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The Case for a
Housing Bubble

by David Stanowski
02 May 2007
Updated 10 October 2007

You may be unaware that a housing bubble swept through the nation from 2002 to 2005; or you may be skeptical that what happened was really a bubble. A bubble is a term applied to a market that goes through a mania where prices move far beyond long established levels of value. Let's see if the recent housing market meets this criterion.

Bubble Burst

It is often difficult to find widely-accepted levels of value, but there are always ways to make good approximations. The foremost authority on housing price history, in this country, Yale Professor Robert J. Shiller, offers the following index, which is his approximation of U.S. housing prices, adjusted for inflation, since 1890.

During the first 110 years, the index only exceeded 120 for short periods of time. However, the current market, has now driven the index up to 200 for the first time, showing a total disconnect with previously established price levels; which represent a good approximation of value. A return to typical post-WWII levels of 100-120 would require a price drop of 40-50%! Of course, when over-extended markets reverse, they usually fall lower than the price levels where they started, which would portend a drop even greater than the 50%!

Another way to calculate the previously established value of U.S. housing is to look at the difference between the total market value of all U.S. housing units, and the Gross Domestic Product. From 1946 to 1986, the two numbers were usually almost equal, with housing often running less than GDP. In 1989, housing surged to exceed GDP by almost $1 Trillion, but then dropped back. However, by 1999, housing began another surge that has carried it so far that it now exceeds the GDP by $7.4 Trillion Dollars!!

This approximation of value would imply that aggregate housing prices need to fall by about $7.4 Trillion to be back in line with previous values, again! Since the
total market value of all U.S. housing units was $20.59 Trillion in 2006, it would take a general price decline of around 36% to erase the current $7.4 Trillion in over valuation!

Still another way to compare today's housing prices with levels of known value is to compute a Price to Rent ratio. Census Bureau data for the median asking sales price, and the median asking rent were used to do this calculation. Investors always look to invest their money in real estate with low P/R ratios, because it represents how many dollars that they have to pay to receive one dollar in rent. Speculators ignore high P/R ratios, because they are betting on price appreciation instead of looking for income. However, when prices stall in their upward movement, speculators usually bail out, and prices collapse to levels that bring the P/R's in line with historical norms.

This chart shows a low of 11.07 in 1Q 1990. From there the ratio worked higher and held near 15 for several years. In 2005, it began to accelerate higher, and currently stands at 25.25! The P/R ratio is up 128% since the 1990 low! The average P/R ratio, for 
the eighteen + years of available data, is 15.89, which means that the current P/R ratio of 25.25 is 59% higher than average! Therefore, if rents remain relatively constant, prices need to fall 37% to bring the P/R ratio back to the average level.

Perhaps one of the best ways to compare today's housing prices to levels of known value is by calculating the ratio of the median new home price to the median household income. New home prices were used, because there is more data on new home prices than existing home prices. This ratio clearly and simply shows the cost of a typical (median) house in terms of a typical (median) household's income, over the last 43 years. 

During the era of high economic growth and financial soundness, that we enjoyed in the 1960's, this ratio averaged about 3.0. As inflation heated up, in the 1970's, the ratio moved closer to 4.0. For the next two decades, it moved between 3.5 and 4.0, but the recent housing boom pushed the ratio all the way to 5.2, in 2005!

If 3.0 is a good historical baseline for value, then a move to 5.2 represents a 73% increase in this ratio.
Therefore, if median incomes remain relatively constant, which they have for many years, prices need to fall 42% to bring this ratio back to the average level.

Computing this same ratio for existing homes, using the OFHEO Home Price Index, shows an even more alarming acceleration over the last seven years!

One final method to estimate the difference between current prices and previously-established values is to compute the monthly cost to buy versus rent. This is even more difficult to do, because you need to compare like properties, and make assumptions about the owner's costs such as: down payment, interest rate, property taxes, insurance, and association fees, etcetera.

Many Blogs, covering the areas where the market has been most over heated, have recently done this calculation, and they are finding it is typically costing much more to own than it does to rent! For example, when such a scenario was run, using very optimistic assumptions on the benefits of owning a house, in Los Angeles County; the owner did not break even with the renter for 17 years! Click here to read the details.

Since one of the major selling points in favor of home ownership, for the last 60 years, has been its lower cost compared to renting, the current numbers should give buyers great pause! 

The first four methods of looking at price versus value used data for the entire country, so they represent a broad average. Since these calculations suggest that the average residential property needs to undergo a price correction of 35-50%, to be fairly valued again, it is not difficult to make the case that the recent housing market meets the criterion to be considered a bubble, AND that properties in the hottest areas (California, Arizona, Nevada, Florida, and the Northeast) are at risk of even larger corrections!

Price corrections after the peak in real estate bubbles are always slow in coming, because many sellers react by holding out for unrealistic prices, for long periods of time, or simply withdraw properties for sale, hoping for a better market in the future. Some areas are already showing significant price declines, but in others the primary evidence that the bubble has topped, is the falling number of sales, and the rising inventory of properties for sale.

Post-Bubble Fallout

Foreclosures have more than doubled over the past 12 months. There were 1.2 million foreclosure fillings in 2006, up 42% from 2005. August 2007 saw 243,947 foreclosures, up 115% from August 2006; on a pace to see more than 2 million foreclosures in 2007.

Vacant Housing Units:
The number of vacant housing units, as a percentage of the total number of housing units, has been climbing since its 8.11% low in 1976. By 2006, the percentage had reached 13.20%, an increase of 63%! In 2Q 2007, there were 17,370,000 vacant housing units, or 13.61% of the total number!

After WWII, most houses had relatively small mortgages, so there was very little debt and leverage in the residential sector. The amount of leverage more than doubled by 1965, where it plateaued at about 30-35% for two decades. By 1990, the amount of leverage finally exceeded the 1965 high, and it has now climbed to three times the amount that it was in 1945!

Although these figures only represent the average amount of leverage on a residential housing unit, today, many housing units have far more than 47% of their value mortgaged. Those owners with 90-100% leverage will be the ones most likely to be forced to sell in the current market.

Median Existing Home Prices:
Prices stalled in June 2005, and have moved sideways for the last two years. Year-over-Year prices changes began to turn negative in August 2006.

Existing Homes For Sale:
The inventory of existing homes for sale has almost doubled during this period.

Existing Homes - Months Supply of Inventory:
The number of existing homes for sale divided by the sales rate yields the number of months supply of inventory. This indicator is growing even faster than the actual number of homes for sale.

Data going back to 1999 shows that inventory held between 4 and 5 months of supply, until the recent surge.

Median New Home Prices:
Prices formed a top in April 2006, but then pushed to a new high in March 2007. Since then, they have declined 14%! This data should overstate the true level of prices, because they do not reflect the significant incentives that have been part of new home sales since the 2005 top.

New Homes For Sale:
The number of new homes for sale peaked at 570,000 in August 2006, but it has remained very high at 531,000 in August 2007.

New Homes - Months Supply of Inventory:
The months supply of inventory has doubled over this period!

Data going back to 1999 shows that inventory held between 4 and 5 months of supply, until the recent surge.

Housing Market Index:
This index is a sentiment gage measuring the optimism or pessimism that homebuilders have towards the housing market.
It was very surprising to find that home builder sentiment did not meet, or exceed, its 1998 all-time high during the peak of the real estate bubble, in 2005. Why weren't they more optimistic at that time? It is also interesting to note that, in September 2007, pessimism equaled its previous all-time low, at this early stage in the decline.

Housing Units Completed:
This chart shows that the previous 7-9 year building cycles were "skipped" after the 1991 bottom, in favor of 15 years of uninterrupted growth! Even with the current over supply, developers are still building at a pace to create 1.5 million more units in 2007, according to data from January through August.
Source: Census Bureau

Since the HMI shows that home builders are well aware of how bad the market is, it appears that the only reason they are still building is because most of them could not survive very long, if they cut their output to the current demand. Many would like to sell most of the land that they bought near the peak, but with few buyers of raw land, the only chance that they have of unloading their property is by building on it!

These forces are just adding to the glut of supply on the market.

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