Prospects for Home Prices

To estimate how much further home prices will fall, let's look at some data. First, let's turn back to a chart from Chapter 1 (repeated as Figure 5.1), which shows inflation-adjusted home prices going back to 1950.We can see that home prices had fallen most of the way back to the long-term trend line by the end of 2008 and that prices need to fall another 13 percent or so to reach it.

Other metrics of home prices are based on the relationships among home prices, mortgage payments, rents, and income. According to one measure, mortgage payment as a percentage of income, homes are downright cheap today, as shown in Figure 5.2.

Before you conclude that houses are cheap, however, there are three big caveats: First, low rates are available only to those who qualify for conforming mortgages, which doesn't help the millions of homeowners or potential homeowners who have spotty credit histories or are underwater on their current mortgages. Second, with low-enough

180-

Trend Line

Figure 5.1 Real Home Price Index, 1950-2008

Source: Robert J. Shiller, Professor of Economics, Yale University, Irrational Exuberance: Second Edition, Princeton University Press, 2005, as updated by the author.

Figure 5.2 Housing Affordability Index

Source: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index.

Figure 5.2 Housing Affordability Index

Source: NATIONAL ASSOCIATION OF REALTORS® Housing Affordability Index.

Figure 5.3 Home Price-to-Rent Ratio

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.

Figure 5.3 Home Price-to-Rent Ratio

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.

interest rates, almost anything looks affordable, but if rates rise, houses won 't look so reasonably priced based on these metrics. Finally, in light of the severe economic downturn, average income may fall for quite some time.

Now let's examine home prices relative to rents. One metric simply divides the median home price by the median gross annual rent, which is similar to calculating the price-to-earnings ratio for a stock. Figure 5.3 shows that this ratio, after peaking above 26, is now back to around 20, near its level during the 1990s.

A final measure compares the average mortgage payment to the average rent payment. Historically, people have paid on average 36 percent more per month to own a house; this rose to over 50 percent more during the bubble and has now fallen back to less than 20 percent more, as shown in Figure 5.4 .

Based on all of these analyses—and taking rising unemployment and the weak economy into consideration—we estimate that home prices as of the end of 2008 were within a 10 to 15 percent further

Figure 5.4 Mortgage Payment-to-Rent Ratio

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.

Figure 5.4 Mortgage Payment-to-Rent Ratio

Source: NATIONAL ASSOCIATION OF REALTORS® Existing Home Sales data series, U.S. Census Bureau, T2 Partners estimates.

decline of reaching fair value, down about 40 percent from the peak based on the S&P/Case-Shiller national index.

Home prices are almost certain to reach these levels, if past bubbles are any guide. GMO LLC, a well-respected global investment management firm, has studied every bubble in history—including stocks, currencies, and commodities worldwide—and found that in every case, without exception, prices eventually returned to the long-term trend line. GMO 's research also reveals a major risk, however: When bubbles burst, prices often go crashing through the trend line and fair value. Consider the two examples shown in Figures 5.5 and 5.6, in which prices didn 't stop falling until they were 45 to 59 percent below the trend line and then took many years to recover.

How likely is it that U.S. housing prices will go crashing through the trend line and fall well below fair value? Very likely. In the long term, housing prices will likely settle around fair value, but in the short term prices will be driven both by psychology as well as by supply and demand. The trends in both are very unfavorable. Regarding the former, national home

Overrun: 59% Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years

Overrun: 59% Fair Value to Bottom: 1.5 Years Fair Value to Fair Value: 23 Years

59%

1927

1930

1933

1936 1939

1942

1945

1948

1951

1954

Figure 5.5 S&P 500, 1927-1954

Source: GMO LLC.

Overrun: 45% Fair Value to Bottom: 7 Years Fair Value to Fair Value: 12 Years

1955 1957 1959 1961 1963 1965 1967 1969 1971 1973 1976 1978 1980 1982 1984 1986

Figure 5.6 S&P 500, 1955-1986

Source: GMO LLC.

prices declined for 29 consecutive months from their peak in July 2006 through December 2008 and there 's no end in sight, so this makes buyers reluctant—even when the price appears cheap—and sellers desperate.

Regarding the latter, there is a huge mismatch between supply and demand, due largely to the tsunami of foreclosures. In January 2009, distressed sales accounted for 45 percent of all existing home sales nationwide—and more than 60 percent in California.' As noted in Chapter 3, the shadow inventory of foreclosed homes already probably exceeds one year, and there will be millions more foreclosures over the next few years, creating a large overhang of excess supply that is likely to cause prices to overshoot on the downside, as they are already doing in California, as shown in Figure 5.7 '

Therefore, we expect home prices (using the S&P/Case-Shiller national index) to decline below fair value, which is roughly a 40 percent drop from the peak, and only bottom after a 45 to 50 percent decline.

Figure 5.7 Median California Home Prices

Source: Reprinted with permission of the California Association of REALTORS®. All rights reserved. www.rebsonline.com, T2 Partners estimates.

Figure 5.7 Median California Home Prices

Source: Reprinted with permission of the California Association of REALTORS®. All rights reserved. www.rebsonline.com, T2 Partners estimates.

We are also quite certain that wherever prices bottom, there will be no quick rebound. There 's too much inventory to work off quickly, especially in light of the millions of foreclosures over the next few years. In addition, while foreclosure sales are booming in many areas, regular sales by homeowners have plunged, in part because people usually can 't sell when they 're underwater on their mortgages and in part due to human psychology: People naturally anchor on the price they paid or on what something was worth in the past and are reluctant to sell below this level. We suspect that there are millions of homeowners like this who will emerge as sellers at the first sign of a rebound in home prices. Finally, we don 't think the economy is likely to provide a tailwind, as we expect it to contract over the rest of 2009, stagnate in 2010, and only grow only tepidly for some time thereafter.

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