House Price Fundamentals: By the Numbers

I've been getting a lot questions in emails from readers about the relationship between fundamentals and prices, and what exactly it means when their real estate agent or stockbroker tells them "the fundamentals are strong" and that they should buy.

A Word on Fundamentals

In the medium and long-run, fundamentals always drive asset price valuation (the value of your stock or real estate). In real estate prices, the main fundamental drivers are incomes and interest rates. When your broker says the fundamentals are strong, she is indeed correct: interest rates are low and incomes are increasing (though not excessively so). However, there is not some line at which fundamentals become "officially strong" and put a lead foot on the infinite asset price accelerator. While this is the way its generally presented in the media or by your brokers, it's ridiculous if you sit for a moment and think about it. If interest rates decline by 1%, what happens? Will the "magic" of 5% mortgage interest cause prices to rise 5 times faster than incomes rise for all time?

The obvious answer is no. The buyer still has the same amount of money in hand to dedicate to housing. The price he is willing to pay will adjust upward in the long-run until the monthly payment approximates what it did at the higher interest rate. After that happens, even though the "fundamentals are strong," it's ridiculous to assume that prices will continue to increase indefinitely unless "Average Joe's" income rises proportionately.

If that's true, then what happened to housing? Answer: Speculation

Notice that I use the term "long-run" above. In the short run, speculative greed and fear of missing out (i.e. you'll miss out if you don't buy now... you'll be priced out forever) can cause significant distortion in markets. Speculators are the "technical" traders in the stock market or the flippers in the real estate market who live by the mantra "the trend is your friend." They don't buy based on an asset's underlying value, but instead they speculate on price swings in search of a short-term "easy money" profit.

To an extent, speculation is a self-fulfilling prophecy. As the rise in prices cause more and more speculators to pile on, with each participant searching to cash-out off of a "greater fool," the rate of price increase accelerates. In the end, the "smart money" takes its profits off of the table before the inevitable fall in prices, and they sell to the "greatest fools" who are left holding the bag as profit-taking feeds on itself, increasing the rate of price decline. Eventually, the market falls out of favor with speculators, fundamentals dominate and the market regulates for a time. The effects of speculation are well documented in history, from "Tulipomania" in 1600's Holland to the dot.com bubble of the late 1990's and the housing mania of 2004-2006, with plenty of stops in between.

What Should House Prices Be Today Given the Fundamentals?

I'll start with the good old days of April, 2000. When the boys were boys, the economy was strong and the "beer flowed like wine." Based on the U.S. Census data taken at the time, the median household income was $42,000 and the median house price in the U.S. was around $125,000. At a rate of 8.2%, a 100% mortgage payment on the "median" house was around $935. Through April 2006 (data is not yet available for April 2007, but I'll provide estimates later), incomes rose 19% according to the U.S. Bureau of Labor Statistics, meaning we can expect, based on incomes, that the median mortgage payment would also rise 19% to $1113 per month.

Given the lower interest rates in April 2006 (6.43%), that $1113 per month can buy a lot more house than it used to(which is why interest rates are a second major "fundamental.") Adjusting for both wages and interest rates, the "fundamental" value of a median U.S. house would be $177,343 in April,2006, up from $125,000 in April, 2000 - a perfectly valid 42% appreciation in house prices (before speculators stepped in and screwed the darn thing up). The manic fever that swept the country (we're always looking for the easy ticket to fortune) drove median prices all the way up to $211,578, based on changes in the OFHEO Home Price Index from our base value of $125,000, creating a 19.3% ($34,000) gap between the 2000-based fundamental value and the actual price of a house. So, when your real estate broker or David Lereah tries (or tried) to use the "fundamentals" to support current house prices, the numbers simply don't add up, and haven't for two years. (Unless you believe that some new housing technology has made houses 20% better at providing shelter... or all houses jumped 20% in size over the last 7 years - most of the houses out there today were around back then.)

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As you can see in the graph above, from 2001 to 2004, buyers were able to get a better "deal" than in 2000, and buying could have been considered a fantastic value in historic terms (especially in 2003). However, as prices began to rise, at first due to better fundamentals, speculation took hold, driving the prices way above their 2000-associated "fair value." Based on estimates for April 2007, we can already start to see house prices converge with the fundamentals.

Assuming (generously) flat house prices from this time last year, and a 3.0% increase in wages (most recent BLS estimate), and given the current drop in mortgage rates to 6.20%, we can already see the house prices begin to converge with the historic fundamentals.

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If we assume mortgage rates stay the same (given the mess in mortgages and inflationary pressures, I believe they're more likely to rise, but just for argument's sake), and incomes rise by 3%, it will be 4 more years until the median family budget buys as much house as it did back in 2000... if house prices don't fall appreciably.

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Divergences from fundamentals don't often last that long... it's more likely that prices will decline slightly to aid the correction. A 3% annual decline in house values and a 3% annual increase in incomes will erase the market distortion by April 2009. At any rate, it looks like a particularly ugly time to buy a house right now.

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For my next post... I'm going to give you the real goods on "Buy vs. Rent," and explain why you can "throw your money away" just as easily by paying too much for a house as you can by renting. In fact, it's not a matter of throwing your money away at all... we do so in both instances. It's a matter of whether you're throwing more money away buying or renting.

- eternitus

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At the request of John M., you can find the numbers for the charts below.

A note on the 2000 adjustment (for the UberNerds out there)... the Census data actually says that the median house price was $119,600 in 2000. However, since the Census doesn't have a yearly home price index, there is no way to get the Census yearly % change. So, I used OFHEO's % changes from this figure. Because of the differences in methodology between the Census and OFHEO, doing that only yielded a value of $202,000 in April 2006, below the $210 - $225 k range reported. Obviously, OFHEO and the Census don't precisely agree (statistical samples rarely do). So, I used a figure close to $119,600 ($125,000) that will get us to a reasonable result when using OFHEO's price adjustments.

At any rate, changing the starting point to $119,600 or to $130,000 would not change the % valuation gap, and only reduces / increases the estimated dollar amount of the gap by $1,000, so it's not material to the analysis... mostly cosmetic.


An interesting fact to note is that prices jumped by 69% as measured by changes in the OFHEO Home Price Index from 2000 to 2006. To put that in perspective, median house values took 40 years to double before this period.


Click on the picture for a larger image.