What home prices would be without the bubble

[patientlywaiting]

I’m in agreement with jpinpb. The low teaser rates is what got people to say: “I can buy that house for just about the same as my rent. Plus I can resell and get rich.”

Bank were qualifying borrowers based on the teaser rate. Big mistake.

[patientlywaiting]

I’m in agreement with jpinpb. The low teaser rates is what got people to say: “I can buy that house for just about the same as my rent. Plus I can resell and get rich.”

Bank were qualifying borrowers based on the teaser rate. Big mistake.

[patientlywaiting]

I’m in agreement with jpinpb. The low teaser rates is what got people to say: “I can buy that house for just about the same as my rent. Plus I can resell and get rich.”

Bank were qualifying borrowers based on the teaser rate. Big mistake.

[stansd]

Hi Rich,

I’ll take a crack conceptually-apologize for this being a bit of a stream of consciousness.

If we assume some sort of rational expectations, a house is like a dividend paying stock (the dividends being the right to live in the house, which has some value). The value of the house, then, would be equal to the present value of cash flows, which I’d say are equal to expected rents over the time horizon (owners equivalent, or something like that), plus the value of the house discounted to the present at the current interest rate over the horizon (10 yr t-bill or something).

On that side of the equation (ignoriing financing), then, lower interest rates should increase the present value of the house, but this effect would be muted by the following: lower interest rates would drive lower future rents (assuming those are based on an expected return from the owner), which would also be based on a spread over inflation.

I plugged this into a very simple model that assumed inflation and rent increases of 3%/year, a T-Bill Rate of 6%, and made the assumption that the spread over inflation on the T-Bill is constant at 3%.

Under this scenario, the rising value of the house from a lower interest rate is almost exactly offset by the fact that it slows down the rate of growth in rents, and therefore, the house wealth gained is also a benefit lost in the sense that you were saving less on the rent you would have paid.

That would be a simple, yet quantitative support for your argument, Rich (the result actually surprised me a bit).

You’d still have the financing side of the equation, but you don’t value stocks based on the method of financing, you value them purely on the cash flows of the stock. I’d argue you should do the same here-it’s the cash flows that you are buying that drive price, not the method of financing. The rate reductions are reflected already in the present values calculation on the house.

There are obviously other considerations: The option to refinance, the potential for spreads over treasuries to change, psychological changes in buyer preferences for owning vs. renting, the fact that emotion can enter the market and that not all participants are acting rationally, etc. The recent bubble bears this out since the above would indicate that the abnormally low rates wouldn’t be a boon for prices-I’d argue that was psychology, not economics driven and that the economics can only explain the long-term gravitational pull toward a rational value

That’s a stab:

Stan

[stansd]

Hi Rich,

I’ll take a crack conceptually-apologize for this being a bit of a stream of consciousness.

If we assume some sort of rational expectations, a house is like a dividend paying stock (the dividends being the right to live in the house, which has some value). The value of the house, then, would be equal to the present value of cash flows, which I’d say are equal to expected rents over the time horizon (owners equivalent, or something like that), plus the value of the house discounted to the present at the current interest rate over the horizon (10 yr t-bill or something).

On that side of the equation (ignoriing financing), then, lower interest rates should increase the present value of the house, but this effect would be muted by the following: lower interest rates would drive lower future rents (assuming those are based on an expected return from the owner), which would also be based on a spread over inflation.

I plugged this into a very simple model that assumed inflation and rent increases of 3%/year, a T-Bill Rate of 6%, and made the assumption that the spread over inflation on the T-Bill is constant at 3%.

Under this scenario, the rising value of the house from a lower interest rate is almost exactly offset by the fact that it slows down the rate of growth in rents, and therefore, the house wealth gained is also a benefit lost in the sense that you were saving less on the rent you would have paid.

That would be a simple, yet quantitative support for your argument, Rich (the result actually surprised me a bit).

You’d still have the financing side of the equation, but you don’t value stocks based on the method of financing, you value them purely on the cash flows of the stock. I’d argue you should do the same here-it’s the cash flows that you are buying that drive price, not the method of financing. The rate reductions are reflected already in the present values calculation on the house.

There are obviously other considerations: The option to refinance, the potential for spreads over treasuries to change, psychological changes in buyer preferences for owning vs. renting, the fact that emotion can enter the market and that not all participants are acting rationally, etc. The recent bubble bears this out since the above would indicate that the abnormally low rates wouldn’t be a boon for prices-I’d argue that was psychology, not economics driven and that the economics can only explain the long-term gravitational pull toward a rational value

That’s a stab:

Stan

[stansd]

Hi Rich,

I’ll take a crack conceptually-apologize for this being a bit of a stream of consciousness.

If we assume some sort of rational expectations, a house is like a dividend paying stock (the dividends being the right to live in the house, which has some value). The value of the house, then, would be equal to the present value of cash flows, which I’d say are equal to expected rents over the time horizon (owners equivalent, or something like that), plus the value of the house discounted to the present at the current interest rate over the horizon (10 yr t-bill or something).

On that side of the equation (ignoriing financing), then, lower interest rates should increase the present value of the house, but this effect would be muted by the following: lower interest rates would drive lower future rents (assuming those are based on an expected return from the owner), which would also be based on a spread over inflation.

I plugged this into a very simple model that assumed inflation and rent increases of 3%/year, a T-Bill Rate of 6%, and made the assumption that the spread over inflation on the T-Bill is constant at 3%.

Under this scenario, the rising value of the house from a lower interest rate is almost exactly offset by the fact that it slows down the rate of growth in rents, and therefore, the house wealth gained is also a benefit lost in the sense that you were saving less on the rent you would have paid.

That would be a simple, yet quantitative support for your argument, Rich (the result actually surprised me a bit).

You’d still have the financing side of the equation, but you don’t value stocks based on the method of financing, you value them purely on the cash flows of the stock. I’d argue you should do the same here-it’s the cash flows that you are buying that drive price, not the method of financing. The rate reductions are reflected already in the present values calculation on the house.

There are obviously other considerations: The option to refinance, the potential for spreads over treasuries to change, psychological changes in buyer preferences for owning vs. renting, the fact that emotion can enter the market and that not all participants are acting rationally, etc. The recent bubble bears this out since the above would indicate that the abnormally low rates wouldn’t be a boon for prices-I’d argue that was psychology, not economics driven and that the economics can only explain the long-term gravitational pull toward a rational value

That’s a stab:

Stan

[stansd]

Hi Rich,

I’ll take a crack conceptually-apologize for this being a bit of a stream of consciousness.

If we assume some sort of rational expectations, a house is like a dividend paying stock (the dividends being the right to live in the house, which has some value). The value of the house, then, would be equal to the present value of cash flows, which I’d say are equal to expected rents over the time horizon (owners equivalent, or something like that), plus the value of the house discounted to the present at the current interest rate over the horizon (10 yr t-bill or something).

On that side of the equation (ignoriing financing), then, lower interest rates should increase the present value of the house, but this effect would be muted by the following: lower interest rates would drive lower future rents (assuming those are based on an expected return from the owner), which would also be based on a spread over inflation.

I plugged this into a very simple model that assumed inflation and rent increases of 3%/year, a T-Bill Rate of 6%, and made the assumption that the spread over inflation on the T-Bill is constant at 3%.

Under this scenario, the rising value of the house from a lower interest rate is almost exactly offset by the fact that it slows down the rate of growth in rents, and therefore, the house wealth gained is also a benefit lost in the sense that you were saving less on the rent you would have paid.

That would be a simple, yet quantitative support for your argument, Rich (the result actually surprised me a bit).

You’d still have the financing side of the equation, but you don’t value stocks based on the method of financing, you value them purely on the cash flows of the stock. I’d argue you should do the same here-it’s the cash flows that you are buying that drive price, not the method of financing. The rate reductions are reflected already in the present values calculation on the house.

There are obviously other considerations: The option to refinance, the potential for spreads over treasuries to change, psychological changes in buyer preferences for owning vs. renting, the fact that emotion can enter the market and that not all participants are acting rationally, etc. The recent bubble bears this out since the above would indicate that the abnormally low rates wouldn’t be a boon for prices-I’d argue that was psychology, not economics driven and that the economics can only explain the long-term gravitational pull toward a rational value

That’s a stab:

Stan

[stansd]

Hi Rich,

I’ll take a crack conceptually-apologize for this being a bit of a stream of consciousness.

If we assume some sort of rational expectations, a house is like a dividend paying stock (the dividends being the right to live in the house, which has some value). The value of the house, then, would be equal to the present value of cash flows, which I’d say are equal to expected rents over the time horizon (owners equivalent, or something like that), plus the value of the house discounted to the present at the current interest rate over the horizon (10 yr t-bill or something).

On that side of the equation (ignoriing financing), then, lower interest rates should increase the present value of the house, but this effect would be muted by the following: lower interest rates would drive lower future rents (assuming those are based on an expected return from the owner), which would also be based on a spread over inflation.

I plugged this into a very simple model that assumed inflation and rent increases of 3%/year, a T-Bill Rate of 6%, and made the assumption that the spread over inflation on the T-Bill is constant at 3%.

Under this scenario, the rising value of the house from a lower interest rate is almost exactly offset by the fact that it slows down the rate of growth in rents, and therefore, the house wealth gained is also a benefit lost in the sense that you were saving less on the rent you would have paid.

That would be a simple, yet quantitative support for your argument, Rich (the result actually surprised me a bit).

You’d still have the financing side of the equation, but you don’t value stocks based on the method of financing, you value them purely on the cash flows of the stock. I’d argue you should do the same here-it’s the cash flows that you are buying that drive price, not the method of financing. The rate reductions are reflected already in the present values calculation on the house.

There are obviously other considerations: The option to refinance, the potential for spreads over treasuries to change, psychological changes in buyer preferences for owning vs. renting, the fact that emotion can enter the market and that not all participants are acting rationally, etc. The recent bubble bears this out since the above would indicate that the abnormally low rates wouldn’t be a boon for prices-I’d argue that was psychology, not economics driven and that the economics can only explain the long-term gravitational pull toward a rational value

That’s a stab:

Stan

[patientlywaiting]

Rich and Stan. Interesting write up. Thanks for sharing. I enjoyed reading.

[patientlywaiting]

Rich and Stan. Interesting write up. Thanks for sharing. I enjoyed reading.

[patientlywaiting]

Rich and Stan. Interesting write up. Thanks for sharing. I enjoyed reading.

[patientlywaiting]

Rich and Stan. Interesting write up. Thanks for sharing. I enjoyed reading.

[patientlywaiting]

Rich and Stan. Interesting write up. Thanks for sharing. I enjoyed reading.

[Rich Toscano]

Hi Stan – Great point about rents. I would also add another point if you are assuming static rates and inflation: if rates and inflation can both be assumed to be low, the “real” burden of your debt will stay higher through the amortization. In contrast, if rates/inflation are high, you are paying more interest, but you are basically paying off your mortgage faster as inflation eats away at the real burden of your principal.

But, what I was more attempting to get at was the fact that rates and inflation are NOT static. So discounting future income using today’s 10-year Treasury doesn’t really take that into account, if I am understanding you correctly.

And again, I’m kind of muddying the waters here by trying to figure out not one guy’s decision to buy or not, but rather what represents a fundamentally justifiable, sustainable level of pricing. For this latter, it seems to me that one must take the long view on rates. Or, that one should ignore rates altogether, because A) they haven’t had much impact historically and B) since their future direction is unknown, they shouldn’t figure into pricing. Or something.

I’m pretty exhausted and out of it this evening so the above may or may not make sense. Thanks for sharing your insights.

Rich

PS – Ray – In bonds, you care not just about the current rate but about future rates. I’m arguing that the same is true in housing.

[Rich Toscano]

Hi Stan – Great point about rents. I would also add another point if you are assuming static rates and inflation: if rates and inflation can both be assumed to be low, the “real” burden of your debt will stay higher through the amortization. In contrast, if rates/inflation are high, you are paying more interest, but you are basically paying off your mortgage faster as inflation eats away at the real burden of your principal.

But, what I was more attempting to get at was the fact that rates and inflation are NOT static. So discounting future income using today’s 10-year Treasury doesn’t really take that into account, if I am understanding you correctly.

And again, I’m kind of muddying the waters here by trying to figure out not one guy’s decision to buy or not, but rather what represents a fundamentally justifiable, sustainable level of pricing. For this latter, it seems to me that one must take the long view on rates. Or, that one should ignore rates altogether, because A) they haven’t had much impact historically and B) since their future direction is unknown, they shouldn’t figure into pricing. Or something.

I’m pretty exhausted and out of it this evening so the above may or may not make sense. Thanks for sharing your insights.

Rich

PS – Ray – In bonds, you care not just about the current rate but about future rates. I’m arguing that the same is true in housing.

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