San Diego Housing Market News and Analysis
Shambling Towards Affordability, Mid-Year 2015
Submitted by Rich Toscano on July 26, 2015 - 2:54pm
Once again, the traditional "Shambling Towards Affordability" title for this series proves inapt. The market does have a bit of a shamble to its step, but the direction in which it lumbers is distinctly un-affordable. (In price terms, anyway... low rates do ease the sting, but that's a separate topic to be addressed below).
While valuations have crept up a bit over the past year, the big picture hasn't changed much: home prices are significantly higher, when compared with local rents and incomes, than they typically have been over the almost 4-decade history of the data:
Yet they are nowhere near the heights they reached in the bubble that, incidentally, topped out almost exactly a decade ago. (Wow! Ten years... so many thoughts in response to that. Most of them relating to how elderly and decrepit I am.) As of last month, San Diego home valuations stood 18% over the historical median -- absolutely nothing next to the towering 76% overvaluation of mid-2005. Still, the market is currently more expensive than it's ever been outside of that mid-aughts bubbliness.
I don't believe that the market must necessarily revert to the median valuation of the past any time soon (or maybe even ever). While I'm generally a big believer in the mean-reversion of financial market valuations, local real estate markets are a weird enough animal that once in a great while, "this time" actually is "different," to at least some degree. Structural factors like land constraints, changing demography, etc. could conceivably justify an indefinitely higher (or lower) valuation than the historical norm, and I think it would be irresponsible to just dismiss this possibility.
Nevertheless, it is an objective fact that San Diego housing is significantly more expensive than it typically has been in recent decades. This warrants caution, at the very least.
And while I think we should be open to the idea that higher valuations could be sustainable in the future, I also think that anyone claiming that "this time is different" needs to bring proof to the table, and not just point to current valuations as justification (as we can see, the market sometimes gets it wrong). Given the complexity of the market, this is not an easy thing to prove, nor for that matter to disprove.
As a reminder, I use incomes and rents as the denominator for the valuation ratio because they represent the two most important fundamentals to home prices: how much potential home buyers are earning, and how much a home could be rented out for. The highly mean-reverting nature of the above graph shows that this has been a very solid valuation measure throughout the history of the data. Ignore it at your peril!
The Effect of Mortgage Rates
Now let's zoom in on one factor that's almost certainly helping to keep valuations aloft right now: interest rates. The chart below shows the ratio of monthly payments to rents and incomes:
What this graph shows is that rates are low enough to more than offset high housing valuations, resulting in monthly payments that are, despite unusually expensive purchase prices, lower than the historical norm.
Now, there are a couple of issues with the idea that low rates justify sustainably higher valuations:
I believe that these two factors help to explain why the first chart, which just looks at prices vs. the fundamentals without taking rates into account, has been highly mean-reverting even across a wide variety of interest rate climates.
But those are long-term considerations. For now people want
to buy, and low rates are helping them to pay higher prices while
keeping the monthly payments reasonable. So homes are
expensive, and they may stay that way for quite a while if low
rates stick around. But I think this factor is a bit
overrated, and I am also skeptical of the new (apparent) consensus
that low rates are a permanent fixture -- so I consider it to be a
pretty big gamble to depend on low rates propping up home
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