One central issue being avoided by many on Wall Street including politicians revolves around pricing homes to reflect sustainable fundamentals. What should a home cost? I know this question may seem too simplistic on the surface but really it is the fundamental issue surrounding the housing bubble. In reality this debt bubble bursting was a […]
One central issue being avoided by many on Wall Street including politicians revolves around pricing homes to reflect sustainable fundamentals. What should a home cost? I know this question may seem too simplistic on the surface but really it is the fundamental issue surrounding the housing bubble. In reality this debt bubble bursting was a reflection of assets being valued much too high. In a classic economic sense this was a bubble. Yet in many bubbles including the Tulip Mania in Holland, once the bubble bursts the underlying speculative fervor pulls away from the good in question and prices collapse to the tune of 90 percent or higher. Yet homes do hold value. People will always need a place to live. It isn’t like a penny technology stock that once the mania burst, was completely worthless. Homes do have a market cost but what is it?
Those claiming that prices hit peaks based on “economics” were out to lunch during the boom. Prices right now also don’t reflect a true free market price because the government is virtually the only player in the mortgage market, has provided a very expensive tax subsidy for buying, and has allowed banks to work their crony accounting magic on what otherwise would be dubious assets. I happened to catch CNBC this morning before the new home sales report was out and they had a countdown clock going. About a minute before the numbers came out, they made sure to undershoot the expectation and of course, the sales report beat expectations. What a shocker. But let us look at this number closely:
I’ll get into the existing home sale jump in a second but that little jump in new home sales was the “giant” beating of expectations. In fact, let us zoom in closer:
At one point in the mania, we were selling on a seasonally adjusted annual rate 1.4 million new homes. Take the above data for what it is worth. We are simply returning to a new normal in new home sales. The existing home sale jump? Much of that is being pulled forward by the fact that nearly one third of all national home sales are foreclosure re-sales and prices have collapsed. In California that number is 40 percent but much of last year it was close to half. That jump isn’t a sign of market stability but a sign that many foreclosures are being sold at much lower prices. For an economy with less money, a lower price will increase demand.
So that brings us back to the issue of pricing a home. Various metrics are used in valuing homes. Some like to use replacement cost analysis. Others prefer to use a combination of methods. In reality there are three major methods:
-1> Cost
-2> Sales Comparison
-3> Income Capitalization
Take a wild guess which method was overused during the boom? If you said number two, you are absolutely correct. How does this method work? Basically it is the method most appraisers use. They look at three recent home sales in the immediate neighborhood of said home, they look at key characteristics, adjust for other data points, and then arrive at a square foot price for the home. Basically you are taking three recent home sales and arriving at a price for the current home. But you can see how poor of a metric this is in housing bubbles especially one unlike anything we have seen since say Florida in the 1920s, but on a national level. It becomes a game of musical chairs. Comparing three inflated homes and inflating a fourth is not an economically viable method in bubbles but that is how things played out. And that is largely how we got into this mess. Ironically, pricing a home has nothing to do with local area incomes but how much debt people could get their hands on. With money being given out to people with no income and cats with supposed MBAs, it wasn’t a stretch to get massive loans.
The cost approach is used more by home builders or for those buying land. You want to see your actual cost of replacing a home or building a new home. Many of the new homes in parts of the country where the economy has been pummeled are selling for replacement value or even less at times. Home builders are not in it to break even. They were in it to make big bucks when the margins were hot.
The income capitalization approach is the most accurate in giving you a fair market price for a larger area. Of course, you will always have areas like the Hamptons, Beverly Hills, or Newport Coast that really are micro markets and don’t adhere to overall trends. This is also the approach used by most real estate investors. After all, you need to make sure that your expenses are lower than your revenue otherwise you are losing money like any business. Now in California, people used the tulip method in that they thought that housing prices would always go up by double digits so when they sold next year, prices would be higher. That was the extent of their analysis. Much of the fire was fueled by Alt-A and option ARM loans and people not needing to verify their income. How it ever came to sound like a good idea to give people $500,000 mortgages with no verification will provide financial historians plenty of anecdotal evidence to cement this bubble in the chapters of financial folly.
We’ll be looking at three cities in California and try to arrive at a price point for local home prices. This is not a science and given the amount of government intervention, it is hard to predict where things will go. But logic will tell you that without jobs, prices can’t go up since government mortgages at least ask you to verify your income via W-2s. I was talking with someone who works with mortgages and he told me, “it takes so much longer now that we have to verify income and other documents. The government is getting tough!” This kind of mentality shows you how far we have to go if actually verifying your income, the money that will pay the mortgage, is too much to ask for. If anything we need more stringent requirements like this:
I’ve pulled three cities in L.A. County that reflect completely different markets. Compton, a market dominated by subprime lending and a collapse in prices. Culver City, a market with an enormous amount of shadow inventory and with prices not too far from the peak. And Rancho Palos Verdes, a high income area.
Compton
The above chart perfectly highlights the housing bubble. At the peak in 2007, the median home and condo price in Compton hit $410,000. This was an absolute insanity fueled bubble by subprime lending, fraud, and delusion that did not reflect market fundamentals. Some of these homes that sold for $410,000 would only rent for $1,200 to $1,400 a month. Take a look at income data from 2008 for Compton:
The median income is $40,000. So without a doubt, having the median home go for $410,000 or 10 times the gross income of a family was nuts. For a $410,000 home you need at least $100,000 a year. How many households made that in this area? Look at the chart above. Out of 23,658 households approximately 600 met this bottom line number. It is no wonder that the median home price is now down to $140,000, a drop of 60 percent and if we look at condos, the current median is at $110,000. In other words, we are inching closer to prices seen in 2000. This would make sense since California is in a massive budget deficit and incomes have not grown over the decade.
Are prices cheap in Compton? They may look that way if you simply look the median price. Yet valuation of real estate goes beyond the three above methods. Cheap real estate may actually go cheaper. What about employment in this market? Is it stable? Will wages hold up? Just ask Detroit how low home prices can go when an economy is destroyed.
Culver City
Where Compton prices are inching closer to 2000 price levels, Culver City prices are back to levels seen in 2005 and 2006. The above chart includes condos as well so that is why the median price is lower. The actual median home price in Culver City for last month’s data is $620,000. Overall including condos the median price is at $487,000 so it has fallen by 21 percent from the peak reached in 2007. Here in California, this is the next market segment to look at. Many think that these areas unlike the lower range of the market are immune to seeing prices decline. First, prices have declined. I tend to see the Alt-A and option ARM data and it looks like prices are still much too high. We’ll find out soon enough. But if we use the above metrics of looking at local incomes, employment trends, and home values prices are still in a bubble:
Source: Culver City
The $620,000 median home price puts the annual median gross income to home price ratio at over 10. Compton hit 10 but is now down to 3.5. Prices have a lot of adjusting. For a $620,000 home in Culver City, you need an income of over $200,000. Only 9 percent of residents make more than $150,000 a year.
Say you buy this place with a mega FHA insured loan with 3.5 percent down. All you need is $21,700 down:
Your monthly payment is over $4,000 for a home you can probably lease for approximately $2,000. Something is off here. Either incomes are going to boom to justify the current price of homes, or home prices are going to decrease further. And as you can see from the charts above, prices are not going up.
Rancho Palos Verdes
Even an elite market like Rancho PV is down by 23 percent from its peak. The current median home price is $965,000. Not a bad jump from the $526,000 point back in 2000. Yet markets like RPV cater to a unique buyer for the most part. During the boom, many over leveraged with Alt-A and option ARMs and they will wash out over the next few years. But there are many with money that will pay to live in Rancho PV but not enough to keep prices at their bubble peak. How hard this hits home prices is really the next question. Those who think there will be no impact are simply in denial. Look at all the data and metrics gathered. Prices in many areas are too high. Even the high end is feeling the pain. But some think they’ll be buying RPV homes at Compton prices and others think Culver City is going to see another boom in prices. Both cases are not going to happen. But prices will come down to reflect new economic realties.
Conclusion
So what should a home cost? I like using a hybrid of valuation methods. First, what are local rents going for? What is your true cost of ownership after factoring every imaginable tax gift from the government? Is the local economy strong? Homeownership will always be a bit more expensive then renting because of the benefits. But if you look at Culver City and see a mortgage payment of $4,000 on a home that will rent for $2,000 something is going to give in the next year or two. That is the current state of the housing market in California. And this makes logical sense because when too much of your income goes to housing, you have no buffer for economic shocks. A 23 percent unemployment and underemployment rate in California does fall under the category of economic shock.
If we look at historical trends, home values usually stay within a tight range of annual income with a multiple of 3 to 3.5. That is, if a local area family income is $50,000 then home prices can range from $150,000 to $175,000. The lower end of the market like Compton is closer to that range. Culver City? Not so much. But that is the next phase of this bubble. You didn’t expect a decade long bubble to correct completely in only two years did you?
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What Should a Home Really Cost? Using Real Estate Valuation Methods to Arrive at a Sustainable Market Price for Homes. Three City Examples: Compton, Culver City, and Rancho Palos Verdes.
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