start arguing that nominal wages and rents will flatten or decline over the coming years... I hope that by now everyone has come to understand that the Fed isn't going to let this happen

I think your prediction is the most likely outcome assuming the fed can really control markets as well as we all think right now. I personally don't put nearly as much faith in the assumption that the fed can control thinks to the level that everybody thinks they can. I think "Don't fight the fed" is going to go down in history as one of those catch phases that attempts to explain why it's different this time, but in the end it will fail. I certainly could be wrong, but there's usually something that everybody gets wrong and don't fight the fed seems to the one area that nobody questions anymore.

Submitted by jimmyle on February 15, 2011 - 8:20am.

Great post Rich,
I am about to close on a house and thanks for confirming that the mortgage payment I will be making is historically low when compared to income. Yes, I plan to be in the house for a long time b/c I hate moving so if prices go down and interest rate goes up it won't affect me that much.
Jimmy

Submitted by Rich Toscano on February 15, 2011 - 9:00am.

livinincali wrote:

I think your prediction is the most likely outcome assuming the fed can really control markets as well as we all think right now. I personally don't put nearly as much faith in the assumption that the fed can control thinks to the level that everybody thinks they can. I think "Don't fight the fed" is going to go down in history as one of those catch phases that attempts to explain why it's different this time, but in the end it will fail. I certainly could be wrong, but there's usually something that everybody gets wrong and don't fight the fed seems to the one area that nobody questions anymore.

My prediction is not based on the Fed's ability to control markets, it's based on their ability to reduce the nominal purchasing power of the US dollar. That's not "controlling the market," because all it requires is sufficiently increasing the supply of dollars in circulation, which is a factor they can control.

FWIW I don't believe they can control markets (obviously they can in the short term, as QE has shown, but in the long term their efforts will fail).

Submitted by peterb on February 15, 2011 - 9:46am.

How has QE kept down the interest rates? Rising rates could be a game changer in the next couple of years. Otherwise, it looks like a slow grind downward. Hard to find any evidence of a scenario where RE prices rise in the next few years.

Submitted by Rich Toscano on February 15, 2011 - 10:09am.

I wasn't talking about interest rates...

Submitted by sdrealtor on February 15, 2011 - 10:27am.

Thanks for the great analysis Rich. For the last year I have really been struggling with where we are in the market cycle. Everything I saw said it was relatively safe to go out and buy again. But I always have had a hard time telling people "its a good time to buy". I'm just too conservative a thinker to get past that easily.

Several months ago, I got there and for the first time in a long while can say confidentally that for most people it is a good time (assuming they are well informed and buy well). Seeing these graphs just gives me even more confidence. While housing still feels very expensive here, it always has been expensive here relative to most places. I beleive folks expecting dramatically lower prices from here are fooling themselves. The window of opportunity is open and how long it remains thus at these interest rates is anyone's guess.

Congrats to all the Piggs who have gotten themselves great homes the last couple years avoiding the worst declines and good luck to the rest who have the opportunity to do the same.

Submitted by peterb on February 15, 2011 - 11:30am.

QE has not kept rates down and CA unemployment is persistently at 12%, without relief anywhere in sight. The grind down may be slow or there could be events that cause real trouble. The only saving grace is that ratios, as Rich's data points out, are now at about historic medians.

3.5M people will be shoved off unemployment checks this year as they hit their 99th week. The state and local govts within CA are at all time budget gaps. They may have to cut jobs.
These are just two things that come to mind.

Submitted by paranoid on February 15, 2011 - 12:46pm.

A new lower low is coming within the next 2 years. The low in the spring of 2009 will be taken out. According to Elliott Wave Theory, the rebound of last year is the wave 4, and the wave 5 has started since last autumn.

I have predicted the price evolution of the last 2 years on this board (in a comment to one post by Rich about 2 years ago), but most people laughed at that time. Temeculaguy even said he would do something if my prediction turns out to be true. Now the rebound has passed, and a new lower low is coming. We will see what happens by the summer/winter of 2012.

Submitted by sdrealtor on February 15, 2011 - 1:12pm.

You statement is far too braod to have much meaning. The low of 2009 isnt much below where we are now in many places, so taking that out would not be such a big deal. In other places we are lower than where we were in 2009. Other places where 2009 prices were much below today (i.e. $150K SFR homes in Oceanside) wont get back below that.

I dont know that anyone laughed at your post as what has happened the last 2 years is much in line with what most of us expected also. Is this the one you were referencing?

http://piggington.com/the_next_big_step_...

Submitted by livinincali on February 15, 2011 - 1:27pm.

My prediction is not based on the Fed's ability to control markets, it's based on their ability to reduce the nominal purchasing power of the US dollar. That's not "controlling the market," because all it requires is sufficiently increasing the supply of dollars in circulation, which is a factor they can control.

Ok, that's fair enough, but I think the inflation process needs to include credit emission and I'm not sure if they control that. The idea for the fed has always been if we create more base money supply the credit and inflation will follow. One could imagine the scenario where base money supply increases but credit does not and that would likely limit inflationary forces. Basically what we are seeing now with the federal government being the only reason credit is expanding.

It ultimately comes down to whether or not the fed can prevent deflation and force inflation via QE and debasing the dollar. My belief is the fed can't even force/control that over the long term, but maybe they can. I would argue that if not for the federal government borrowing we'd already be seeing deflation regardless of the fed's actions. Of course as long as the federal government obliges with record deficits I can't prove that.

Submitted by Rich Toscano on February 15, 2011 - 2:21pm.

If the federal govt were to stop borrowing, the Fed would find another way to get money/credit into the economy. They change the rules when it suits them. But it doesn't matter, because the federal govt isn't going to stop borrowing until the foreigners take away our credit card -- and that won't be deflationary.

This topic was addressed in great detail here: http://piggington.com/no_deflationary_sp...

Submitted by albatrosw on February 15, 2011 - 6:29pm.

I keep an eye on the apartment buildings in the area and for a cash buyer, there arent many deals out there.
Cap rates are 6% and lower, not very appealing. Actually once you start looking at the operating statments of apartment buildings for sale, cap rates are more sub 5% as they sugar coat the marketing package for the unsuspecting buyer.
I am waiting for the cap rates to come into the 8% range before jumping into this market. Maybe next two years.

Submitted by davelj on February 15, 2011 - 8:43pm.

paranoid wrote:
According to Elliott Wave Theory...

We may indeed see lower lows (although I doubt it - I think we'll drift down a bit more from here without piercing the previous lows), but it will have nothing to do with Elliott Wave Theory, on which I defer to analyst David Aronson:

"The Elliott Wave Principle, as popularly practiced, is not a legitimate theory, but a story, and a compelling one that is eloquently told by Robert Prechter. The account is especially persuasive because EWP has the seemingly remarkable ability to fit any segment of market history down to its most minute fluctuations. This is made possible by the method's loosely defined rules and the ability to postulate a large number of nested waves of varying magnitude. This gives the Elliott analyst the same freedom and flexibility that allowed pre-Copernican astronomers to explain all observed planet movements even though their underlying theory of an Earth-centered universe was wrong."

To paraphrase the title of an old book on the stock market: "Where are Robert Prechter's clients' yachts?"

Submitted by paranoid on February 15, 2011 - 11:47pm.

Davejlj, two years ago, I didn't bother to argue with many who laughed at my prediction. Today I just say again, we will see.

Btw who is David aronson?

Submitted by temeculaguy on February 16, 2011 - 2:08am.

SD Realtor wrote:
Looks like you may need to start a new site. Housing is getty kind of boring. Or just convert this one to a full blown site for political rants.

There is very little fun and no money in political rant sites. If were voting or making suggestions, I say sports, porn, car reviews, penny pinching or relationships. Those OT's always get the most play. Let's face it, we saw this coming, the long flat part. Flat charts, flat markets, flat tires, flat chests, nobody turns their head for any of them. But theres still a lot to learn and do until volatility returns to this asset class. From just an educational standpoint, if it weren't for FLU and his car threadjacks, I'd be rolling in a BMW right now, hell I didn't even know they had model numbers for engines that were different from the actual model number of the car. But thanks to the OT's, not only do I know the various technical issues and recalls, I'm scared of them. Now I'm looking at Expeditions and Tahoes again, and I dont's even haul kids around anymore since they drive themselves. Let me add two more suggestions, environmental issues and potential personalized license plates. I'm going to combine the two, so when I'm cruizing in my 4x4 american consumer beast, feeling mildly guilty, I'll blame FLU and piggington. Im even working on a license plate for my ameribeast. Perhaps PIGNTON, PROFPIG, FLUSAID, TG 9MPG, FLTPART, RPORYDER, BMWFEAR, REOSLUT, SFR 4ME, BAILOUT, NOINTRST, NEG AM, 3CARGAR, FYRNORV, or my all time fave, TKSRICH.

Submitted by ctr70 on February 16, 2011 - 5:32am.

Didn't Eliott Wave guy Robert Prechter famously predict a big market crash and depression coming in 1995 right on the eve of one of the biggest 6 year bull markets in U.S. history? Talk about getting that one wrong. He seems like more of a "permabear" type. A broken clock is always right once a day.

Submitted by davelj on February 16, 2011 - 1:00pm.

paranoid wrote:
Davejlj, two years ago, I didn't bother to argue with many who laughed at my prediction. Today I just say again, we will see.

Btw who is David aronson?

I'm not laughing at your prediction. I'm merely questioning the basis for your prediction. If I tell you it's going to rain tomorrow because "I can feel it in my bones" I hope you won't think I'm some kind of weather predicting genius if, in fact, it does rain tomorrow.

David Aronson (with whom I neither agree nor disagree in any general sense, just to be clear):

http://evidencebasedta.com/

Submitted by BSofSF on February 17, 2011 - 2:16pm.

Rich,

I read your blog frequently and think it's great. I'm not trained in the economics lingo, though. Can you clarify this from your summary: "...lower valuations, but not necessarily to significantly lower nominal prices."

Also, I know the focus of your analysis is San Diego County, but do you know if there is a pretty strong correlation between the San Diego market and one county north where I live in Orange County?

Thanks,

Bob

Submitted by Rich Toscano on February 17, 2011 - 2:38pm.

Valuations = price/income ratio and price/rent ratio.

Yes, I think there is likely a strong correlation with OC...

Submitted by sdrealtor on February 17, 2011 - 3:33pm.

Bob
I do a fair amount of business up in OC as well as in SD. From what I have seen over the years, OC tends to lag what is happening in SD by 6 to 12 months.

Right now things seem rather slow up there to me while things are moving well again in SD. It seems like OC is in a bit of a depreciation cycle right now but that is just what I'm seeing. Could be different things going on that i am not seeing.

sdr

Submitted by Pichon on February 19, 2011 - 3:53pm.

We may not see prices rally significantly. But what we are seeing is homes built when materials were much cheaper selling for fabulous value. You can purchase some superior built homes, in the higher end, that you could not rebuild for the same price plus some, today. The land is thrown in for free. So any new builds need to be of a lower standard of quality, as costs have risen dramatically - take a look at copper, steel, energy etc. The market will recognize this when the distressed sellers are finally and eventually cleared out. So opportunity still exists now. It is not only the statistical prices, but what home you are getting for the price. Interest rates will rise significantly. It may take another year. The market will do it well ahead of any fed action. We have already seen the first signs of that over the past month. So Rich is correct, if you are able to leverage with a great fixed rate mortgage. Getting one is a whole new endeavor than it was only a short time ago though.

Submitted by anxvariety on February 20, 2011 - 11:53am.

Do you have a chart which shows interest rate at the time? Anything interesting there, I'm interested in seeing the relationship - maybe it's so obvious to others that it doesn't need a chart.

Submitted by Rich Toscano on February 20, 2011 - 12:05pm.

Mortgage rates are the green lines on the charts.

Submitted by Rich Toscano on February 20, 2011 - 2:17pm.

In case anyone is interested, here are some further thoughts on the distinction between the price-based and payment-based indicators, taken from my voiceofsandiego.org article on this same topic:

When it comes to predicting the future path of home prices, we should look to the price-based valuation ratios (the first and second graphs).  There is an inexorable pull to the center in these ratios -- a "reversion to the mean," as we numbers nerds call it.  When the ratios get too high, they want to go lower, and when they get too low they want to go higher.  This is exactly what we would expect, because moves away from the center in the price-to-income or price-to-rent ratios indicate that housing is becoming either too expensive or too cheap in comparison with the fundamentals.  And markets always come back to their fundamentals eventually.

Right now the price ratios tell us that there is effectively no pressure, either upward or downward, coming from valuations.  There are other factors that could affect home prices going forward, such as employment, economic growth, the foreclosure backlog, and the potential for an interest rate spike (while mortgage rates don't dictate sustainable price levels, sufficiently large rate changes could certainly impact valuations in the short term).  But there is no pressure coming from reversion to the mean, because valuations are at the mean already.  This is good news in that there is no dangerous overvaluation to contend with as there was in the mid-2000s; it's bad news in that there is plenty of room for valuations to decline should other market factors turn more negative.

The payment-based ratios (the third and fourth graphs) don't tell us much about valuation pressures, but they can tell potential home buyers how much they would be paying on a monthly basis were they to buy with a mortgage right now.  When we consider that the median historical monthly payment has, compared to incomes and rents, been roughly 50 percent higher than it is right now, the answer there is "not much." 
Submitted by evolusd on February 21, 2011 - 12:11am.

Rich - what are the assumptions about down payment for the monthly payment to rent graph?

The last graph seems to say that, today, monthly mortgage payments are about equal to rent payments, even a little less as it's currently under the 1.0 mark.

I know you're dealing with medians, and maybe that explains it, but this doesn't make sense from my personal experience looking at rentals vs. sale listings in most areas of SD. Currently, we rent a house for $2,550 that would sell for around $600k. I would have to put 36% down to force a mortgage payment of that amount (assuming 1.2% prop tax rate and 4.5% mortgage rate).

Am I just getting a super deal on my rental?

Submitted by Rich Toscano on February 21, 2011 - 8:03am.

The absolute values of these ratios aren't really meaningful, due not only to medians but to having to to use different property types to get those medians.

In any case, you live in an above-median area, which means a couple things. First, price-to-rent ratio is always higher in higher priced areas... that's just the way of things. Second, a lot of those areas are still somewhat overpriced in comparison to the fundamentals.

Submitted by Rich Toscano on February 21, 2011 - 8:21am.

TG, somehow I missed your comment above and just saw it now. Awesome.

You are right, as far as alternate site topics go, politics would be last on my list. To your list of favored topics I'd add: wine, sharks.

As far as your beast is concerned, note that the official stance of the Piggington editorial board is that gas prices are going substantially higher (though not in a straight line, of course) over the decade ahead. I recall you mentioned once that your employer reimburses you for gas, so perhaps that's not a consideration... otherwise, BLMEFLU.

Submitted by ocrenter on February 21, 2011 - 8:53pm.

excellent series of graphs and write up. right on target as always.

agree with sdr, has been hard to give an unequivocal "get out and buy" due to so many variables. Afterall, still with many sub-segments with higher than realistic prices and still with many sellers with unrealistic asking prices. the issue of purchasing with high LTV is a concern too, as Rich is right, we are looking at a flat if not somewhat downward slope when it comes to prices. hard to give a thumbs up to run out and buy if someone ends up having to sell in near-term and will need to cough up the 6% commission.

but otherwise, if you are in for the long haul, if you got plenty of cash on the sideline, and you know to avoid the high priced bombs, this is and has been a fantastic time to get in and lock in historic low interest as the icing on the cake.

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