Why U.S. House Prices Won't Recover
Hough: Taking inflation into account, U.S. home prices are down to 1895 levels.
By JACK HOUGH
When will U.S. house prices recover? Likely never. But that's no reason not to buy.
The latest S&P / Case-Shiller numbers, reported last week, show that prices in 20 major markets declined 3.5% over the year through February. They're now back to 2002 levels. If we subtract for inflation, they're back to 1998 levels.
But consider: After subtracting for inflation, prices are also back to 1986 levels. And 1955 levels. And 1895 levels (see chart).
That's because the natural rate of price appreciation for houses is zero after inflation. Prices will eventually stop falling. They'll resume rising. But over the long term, they're unlikely to resume rising faster than inflation.
That's why prospective buyers should stop focusing on the vague hope that house prices will jump from here and focus instead on the functional value houses provide for the money. In most markets, they provide enough of that to make buying a good deal.
To see why house prices and inflation are linked, consider that inflation is a general rise in the price of consumable goods and services. We measure it as a nation just as you might think: pollsters collect prices on thousands of items and statisticians turn those prices into an index, called the Consumer Price Index.
The inflation rate over the year through March was 2.6%. Behind that number is a lot of variation; dairy products got 6.3% more expensive, while utility gas service got 9.1% cheaper.
That's because inflation isn't the only thing that drives individual prices. Short-term supply and demand factors drive them, too. For example, the U.S. has a severe glut of natural gas at the moment. But prices have a way of self-correcting over time. Power companies have already sharply increased their electricity production from natural gas while pulling back on coal.
Few things escape the gravitational pull of the inflation rate forever. Even healthcare and college tuition are showing signs of slowing price growth. U.S. housing had spectacular booms and busts in the 1920s and mid-2000s, but smoothing out the swings and adjusting for inflation, prices have gone nowhere for more than a century.
Houses are ordinary consumable goods: wood, stone and metal bound pieced together through labor. There's no reason to believe they should enjoy a special rate of return distinct from those for, say, apples and shoes. My best guess for the rate of price increase of all three is 2.2% a year over the next 10 years--equal to the rate of inflation.
To get that number, I looked at yields on Treasury Inflation-Protected Securities. Those are a special kind of bond that adjusts in value each year for the rate of inflation. The difference between the yields on 10-year TIPS and those on regular 10-year Treasurys shows what investors expect inflation to look like over the next decade.
Of course, house buyers can also base projections on factors like house inventories, shadow inventories, the foreclosure rate, the construction rate and so on. But market prices already adjust for factors the public knows about, so buyers who try to form special predictions on prices had better have special knowledge the public isn't privy to.
The good news is that houses--like apples and shoes--have functional value, and right now buyers are getting plenty of it for what they spend. The easiest way to see this is by dividing yearly rents by purchase prices for similar properties, to come up with a "rent yield". Landlords literally collect rent yields; owner-occupants collect implied ones because they don't have to pay rent.
In more than half of U.S. housing markets, the rent yield is over 10%. That's a gross yield; buyers should subtract for things like taxes and maintenance. But even so, buyers in most markets will end up with yields of over 5%. That's a pretty good deal at a time when 10-year corporate bonds of decent credit quality pay only 3%. And with the average 30-year mortgage rate sitting below 4%, financing terms are attractive relative to rent yields (for buyers who can get loans).
Similar math led me to believe five years ago that buying a house had become a bad deal in most of the country (see "Renting Makes More Financial Sense Than Homeownership") and to decide last year that it had once again become a good deal in many markets (see "Time to Buy That House"). Prices declined 33% nationwide between those two columns, or by more than $80,000 for a typical house. I didn't time the top or the bottom of the market to the month, of course, but buyers who base their math on the functional value of houses don't have to worry about next month's price change. They just have to pay a price that allows them to extract good value from their house.
To see whether houses are a good deal in your market, start by checking a list of price-to-rent ratios like the latest one published by Trulia.com. To turn a price-to-rent ratio into a rent yield, simply divide "1" by the ratio. So the New York City area's price-to-rent ratio of 14.5 is equal to a rent yield of 6.9%. (That's not such a high number, especially after subtracting for taxes and maintenance costs, making New York one of a handful of markets where renters shouldn't be in any hurry to buy.)
Four last points to keep in mind: First, those price-to-rent ratios are based on average price data. Individual buyers can do better or worse than the averages, depending on how carefully they shop.
Second, your market is probably not special. It can be tempting to think that, because prices in your area have risen faster than the national average over the past five years, they will continue to do so. That temptation is called recency bias--the belief that things will always be the way they've been lately. They probably won't.
Third, renters who base their house buying decision on rent yields will come to a radically different conclusion than those who buy because they're optimistic about future price growth. For single-family houses, the way to maximize value is to buy only as much house as you need, rather than locking in as much house as you can afford.
Fourth, there are some useful buying-versus-renting calculators on the web. Some show buyers exactly how many years it will take for them to be better off owning versus renting. But most allow users to put in independent values for the inflation rate and the rate at which house prices increase. If you set inflation to 2% and house price growth to 6%, just about anything looks like a good deal. The prudent thing is to use the same rate for both. Again, use the difference between the 10-year TIPS yield and the 10-year regular Treasury yield, which works out to 2.2% at the moment.