NMHC Notebook: How Far Will Prices Fall?

NMHC Notebook: How Far Will Prices Fall?
Published: April 01, 2008

Right now, the for-sale housing market is in the throes of its most serious downturn since the Great Depression: Sales of previously owned single-family homes dropped 13 percent in 2007, according to the National Association of Realtors. That's the biggest annual drop in 25 years. What's more, this is the first time in the post-World War II era that house prices have fallen on a nationwide calendar-year basis.

This is important for the apartment industry for two reasons. First, the housing downturn is clearly pulling overall economic growth downward, perhaps into recession, just as the associated mortgage market meltdown has reverberated around the global financial system. Second, at some level, all types of housing compete with each other; in particular, apartments compete not only with single-family and condominium rentals, but also with owner-occupied housing. Falling prices change the dynamics of this competition, which means the impact of the for-sale downturn on apartments may well depend on just how far prices fall.

Though there is not a single, universally accepted data series for house prices, there are three widely followed data sources. They are the National Association of Realtors (NAR) median and mean price of existing houses sold, the Office of Federal Housing Enterprise Oversight (OFHEO) house price index (based on repeat sales of the same houses in the mortgage databases of Freddie Mac and Fannie Mae), and the S&P/Case-Shiller (CS) house price index based on repeat sales of single-family houses.

For the year, the NAR data showed a 1.4 percent decline, but a 5.0 percent fall when measured from the fourth quarter of 2006 to the fourth quarter of 2007. This is the first price decline in the 40-year history of the NAR data. The OFHEO data will not show a calendar-year drop, but are expected to show a fourth quarter of 2006 to fourth quarter of 2007 decline, also for the first time in its 33 years. The CS index, which covers fewer markets and is not complete for 2007, will also show a decline in house prices, probably 4 percent on a calendar-year basis.

Of course, these data record nominal price changes. But economists prefer adjusted-for-inflation "real" values, which give a more accurate depiction of an asset's actual value. Declines in real house prices are not unique to 2007. In fact, they've occurred at various times in the past, including 1980-1982 and 1990-1995.

While peaks and valleys in house appreciation are not unprecedented in nominal terms, the valleys are much deeper, and this particular run-up is much bigger when viewed through an inflation-adjusted lens. Between 1975 (the first year of OFHEO data) and 1995, real house prices rose by only 6 percent (a compound annual rate of 0.3 percent). From 1995 to 2006, real house prices went up by a cumulative 61 percent (4.4 percent annually).

The "Right" Level for House Prices

There is probably as little agreement about the "right" level for house prices as there is about a right level for stock prices. Similarly, there's little consensus on the best framework with which to address the issue. One increasingly popular approach is to compare single-family house prices with apartment rents. At a broad level, the theory goes, all housing types compete with each other; if the cost of homeownership gets too high, more households will choose to rent, thus reducing the demand for single-family houses and increasing the demand for rental residences. In addition, some investors who have bought houses and condominiums to profit by renting them will realize their plan isn't working and will sell the units, thus increasing the supply of for-sale houses and condominiums on the market and lowering their prices.

This "house price to rent" ratio is akin to the stock market's price-to-earnings (P/E) ratio. Like the latter, it should not be used as a predictor of short-term price movements, but rather a rough guide whether the cost of owning vs. renting is sustainable.

From 1975-1995, the house-price-to-rent ratio varied no more than 10 percent from the 1.00 level. In this case, the first quarter of 1995 is indexed to equal 1.00, but the level—which is just the ratio of two indexes—has no particular meaning; it is the trend that matters. Even the rise from 1995-1999 seems unsurprising. But starting in 2000, the ratio surpassed its previous peaks and rose at an accelerating pace, especially from 2004-2006, at which point it was more than 50 percent above the 1995 base level.

There is reason to expect the ratio to continue falling—that's what happened in areas like Los Angeles in similar circumstances almost two decades ago. Let's assume the house-price-to-rent ratio falls until it is 12 percent higher than the pre-run-up level (as happened in LA), and that this occurs over four years. If rents rise four percent annually, then house prices must fall by about 14 percent in nominal (non-inflation adjusted) terms to restore balance to the ratio. That means prices must return to mid-2005 levels. Rents rising three percent annually would mean house prices must fall by a combined 17 percent—to year-end 2004 levels. In these scenarios, real house prices could fall by up to 30 percent.

A Temporary Run-up

Housing represents both consumption and investment. One purchases "housing services," in the economist's lingo, as shelter. From this angle, there is little difference whether the occupant rents or owns the home. The run-up in single-family house prices, therefore, must reflect changed expectations about houses as investments. Such thinking seems to have driven the rapid house price appreciation seen in recent years. While there can be good reasons for long-term shifts in relative house prices, it is hard to see any reason for a permanent shift in house prices relative to rents. Look for the house price to rent ratio to become more balanced in the days to come.

The opinions expressed in this column are those of the author and not necessarily the editors. To comment on this column or to express interest in writing a Perspective, contact Diana Mosher, editor-in-chief, at dmosher@multi-housingnews.com