I’ve updated long-term charts of the ratios of San Diego home prices to rents and incomes:
Despite the steep decline to date, San Diego homes are still quite overpriced based on their relationships to both rents and incomes, around which they mean-reverted in a fairly well-behaved manner up until the late great 2000s bubble. To put some specific percentages on it, the price-to-income ratio would have to fall 13% from here just to get down to the level of the 1990 bubble peak. The price-to-rent ratio would have to fall 20% from here to get to the 1990 peak.
To get to the post-bubble 1996 trough, the price-to-income ratio would have to fall 40% from here and the price-to-rent ratio 36%. If we are to get back to 1996 valuations, these ratios suggest that the decline is about halfway over in magnitude.
Whenever I put out charts like this, some people object that prices should be higher in comparison to incomes and rents because rates are lower. I can understand the rationale but the facts don’t really seem to support this contention. Check out the p/i graph with 30-year fixed mortgage rates overlaid:
In the past two cycles, the p/i ratio peaked at pretty much the exact same spot despite the fact that rates fell subtantially between the first and second peaks. And despite much lower rates during the second trough than the first, the second trough actually saw the p/i ratio fall even lower than it had the first time around.
The peaks also look similar with the p/r ratio, although the second trough bottomed out higher than the first:
The p/r ratio declined less than the p/i ratio because rents declined during the 1990s bust while incomes continued to rise. It’s not that home prices stopped falling; it’s just that rents fell too. This is probably due more to the overbuilding for which the 1990s boom was so famous than to low rates.
Of course, both ratios went parabolic during a period of very low rates. But given that rates weren’t a big driving factor of home valuations in the past, it seems more likely that something else was at work during the latest bubble. For that honor I nominate the previously unimaginable orgy of reckless underwriting enabled by the great securitization boom.
Now that EZ-credit has left the building, it’s reasonable to assume that these ratios may eventually return to something approaching historical normalcy.
Thank you for these updates,
Thank you for these updates, they are excellent. Although I’m paying more attention to the supply glut of NOTs and NODs, it would seem easy enough to say there is no point in considering buying again until the price/rent returns to below 200. This is the stuff on which rational decision making is based.
So, do we read this as
(a)
So, do we read this as
(a) Prices will undershoot to 7x and then rebound
or
(b) Prices will undershoot by slightly less than they overshot the 8x line?
There’s a big difference between those two “bottom” scenarios.
Im not sure my numbers match
Im not sure my numbers match Rich’s, but my calculations show that we just hit 5.92! and we will go lower until we blow this this massive foreclosure inventory.
I wish Rich would update this chart every month. Its the most important one out there. Wish I knew where he got his data from too.
Hilarious title.
I feel it
Hilarious title.
I feel it necessary to occasionally chime in with a reminder that the government changed the tax code with respect to taxes on proceeds from selling a primary residence in 1997.
I think it has a fairly serious effect on the “normal” rent vs. price ratio as it makes ownership quite a bit more attractive.
Just something to keep in mind when using this graph to project what the price/rent ratio “should” be.
Good stuff for multiple
Good stuff for multiple reasons:
1. For boneheads who think we have reached bottom, which is the obvious reason for updating this.
and
2. For boneheads who still seem to think that housing is as overpriced as it was in 2005 and cite things like it costs twice as much to buy as to rent. We are already significantly into the correction … maybe even half-way there.
FormerSanDiegan, I totally
FormerSanDiegan, I totally agree. This is no where near bottom in term of median/average but this is not 2005 either. The question I have is, since most of the lower end homes have been falling through the floor and the high end homes have been pretty stable, yet we still average out about 50% declined from peak to trough. Would that in a way mean that the first 1/2 of the decline is led by the bottom end. The 2nd half of the decline will be the high end catching up to the bottom end? If so, is it safe to say that the bottom end houses is near the bottom?
Another variable that could come into play is inflation. We can very well inflate our way to fundamental.
*nm*
*nm*
The question I have is,
The question I have is, since most of the lower end homes have been falling through the floor and the high end homes have been pretty stable, yet we still average out about 50% declined from peak to trough. Would that in a way mean that the first 1/2 of the decline is led by the bottom end. The 2nd half of the decline will be the high end catching up to the bottom end? If so, is it safe to say that the bottom end houses is near the bottom?
I generally think that the high end will bear the brunt going forward. But, I still think the low end has another at least 10% or more before bottoming. There are places in San Diego where it starts to make sense to me for investment purposes with another 15% decline in prices, assuming stable rents and interest rates within about 1/2 to 1% of current rates. Of course changes in rents and rates would change my target. If both rents and rates creep upward, this holds. If they both creep downward, this holds. If rates increase and rents decrease we will likely go much lower in price, even at the low end.
asianautica – Great question
asianautica – Great question !
I wondered the same thing myself. Then when I see some of Rich’s other graphs ( foreclosures, Schiller’s index by price range), I have to conclude we aren’t quite there yet.
JWM in SD
“Another variable
JWM in SD
“Another variable that could come into play is inflation. We can very well inflate our way to fundamental.”
NO, YOU CANNOT DO THAT!!! How many times do I have to explain this?!?!? Do I need to draw it in crayon for you people????
@AN, check out the
@AN, check out the three-tier case shiller charts. The bottom tier is still more overvalued than the top.
@SDD, I am not sure why the tax law change would make a big difference. An investor in rental properties who might like to take capital gains is unaffected. If you are buying a single family residence and you sell, you are probably just going to plug your profits into your next house. Correct me if wrong, but I thought the old law was that you could roll gains into a new house anyway. The tax change provided huge benefit to both flippers and reverse flippers (fence sitters) during the bubble, but I don’tsee how it significantly changes the equation going forward. Am I misinterpreting?
FWIW I am not arguing that these ratios are going to return to a specific level. There are things that could change the fundamentals — I think a more likely thing is all the stimulus bailout stuff (there will probably be even more subsidization of housing and increased owner tax benefits before this is all done). These just provide a big picture for approximately where we are. Luckily there are other "gauges" that can indicate when things may turn around, e.g. months of inventory, sales volume, foreclosures, etc. This can and should all be looked at together when trying to figure out if the bottom is near. All I know for sure is that 1. it isn’t (all gauges looking horrible) and 2. valuations are still pretty dang high.
Rich
With all the bears here I am
With all the bears here I am somewhat surprised no one is using the “R” word. While driving around town today I was surprised to see how many businesses are going under. If we are heading into a recession/(are in one already) then I think it will change everything and the bottom could be much deeper than everyone is thinking now. Sorry I can’t throw any numbers out there, just my impression of the economy in general.
Under the old tax law, you
Under the old tax law, you could roll forward any profits on your primary residence into another primary residence on a tax-deferred basis.
Then, after you turn 55 you had a once-in-a-liftime chance to sell your primary residence tax free, up to $125,000 in profit.
This gave you 1 chance at a small tax-free sale in your life. Once you take the single tax-free sale, you can only sell your home in a tax-deferred environment, not a tax-free environment.
The new law allowed you to sell a home without paying tax on the first $250,000 profit (500K for married) on any number of homes in your lifetime, as long as you have lived in the home for 2 of the last 5 years. Even if you lived in the home less than 2 years, you still could earn a prorated amount of tax-free profits.
Regardless of the asset, or how often you actually sell it, if you can sell it tax-free instead of tax-deferred, the asset is simply worth more. Put another way, people would tend more to buy that asset than to rent it if profits generated from the sale were tax-free and not tax-deferred.
Plus, the added flexibility to sell and buy at will, tax-free is worth something.
For example, if you time the market perfectly and buy low, sell high then rent, then buy low again, you have made money that you could not have made under the old system, which would have forced you to buy again soon after the “sell high” event. Or you would have to pay tax on the profit. Now, you can buy low, sell high, take all the profits, rent for a while, then reinvest with no tax loss.
Furthermore, those who own multiple homes can sell their primary residence tax-free, then move to one of the other homes for two years, and sell it tax-free.
Thus, it helps investors operating on a 2-year horizon or longer.
It also helps those who inheirit a home (whether you inheirit the old tax base or not).
I believe the capital gain tax rate was also reduced.
I see all of this as making home ownership more valuable, compared to renting, than it was prior to the law.
It may have also helped
It may have also helped flippers – but it helped them in a real, tangible way. Not in an artificial way. The existence of the new laws changed the market, and given those laws are still in effect now but were not in effect in 1996, that change has to be viewed as a fundamental.
This is all to say – if they reversed the law right now, it would have a negative impact on home prices as buyers would be even more reluctant to buy.
Don’t forget the last two
Don’t forget the last two bubbles over-corrected, they didn’t hit the mean and then take off again. They bottomed out below the mean.
There is plenty this time around to support that happening again.
I think Rich makes some very
I think Rich makes some very good points, as usual. “Sell-to-rent” fence sitters and flippers gained the most by the tax exemption, especially because of the credit bubble, since gains were so very high. The tax exemption on home sales would only benefit buyers IF the prices went up. What if prices were stagnant or went down? Not sure that most buyers even knew of the exemption during the run-up. Most of the people I know who bought during the 2001-2005 period certainly don’t know about it, and I’ve never heard anyone discuss it as a reason to buy overpriced real estate.
IMHO, the RE market reached a “natural” peak in 2001, and we should have had a normal correction from there. Problem was, the stock market was tanking at the same time, and the central banks panicked. By lowering rates to 1% (negative real rate), they forced lenders to frantically seek any other way to realize returns. Don’t forget, large institutional investors & pensions funds, etc. REQUIRE a certain return in order for their models to work. All lenders were forced further and further out on the risk curve, and it was this that fed the loose lending — too much money chasing too few borrowers who could pay the required rates, because the central banks were forcing rates to artificial lows.
If in doubt, look at what happened to ALL asset classes since 2001: stocks, bonds, commodities, precious metals, oil, etc, etc. Housing was just more obvious to general public, so it’s what everybody is focusing on.
I think we are in for a wicked credit contraction, and we’ve only just begun. One could make the argument that we will unwind all the way to 1982, when the credit bubble began. It’s extreme, but one should always consider all possibilities when in such extreme circumstances — and these are extreme circumstances. Just MHO.
Great observation AN.
Great observation AN. Looking at those graphs tells you what happens across market averages but on the street level things are radically different across a wide spectrum. There are submarkets that are only getting started on the decline while there are others that either didnt boom all that much or that have already undergone the majority of the correction they needed.
So my question is, if you
So my question is, if you buy low and sell high, take the profits and rent for a while (which is what I’m doing) how long do I have before I have to pay capital gains. I lived in my condo for a bit over 4 years. I thought you only paid capital gains if you bought and sold within two years. But a coworker of mine was just telling me that after selling you can only rent for upto two years before having to pay capital gains. How true is this?
So my question is, if you
So my question is, if you buy low and sell high, take the profits and rent for a while (which is what I’m doing) how long do I have before I have to pay capital gains. I lived in my condo for a bit over 4 years. I thought you only paid capital gains if you bought and sold within two years. But a coworker of mine was just telling me that after selling you can only rent for upto two years before having to pay capital gains. How true is this?
Your coworker is misinformed.
The confusion in this area never ceases to amaze me.
There is no requirement on what you do with funds after making a tax-free sale of a principal residence. You can buy another house or rent the rest of your life, or live in a cardboard box. You can spend the money on lottery tickets, hookers or you can buy gold. It does not matter.
All that matters is that you lived in your principal residence for at least 2 out of the previous five years when you sell it. If you are single you can exclude up to 250K in gains, 500K for married couples. That’s the basics.
If you have a more complicated situation there are other rules. If the property was previously a rental there are other conditions. If you lived in it less than 2 years you may still qualify for some tax exemption depending on the reasons for selling.
Are the expenses paid to the
Are the expenses paid to the hookers tax-deductable ?
Thank you FormerSanDiegan, I
Thank you FormerSanDiegan, I knew this much, but my coworker seemed so convinced, she made me-second myself.
Inflation was mentioned in
Inflation was mentioned in some of the preceding posts. I thought I’d add some specific thoughts on the subject. We know that both the “core” and regular CPI are headed higher (and are probably under reported, also). The Fed appears, for now, to have no problem with inflating the value of goods and services for the American consumer. Right now, there does not appear to be an obvious wage-price inflation cycle on the horizon. This may change down the road, but for now inflation is strong, but seems pretty much restricted to the price arena. If wages start heading higher, the Fed will probably put on the brakes. That, in my opinion, may be only a few FOMC meetings away, and wouldn’t be good for the overall economy.
With consumer prices (including food, gasoline, and other basic materials) sky-rocketing the burden for all is going up. Wages, to date, are mostly not. Perhaps, even the more affluent are starting to feel the pinch. With the price of basic necessities headed higher, there will be less income available for other purchases, including houses. In this environment, the RE bottom (especially in bubble markets) may be even lower than many of us project.
As a side note, I heard that Prof. Ravi Batra will be on the Thom Hartman show (Progressive (liberal) radio) tonight. He is always insightful and has much to say on macro-economics.
‘Half way there’. That may
‘Half way there’. That may be the best guess from eye balling just as chartists do for stock markets.
You know it is only just in the last couple of weeks that the big national players, political and business are finally recognizing the truth (as told by Rich and his Piggies).
Bernanke came out today and said lenders should write off principal as the most effective way forward. Mind you, at the rate of decline many of us are expecting, they would have to reduce the principal twice at least.
Looks like we are officially
Looks like we are officially into the bottom of the fourth inning.
Thank you Mr. Rich!
sdduuuude:
Whereas that 1997
sdduuuude:
Whereas that 1997 tax law change (I assume you mean the ability to avoid up to $500K capital gains per couple if you live in your house for two years before selling) may have helped inflate the bubble, it doesn’t help make RE attractive if house prices are declining. You can’t even write off your capital losses when you resell your $800K 2005 purchase for $500K in 2008.
I agree. I’m definitely not
I agree. I’m definitely not calling a bottom because of that. Just pointing out that the bottom may not be as low as it was in ’96. (And certainly not as high as in 2007.)
I don’t see that the 1997 tax law change “helped inflate the bubble.” Rather, it changed the fundamentals (as much as a tax can be conisidered a “fundamental”) underneath the bubble, which makes the bubble appear a bit larger than it acually is.
The least desireable areas
The least desireable areas are not near the bottom because they went up the most. If they had all gone up the same, and we observed the drops we have, then yes they are close. But they went up more, so theyll go down more. Simple as that. Think of it as the high end is trying not to fall off torrey pines, the middle end is bumping its way down palamar, and the low end just took a flying leap off Mt. Wittney last August. Theyll all eventually get to sea level, if not make a few dents in the sand.
With regards to the 3 tier
With regards to the 3 tier chart from Case Shiller, I noticed that the last bottom, the bottom end didn’t fall as low as the mid or the high end even though they all reach the same height at the peak.
Maybe it’s the area I’m paying attention to that’s screwing with my perception, but base on the price vs rent fundamental, the bottom end is much closer to equilibrium than the mid or the high end. Here’s some example to show where I’m coming from.
Low end:
4bed/2bath ~1300sq-ft house in Mira Mesa.
Rent ~$1800-2000/month.
Price $330-400k w/ 6.5% interest & 20% down, monthly mortgage (P+I) = $1700-$2000/month.
Mid range:
4bed/2.5bath ~2000sq-ft house in PQ.
Rent ~$2200-2400/month
Price $500k-600k w/ 7.5%(since it’s jumbo rate) & 20% down, monthly mortgage (P+I) = $2800-$3300/month
High end:
4bed/2+bath ~2000sq-ft house in CV.
Rent ~$3000/month
Price $700-$800k w/ 7.5% & 20% down, mortgage (P+I) = $3900-$4400/month.
So just base on these 3 scenario alone, the low end mortgage is equivalent to rent. The mid range still need to fall 25-35% more and the high end would need to fall 25-35% as well. If we don’t have any down payment, which I think would make the comparison of price vs rent much more reasonable, then the % that need to fall to get back to fundamental will increase, but the relativity between the 3 area still concur to my statement. Which is the bottom end is much closer to what I’d consider as fundamental (price vs rent). That’s why although it’s nice to see the Case-Shiller chart, I just don’t think it’s 100% accurate.
Also, that’s why I think the 2nd half of the way to the bottom will be led by PQ/CV and such areas. If Case-Shiller is correct and that price of a Mira Mesa home need to drop another 30-40% to get to the bottom, I’d be ecstatic, because a price of such house would be in the $200-250k range. Which means it would be 10-20% cheaper to buy a 4bed/2bath house than rent a 2bed/2bath apartment. I’m all for that, I just don’t see that as reasonable.
an – The higher end areas
an – The higher end areas never tend to cash flow too well in any market. Rents are typically much flatter than home prices across areas. This is true now and was true in the mid-1990s. One might see a rent difference of 10-15% between Clairemont and Point Loma for example. Whereas the price differential at it’s closest was 25% or more in the mid-1990’s.
I agree with you that some areas (like Mira Mesa) might be within about 10% of break even cash flow as rentals from an investor stand-point.
If Case-Shiller is correct and that price of a Mira Mesa home need to drop another 30-40% to get to the bottom, I’d be ecstatic, because a price of such house would be in the $200-250k range. Which means it would be 10-20% cheaper to buy a 4bed/2bath house than rent a 2bed/2bath apartment. I’m all for that, I just don’t see that as reasonable.
I agree with you 100% here. I wouldn’t bank on another 35% in those areas. However, the wild cards are interest rates and rents (which reflect jobs and wages).
I have a question about the
I have a question about the first graph. Can someone confirm that the 12/31/2007 data point is approximately 13? If that is the case does that mean that data point of 11 is an projection for 12/31/2008?
Michelle Steffes
I think you
Michelle Steffes
I think you have to make some adjustment for the interest rate. Interest rates were above 10% in the 1990’s and they have been half that recently. A person could buy a much more expensive home with the same income and thus make the graph less than useful.
it seems like i’ve been
it seems like i’ve been hearing that prices will be sticky on the way down for over a year now…and yet looking at that chart really puts the fall into perspective. This bust is happening much faster than the previous two. And as this recession gets moving along its possible we won’t see it slow for a while now.
Michelle, I think Rich addressed your point in his subsequent graphs…did he not?
Obviously the values change,
Obviously the values change, but does the shape of the curves change if you compare the SFR price to Median Family income and/or to median income instead of per capita income.
The housing/family mix is changing and I’m wondering if that reflects in more reasonable multipliers versus family income for SFRS, etc.
Hi Rich,
Thanks for posting
Hi Rich,
Thanks for posting this information. The charts provide great data to think about and analyze.
I’m one of those who thinks that interest rates do have an effect on home prices … but only under certain condition. My theory is that interest rates are only useful in calculating a lower limit to the price/rent ratios. They don’t have much influence on peak prices or anything in between.
From my observations, the average person buys a home based mostly on emotion and just partially on financials. The emotional justifications is: “I need to buy a house now because …”. The financial analysis is little more than “about how much can I afford?”. Because emotions have such a huge influence, fundamentals such as interest rates usually don’t matter that much.
On the other hand, a professional investor purchases homes based purely on the financials. For him, rents and interest rates play a major part in assessing the value of a rental property. Lower interest rates means cheaper financing. Cheaper financing means that the investor could pay for a property and still get the same return on equity. Or if the investor were buying with cash, lower rates could correlate with a lower expected ROI.
The charts you provided shows that interest rates don’t seem to correlate with price/income ratios. This makes sense because even professional investors couldn’t use price/income ratios to evaluate the ROI on a rental unit.
The charts also show that interest rates don’t correlate with peaks in the price/rent ratio. This also makes sense because during bubble times, its the emotions of the average joe that are setting the market prices. The professional investors won’t be participating.
I suspect that interest rates do affect the theoretical lower limit of price/rent ratios. During bust times, prices can get low enough to attract the professional investors. In this type of market, the investors will add support to the price levels. And because interest rates affect the amount investors are willing to pay for a rental, its affecting the price/rent ratio as well.
In the price/rent vs interest rates chart, we see some support for this theory. During the 1980’s, the P/R ratio bottomed out at about 155. Interest rates at the time were about 10%. In the 1990’s, the P/R bottomed at about 175 while interest rates were at 8%. That’s not much data to go on but its a start.
I still haven’t figured out a good way to model the value of a house to an investor. One idea I had was to ask what % downpayment (N%) could you buy a house with and get a positive cash flow. In theory, you should never get to N=0% because then its like getting the house for free. But while I think N=0% does let you calculate a hard lower limit, I’m not convinced that its a limit you would ever see. I think other factors get in the way and prevent you from getting close to N=0%.
so if price to rent ratio
so if price to rent ratio drop to 200, can I say it
is a safe point to buy ? considering market
over-reaction is expected and difficulty to
catch the bottom.