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December 15, 2004

Analytics of the Housing Bubble

Matthew Yglesias asks a good question:

Matthew Yglesias: I don't understand why the buy/rent ratio point isn't almost entirely dispositive here. Shifts in the fundamentals that increase home prices should increase rental prices proportionally, but buy prices have increased faster. If demand for home purchases is rising faster than demand for home rentals, it seems to me that that can only mean that people are buying houses as speculative commodities -- spending more than the house is really worth to them in the expectation that it's value will only increase in the future. That means a small dip -- or even a market that stays flat for a little while -- could send the whole thing into reverse. Right?

There is one fundamental factor that affects housing prices and boosts demand but that doesn't have a (first order) effect on rents: the interest rate. When interest rates go down, the same mortgage payment supports a greater amount borrowed, and homebuyers can mobilize more (current) buying power without pushing closer to the margin on their (long-run, future) income. You wouldn't expect the price-rental ratio to stay the same when interest rates went down--you would expect it to rise.

By how much should the price-rental ratio rise? And has it risen too much? Ah! That is a good question that depends on the "duration" of housing considered as an asset. I don't know. But I do know that the ratio of 30-year mortgage payments to rents is much more likely to be a useful indicator than the raw ratio of house prices to rents.

Posted by DeLong at December 15, 2004 01:27 PM

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What assumptions are needed in this claim?

Consider the present value of the rental stream, P for a particular house. If H > P, the owner will tend to sell the house. If P > H, then the price of the house should be bid up. Thus H = P.

Now P is a function of future rents and the financing rate function, i.e. P = Sum ( rent(i) * phi(i) ). If we assume that
rent(i) = rent(0) * f(i), for some function f which depends on the interest rate and the real rate of inflation, then H/rent(0) =
P/rent(0) = Sum (f(i) * phi(i)). If we assume the real rate of inflation is 0, then the most natural f to take is the inverse of phi, so we just have Sum(1) on the RHS, with the LHS being the price of a house and the current rent That is, in order to make the conclusion that Brad does, somewhere there has to be an assumption on the character of f, which does not seem to be obvious.

This is written quickly, so I could be making a bone-headed errror.

Posted by: Andrew Boucher at December 15, 2004 01:43 PM

Even if you adopt the 30y mortgage payment to rent ratio instead of price to rent ratio as your valuation metric there could be a big negative correction if and when rates rise. Real estate investors would be facing the same risks as long bond holders are today.

In valuation models which are interest-rate sensitive (for example, the Fed model for equities (P/E vs inverse of 10yr yield) or the one Brad suggested for housing) it is probably better to use some running average for the interest-rate, over a timescale of at least a few years. Otherwise you can get wild swings in valuation.

Posted by: steve at December 15, 2004 02:32 PM

Brad wrote:
"There is one fundamental factor that affects housing prices and boosts demand but that doesn't have a (first order) effect on rents: the interest rate."

Another hugely important factor that affects demand for home purchases is lending standards. Rising default rates could occur independent of interest rates and reduce the number of buyers.

Posted by: Ottnott at December 15, 2004 02:40 PM

the new york fed sed pretty much said the same thing recently :D


"This article assesses two measures frequently cited to support a bubble—the rising price-to-income ratio and the declining rent-to-price ratio—and finds the measures to be flawed and the conclusions drawn from them unpersuasive. In particular, the measures do not fully account for the effects of declining nominal mortgage interest rates..."

dunno about the mortgage payments to rent ratio, but the fed does have a "financial obligations ratio" (debt service payments to disposable personal income) that i think would broadly mirror mortgage/rent...



Posted by: glory at December 15, 2004 02:47 PM

OK, so here's a recent paper on this issue. Not being a card-carrying economist (or any kind of economist) I'm not sure it's the *best* paper, but...


The claimed result is that rent/price ratios are still meaningful even when cost of capital issues are addressed.

Myself, I can't help but notice that the most bubbly places at this point in time are the ones that are also the most built-out (in the sense that there are few additional places left to put attractive suburbs). I don't see how interest rate increases are going to cure that basic supply problem. The demand side, on the other hand...I would think this could be pretty brutal. I currently live in a housing market where existing housing prices are theoretically constrained by the cost of developing easily accessible former pasture land, and, sure enough, housing price increases have been very modest despite the fact that the city itself is growing by about 2% per year. In other words, we have a situation where supply is at the moment essentially infinite, so housing costs have essentially tracked what you'd expect from interest rate changes (actually a little short of that). Price to rent ratios have increased, but only because the entire market converted a year or three ago (it made no sense to rent a 3-bedroom house when you could buy one as cheaply).

Posted by: Jonathan King at December 15, 2004 02:57 PM

which stocks to short for next year's housing crash?

washingtonmutual? c'mon.

Posted by: wert at December 15, 2004 03:29 PM

I don't understand why nominal mortgage rates should matter to price-rent ratios rather than real rates. Nominal mortgage rates have fallen significantly but real rates have fallen less.

The best explanation I have heard is that lower nominal rates removes some credit constraints preventing home buyers from borrowing the large amount they would prefer.

Posted by: Gavin at December 15, 2004 03:36 PM

So, how has the mortgage-payment/rent ratio fared over the past few years?

Jonathan King: true that tight supply makes for high prices, but that's different from a bubble. And besides, even in places that are heavily built-up, supply can increase to meet demand: single-family houses can be converted to 2-3 family condos, condos can be converted to rooming-houses or tenements (as happens in Allston, MA as students overwhelm the neighborhood's ability to absorb them). And factories can be converted to housing: witness Lowell, MA's mills... I've seen a lot of new condos going online in the past year, especially given how hard it is to get through permitting for a new building in the greater Boston area.

So, the limited supply thing may mean that it's slower to adjust, but it's not going to stop supply from rising.

Posted by: verbal at December 15, 2004 03:50 PM

Rent/30 Year Mortgage Obligations.

Having looked for housing to buy in the Berkeley/Kensington/Albany/Oakland market and having known lots of people with more experience than me in this vastly frustrating endeavor, I can tell you a quick way to find out the rent to mortgage obligation ratio. Look for weekend "open houses" in Berkeley. This is where the house is open for all people interested in seeing it. Go there and talk to the people who come to look. Many of them have been doing this for over a year and a more bitter and angry bunch of people you are unlikely to meet. They will know the market cold.

When I was last in that market (about two years ago) Berkeley rents would not cover the mortgage payments you would have to make on a house the bidding war for which you managed to win.

All the people I knew who were looking to buy were actually trying to buy a house they would live in. They weren't looking to speculate. One reason they were willing to pay more in mortgage payments than in rent was that the interest on their mortgage is tax deductable.

I finally gave up and moved to Humboldt County, where the Chicago maxim then held -- twice the space for half the price.

Posted by: kaleidescope at December 15, 2004 04:35 PM

verbal wrote, "And besides, even in places that are heavily built-up, supply can increase to meet demand: single-family houses can be converted to 2-3 family condos..."

What about zoning restrictions?

Posted by: liberal at December 15, 2004 05:43 PM

The ratio becomes extremely important when considering what provides liquidity to this market. Keeping the interest rates at historical lows for extended periods, lowering lending standards, and encouraging buyers to finance with ARMs in a low fixed rate market cause dislocations.

That same low interest rate which makes the purchase possible may have an absolutely inverse effect when it comes time to sell. When the long line of desperate buyers disappears, the only options are to rent the place or sell probably at a loss. However, many recent purchasers may be effectively "upside down" in the property. Since the purchase price was at least partly a function of unsustainable interest rates, the seller may be further underwater when rates rise.

Someone, somewhere will eat the loss, whether it is the seller, the lender or perhaps the bondholder. If the secondary mortgage markets end up sticking the bondholders with the losses, those secondary mortgage markets will no longer be able to attract money to a "safe investment".

Eventually the property will liquidate at some value having a much closer relation to the value of the rental stream.

Posted by: RickG at December 15, 2004 06:35 PM

We are all overly logical people believing that the market clears...
The emotional dimension of so-called ownership (a.k.a. low equity ratio on real estate beyond ones means), the traditional mindset that does not question the wiseness of such "investment" until a bubble has burst, the comparatively small rental market, and the social stygmata associated with renting are all driving a "utility for ownership for the sake of ownership" that might well account for part of the gap.

Posted by: ergos at December 15, 2004 06:36 PM

well, one might check the localmaraketmonitor for one:


and ofheo for another:


berkeley does not the rest of the nation's housing market make.

altho, san diego might :D


one might also check rental vacancy rates, which seem awfully high, implying the rental market is crap:


dunno 'bout 2004 tho!

altho the office vacancy rate seems to be improving:


and finally the bls offers insightful statistics as well:


and last but not least :D



Posted by: glory at December 15, 2004 07:11 PM

I've owned homes off/on in Calif for 30 years and have generally used the ratio b/w annual rent to home price as a useful guideline to determine whether the home is "overvalued" or "undervalued".

Since the mid-70s, the ratio has generally fluctuated b/w 7-15x---i.e., home prices sold for around 7-15x annual rent. Whenever homes were priced around 15x, you could pretty much guarantee a slump was dead ahead.

I bought a home in Berkeley for 6x in 1977, one in LA in '83 for 12x, and one in SF in '96 for 13x.

What is happening today in Calif has no historical precedent. I rent a home in Marin County that is assessed at 42x rent (home is worth $2M and I pay $4K/mo). The avg $1.2M home here rents for about $3K/mo or 33x. The median home in SD and OC goes for about 22x rent. The home I live in would cost me 2.5x (net after tax deductions) more to own than rent.

This is 2-3x historical highs, not just historical averages!

The Fed, realtors, and other property believers can talk all they want about the "new era" of real estate. I, for one, think it's an accident waiting to happen. Buyers here in Calif are either 1) rolling over gains from a previous sale to afford the "next level" or 2) using creative financing to keep short-term costs down while hoping for a bail-out upon sale through asset inflation.

If interest rates rise and the asset inflation everyone is counting on doesn't come, watch out.

And with so many buyers today coming to the table with little or no money down, we may have to revise what the word "homeowner" really means. In reality, most of these "no/low cash" buyers are really (leveraged) real estate speculators disguised as new homeowners.

Posted by: wheeler at December 15, 2004 07:19 PM

oh, and one might also note that owner's equity as a % of household realestate values is near record lows...


also noted here :D



Posted by: glory at December 15, 2004 07:40 PM

---In reality, most of these "no/low cash" buyers are really (leveraged) real estate speculators disguised as new homeowners---

Good point. Many buyers today don't realize that they are involved in a leveraged financial position when buying a home.

Let's say a new buyer buys a $500K home, even with no money down, etc. They can afford the payments (barely.) But everything is cool. Then interest rates go up a bit, but that's OK, their ARM protects them to some extent.

But then, let's say 5 years from now, they need to sell. The housing market has cooled a bit, homes are down about 10% from 2004 levels (a very small correction given the recent runup.) The happy buyer from 2004 is faced with the prospect of selling his/her home for $450K plus a sales commission of $22,500. So to get out from under this home, they will have to come up with $72,500 or face bankruptcy. In the stock business, this is known as a margin call. For those with equity or down payments, they will lose it all with just a very minor market correction.

Think it can't happen? Think again. Maybe some will rationalize this risk away by saying, "Well then, I just won't sell my home." But when push comes to shove, sometimes you gotta sell for reasons beyond your control. This is the future that awaits many who are buying today.

Posted by: brightlightsbigcity at December 15, 2004 08:23 PM

the economist thinks it is a global phenomenon, btw:


not to mention morgan stanley's andy xie's (and roach's) reservations on property bubbles in china...


but you're right wrt (hybrid-)ARMs it may be a "slowburn" as they won't reset for awhile...

Posted by: glory at December 15, 2004 08:42 PM

I wouldn't pay 90% of maket value for most properties in my area (Philadelphia). It is indeed time to sell. In fact, I recently have.

The relevant question, which I'm not surprised that those of a theorizing nature don't want to answer, is how best can one profit from the coming crash.

By the way, the coming correction will far exceed 10% in 80 percent of the country -- underpriced areas in key SMSAs and regions/properties attracting retirees excepted. (There are still a ton of anomalies and always bargains to be found.)

Still, for all those versed in more esoteric financial strategies, not even an anonymous guess on how best to play the coming crash?

Posted by: ihavenoidea at December 15, 2004 08:46 PM

apartment REITs?

Posted by: glory at December 15, 2004 09:12 PM

Who will take the losses when home mkt corrects? How many of you know the meaning of "single option" States (aka States with non-recourse loans)?

You all will when the bubble bursts.

Posted by: B5 at December 15, 2004 09:46 PM

--Still, for all those versed in more esoteric financial strategies, not even an anonymous guess on how best to play the coming crash?---

Unlike stocks, you obviously can't "short" homes. You can sell and buy cheaper, I guess. It's a tough call. Going to cash seems like financial suicide right now given that cash is being savaged in favor of other paper assets. Borrowers (our government being Debtor Uber Alles) aren't being given the red carpet treatment, those eschewing credit are a laughingstock.

Will the worm turn? Ultimately. Shorting housing stocks and mortgage broker stocks has proven unprofitable---as they continue to make all-time highs. I guess wait until they begin to break down and take a shot. It seems as if all asset classes are rising in tandem (commodities, metals, stocks, bonds, real estate). Perhaps this means that, if/when the turn comes, all asset classes may also fall in tandem. If that's the case, cash might well prove popular again. But which currency? Questions, questions...

Posted by: wheeler at December 15, 2004 11:12 PM

Housing bubble, and possible hedge

Robert Shiller, the Yale economist who coined the phrase "irrational exuberance" to describe the tech bubble, has been advocating new financial instruments that let ordinary people manage the increasing levels of risk in their financial lives. This NYT article describes new derivative instruments designed by Shiller's company that are essentially index funds linked to home prices in certain major markets. They will trade on the Chicago Mercantile Exchange and allow investors to, e.g., hedge against a decline in real estate values in their city.

Interestingly, there will be a pair of derivatives linked to each underlying index, whose prices behave oppositely. This allows bets against the index without requiring a short position that might lead to margin calls or unbounded losses...


Posted by: steve at December 16, 2004 12:04 AM

There is every reason to be bearish, but we need to be intelligent bears as we need to be intelligent bulls. There is a large investment world before us, and all sorts of ways to be balanced and conservative. How can anyone know the future, but we can be intelligently invested in stocks and bonds and a home. We can invest in America and abroad. I am optimistic because I think about how to be balanced in investing. I read all the literature I get from Vanguard, and I read this board and make cautious portfolio decisions. We have had another fine investment year.

Posted by: lise at December 16, 2004 03:12 AM

(1) On interest rates and the rent to price ratio: there is absolutely a relationship, which may be observed using cross-sectional data. Places with high marginal federal and state income tax rates have a lower after-tax interest cost, and also tend to have the lowest rent-to-price ratios. Thus California cities (where people pay high marginal state tax rates and have high nominal incomes that produce high marginal federal tax rates) always have among the lowest ratios, and Texas cities have among the highest. For similar reasons, places with low property tax rates have lower ratios; places with higher rates have higher ratios. Regressions relating the rent-price ratio to after-tax interest rates confirm this.

(2) There is a strong relationship between places with high prices and the land use regulatory regime. The high prices arise from a lack of supply elasticity, and nothing explains differences in supply elasticity better than the level at which land use is regulated.

(3) That said, it is clear that prices in the Bay Area are "too high," because discounted rents cannot explain values there. I taught Real Estate Investments at Wharton West last year, and finished the course by discussing why people living in the Bay area should sell their houses. They very smart people in the class all understood the reasoning; all understood they were paying a large premium for owning--and did not want to sell anyway. Part of it is that people values their houses ideosyncratically (they do not want to give up their neighbors, gardens, etc.); part of it is that moving is costly and a pain; but part of it is just hard to explain.

Posted by: Richard Green at December 16, 2004 04:08 AM

I'm no economist but I do understand that now would be a good time to sell our Bay Area house in a modest but popular neighborhood. It's worth well over 2x what we paid for it 5 years ago. Our 10% down payment has yielded us what we believe is conservatively 400K in equity. Even though our mortgage of $250K is laughable compared to what other people - in our neighborhood! - owe, our payments, property tax and insurance are probably higher than what we could realistically get in rent. (OK it is a 15 yr mortgage, so that changes the picture). So by Mr. Green's calculations, we would be foolish not to cash out right now.

But where would we go? NOt only does my husband have a good job and many other prospects in a field he loves, but we also have a huge network of family and friends nearby. Parents and friends in the area have a marked impact on our life. We have 2 small children and have had a health crisis recently - our support network has helped us in ways that could not be replaced by $400K in cash. We could rent, but renting houses is uncertain - landlords sell them and you have to move, maintenance can be a problem, and often rental properties are just not as desirable as the house you already own.

So we're diversifying our (relatively small) investment portfolio and trusting that it will work out in the end. Our standard of living is lower here in the bay area than it might be elsewhere in the USA. We're not staying here for purely financial reasons.

But do we discuss selling out? About 3x a year. We could own a house with no mortgage in many desirable cities across the country. It's tempting.

I figure that even if the market corrects 50%, we're still ahead. We just haven't taken out any equity, that's all.

Posted by: leila at December 16, 2004 05:33 AM

Better to not totally set aside any regulatory, cultural, or political effects on the ratio between rentals and ownership. The federal government has devoted tremendous resources in support of ownership and to make rental a second class citizen. The political drivers and cultural story telling that lead it that direction have now been embedded in a large pool of voters who consider owning to be moral and renting to be suspect; that has lead to an erosion of the regulator protections for renters and decreased the attractions of that as a housing alternative. Failure to see these effects undercuts your ability to model what it going on with a meme like 'ownership society.'

Posted by: Ben Hyde at December 16, 2004 06:41 AM

Hmm....it would cost me 27 times the annual rent I pay to purchase a similar 1 bedroom apartment in my Washington DC neighborhood. That's up from 10 times my annual rent in 2000.
Of course, Washington DC is a desirable place to live, and crime in the city is improving - it's been almost a year since anyone was shot in the neighborhood, the rats don't seem quite so bad this year, and the schools are almost safe enough to send your children to, and the nonprofit sector is slowly recovering from 9/11 - I hear most of those people are back to work now - so I can see why the condo across the street went for $1.2 million and why my next door neighbors watched their $4,000 downpayment turn into $300,000 worth of equity in three years.

It's all supply and demand of course. No bubble here. Everyone keep moving on, nothing to see.

After all, interest rates have never been lower!

Posted by: Matilde at December 16, 2004 08:43 AM

The three most important facts of real estate used to be location, location, and location. Now they are permits, permits, and permits. In the metrocoastal areas that are overpriced, it is the local and state tax structure that discourages issuing permits and that encourage useless construction standards that always increase the cost of building a house and are not justified by earthquake and hurricane needs.

Posted by: wkwillis at December 16, 2004 10:05 AM

---There is every reason to be bearish, but we need to be intelligent bears as we need to be intelligent bulls...I am optimistic because I think about how to be balanced in investing. I read all the literature I get from Vanguard, and I read this board and make cautious portfolio decisions. We have had another fine investment year.---

Mentioning Vanguard is a perfect case-in-point to why ignoring "bubble" signs in real estate can/will be painful to many.

Vanguard's largest fund (and the largest in the world) tracks the S&P 500. It is by far the fund that most passive investors hold in their 401k's.

As of today (12/16), the fund has now hit a 3-year high---a 57% gain since 10/02. Outstanding, you might say. But look back a bit. The fund is exactly where it was in mid-1998---over six years ago. That's right, after a 57% gain, the fund shows zero appreciation for the past six years.

What does this tell you? It tells you that reading the Vanguard literature (i.e., PR) will make you no money. It matters greatly when you buy and when you sell.

A momentum daytrader (or real estate speculator) can make money buying high and selling higher. But a long-term investor (and that's most of Americans who hold mutual funds in their 401k's) can only make real money buying low and selling high.

It's fine to be optimistic. But given that most Americans have seen no appreciation in their Vanguard index fund for six years, there is hardly cause for celebration. I see no difference between buying a home (in California, for example) today during an historic bubble in prices and loading up on Vanguard index funds in 1999 or 2000.

Right now, in many markets (California, for one), home values are out of whack---and on a historic basis. When things get this stretched (a la equities in the late '90s), whack has a nasty habit of making an appearance.

Posted by: wheeler at December 16, 2004 10:39 AM

"In the metrocoastal areas that are overpriced, it is the local and state tax structure that discourages issuing permits and that encourage useless construction standards that always increase the cost of building a house and are not justified by earthquake and hurricane needs."

Yes, and these factors have all changed dramatically in the Bay Area in the past four years.

Posted by: kaleidescope at December 16, 2004 07:02 PM

---"In the metrocoastal areas that are overpriced, it is the local and state tax structure that discourages issuing permits and that encourage useless construction standards that always increase the cost of building a house and are not justified by earthquake and hurricane needs."---

Homes in San Francisco have nearly doubled in price since 1999, while the city has actually LOST population and over 25,000 jobs. Do you really believe that pernicious property regulation was the principal cause of this outsized gain in home values?

Don't you think dropping the Fed rate from 6.5% to 1% in 24 months (world land speed record for rate reduction) had a little something to do with it?

Can we expect to see another similar drop in the short rate in any 24-month period again in our lifetimes?

We have seen this movie before. During the late '90s runup, Greenspan flooded the nation with liquidity by opening up the credit spigots in '97 (Asian currency crises), '98 (LTCM hedge failure), and '99 (Y2K scare). The result? A blowoff top in the stock market.

Then he repeats the magic in the early '00s after 9/11, stock crash, and corporate fraud scandals. Ergo, capital washes into "safe" real estate and now also bonds, commodities, metals, emerging markets, and stocks again.

When real estate craters, no doubt he'll flood the market yet again in search of another asset class to inflate. Problem is, he's inflated just about every asset class now. What's left? Beanie babies?

Posted by: deuce at December 16, 2004 08:46 PM

He is certainly trying to induce one more boom. Interest rates are now negative. I expect they will get more negative.

Posted by: wkwillis at December 16, 2004 09:13 PM