Housing … undervalued?

From the Wall Street Journal:

Is Housing Undervalued?
August 17, 2007; Page A13

The housing market isn’t nearly as mysterious as it seems. Much public confusion stems from our failure to clearly define our terms. Take the popular, long-standing belief that housing is overpriced and unaffordable relative to income. It was said 30 years ago and it is still being said today. The key to solving this puzzle is to widen the definition of income so that it includes the increase in existing wealth. Milton Friedman, in the course of the work on consumer spending that won him a Nobel Prize, introduced a much broader, long-term measure of income called “permanent income” — including capital gains, physical assets and factors like education that would affect a consumer’s earning potential.

Permanent income grows at the same rate as wealth, and generally faster than conventional forms of income. Friedman demonstrated that households base their spending decisions on permanent income rather than on narrowly defined income, such as short-term wages. Fifty years later this idea has yet to sink into our national consciousness. Yet, in a highly developed and wealthy country such as the U.S., annual gains in the value of pre-existing assets are getting larger and larger relative to annual cash income from wages, rents and dividends.

Home prices behave the way they do because housing is not a typical consumer good. Rather, it is a capital asset for which the price is set by the markets for capital assets. These markets continually clear in a way that typical consumption markets do not, and housing is therefore being constantly re-priced. In this limited sense, real-estate prices behave like the prices of other tangible assets such as commodities. Of course, in other ways housing is quite unlike a commodity — it is immobile, provides services such as shelter to its owners, and its price is geographically very specific. Still, the general level of housing prices, when measured as an index, is as acutely and promptly sensitive to an uptick in inflationary pressures as are other forms of financial or tangible capital.

Inflation tends to boost housing prices in the same way that it boosts the price of any tangible asset. And inflation is surely a major part of the housing-price story. Over the past three decades, the price of housing at the national level has risen at a rate similar to the growth of nominal GDP, and the correlation between housing prices and GDP is statistically significant. But the relationship between housing prices and the prices of highly inflation-sensitive assets such as commodities is much more impressive than the relationship with the economy. There is a particularly strong correlation between percentage changes in housing prices and percentage changes in the price of gold — especially when a short time lag is taken into account.

When paper money is depreciating rapidly, as in the last five years, it is normal for tangible assets such as housing to appreciate more rapidly than usual, while financial assets such as stocks and bonds tend to perform relatively poorly. This can be understood in terms of the flow of financial capital from one economic haven to another. Capital is mobile. It flows out of assets that are vulnerable to the dollar’s depreciation, and into assets that are invulnerable. Capital promotes growth and price appreciation in the sectors into which it migrates, at the expense of the sectors from which it escapes.

Instead of viewing the price performance of housing during the first half of the current decade as a “bubble,” I see it as having appreciated for the same reason that the prices of commodities and other tangible assets have appreciated. In nominal dollar terms these prices have to rise in order to maintain the status quo in real terms. The rise in housing prices is one more symptom or early warning of the inflation of which the Fed (rightly) is so fearful.

To better understand housing-market trends, we need to clearly distinguish between real and nominal terms. I define the “real price of housing” as the ratio of the national home-price index to an index of precious-metals prices, while the nominal value refers to the price in dollars. Failure to draw this distinction can cause great confusion. For example, the annual gain in the nominal price of housing averaged 4.8% in all the years in which the Fed lowered interest rates, and averaged 7.3% in all the years in which the Fed pushed interest rates up. This calculation, at least in nominal terms, directly contradicts the popular belief that higher interest rates bring real-estate prices down. When the above calculation is repeated using the real price of housing instead of the nominal price, however, the inverse relationship appears. Higher interest rates do tend to depress real housing prices, and this can happen without any significant fall in nominal housing prices.

Expressing the price of housing in real terms not only clarifies the interest-rate confusion, it also changes the overall housing picture. The accompanying graph shows the history of the real national home-price index over the past 30 years. Notice how, during the current decade, instead of the continuing rise in nominal housing prices that made everyone so fearful, in real terms there has been a significant decline. Far from a bull-market bubble that has begun to collapse, housing when viewed in real terms has been in a bear market since the beginning of the decade.

Moreover, like the real price of oil, the real price of housing consistently reverts to the norm. In particular, housing prices have a strong tendency to rise when they have underperformed precious-metals prices. The graph illustrates how the real price of housing sticks to a steadily rising trend over the long haul, occasionally diverging from this trend but afterwards reverting to it. According to the same data, the real price of housing was 30% above its norm as recently as 2001.

Since that time commodity-price inflation has escalated, and nominal housing prices have lagged far behind. The graph suggests that housing prices are now 30% below their equilibrium in terms of the precious-metals benchmark. Any further decline in the ratio plotted in the chart would transcend the bounds of historical experience. The last time that housing prices underperformed the precious-metals market as dramatically as this was in the 1978-80 period, after which they bounced back dramatically.

We can also calculate from these data the average speed at which the real price of housing has historically converged toward its norm. It shows that norm reversion is virtually complete after three years.

All of these various empirical reasons challenge the popular view that housing prices will remain weak because they are in the throes of a “correction” from “bubble” levels. On the contrary, housing prices are weak only in the sense that, after outperforming commodity prices in the late 1990s, they have fallen behind since 2001. History suggests that housing is significantly undervalued, and nominal housing prices have a lot of catching up to do over the next few years.

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14 Responses to Housing … undervalued?

  1. Everything's 'boken says:

    Wow! Housing is ‘like’ gold. This seems odd. The barriers to acceleration in gold supply are large, unlike housing, where oversupply can be created easily.

  2. RentinginNJ says:

    Two things:

    First, the idea of taking a more expansive view of income beyond wages does make some sense. I see a problem, however, in including asset prices as part of the wealth calculation. For most people, their house is their largest asset. This sets up a self-reinforcing positive feedback loop that is clearly unsustainable; housing prices rise, so the wealth of homeowners rises, so housing prices rise. Without first time buyers, this breaks down.

    Second, lets assume the author is correct. Housing prices relative to gold and other commodity prices have been stable. So, what we really have is fairly priced houses in an environment of massive inflation. If true, then we have also seen massive wage deflation over the last few years, as nominal wages have only risen by a few percent per year. Real wages have fallen substantially (>50%). Since homes are paid for with wages, how can you sustain home prices in a world where incomes have dropped markedly?

  3. pretorius says:

    I agree with the article. When determining housing affordability in a particulars, the most important factor is the net worth and income profile of the people looking to buy there.

    The median income in an area is meaningless, although it is routinely used by mainstream journalists looking to support their home-prices-are-too-high arguments.

  4. skep-tic says:

    more ponzi economics. house prices are high because house prices are high.

    also, nice to know that housing is cheap from a precious metals standpoint. too bad we get paid in dollars, not gold.

  5. Everything's 'boken says:

    Or there is a gold bubble.

  6. RayC says:

    #4 Ponzi economics with a hard sell. “Permanent income”? Does he think people haven’t been aggressive in overextending themselves in the last few years? People with no upside income potential beyond 2-4% yearly raises have been buying houses like they were a young lawyer or doctor, with serious future earning potential.

  7. lisoosh says:

    What Renting said.

    Counting paper wealth (home equity, etc) as income is absolutely pointless when the vast majority of people pay for houses with regular earned income, which hasn’t risen with the same speed. All he is describing is more of the same attitude that has fueled this ridiculousness for the past few years (house prices always rise, you can always refinance). It’s an interesting academic excercise that has no correlation to peoples real lives.

    Can you imagine telling someone upside down on a mortgage that they are contributing 80% of their income to that it is all OK because relative to gold their house is cheap? Or the PhD making $70k a year that he really can afford that $800k house because his education counts as “permanent income”?

  8. subprimate says:

    Housing when used for living is a consumption item, not a tangible asset like gold.

    I could understand the analogy if he was comparing gold to rental/commercial properties.

    So the real issue is that when someone buys a very expensive house for living in, they are overconsuming in comparison to whatever their income is, rather than “building wealth.”

  9. Brooklyner says:

    Pretorius you’re hallucinating. Housing is anything BUT cheap. And drawing correlations between housing and commodities prices is absurd. Housing prices are going down because they were simply too high for people to afford.

  10. pretorius says:

    It is completely reasonable for home prices, over the long term, to appreciate faster than inflation in certain areas.

    Picture identical houses on 1/4 acre lots in upper-middle-class suburbs of the following cities: New York, San Francisco, Detroit, and Cleveland.

    Obviously, the New York and San Francisco houses cost more. Their values have risen faster during the past twenty years compared to similar houses in Detroit and Cleveland, and despite being dramatically less affordable using the median-income-to-home-price metric favored by many, their values will rise faster during the next twenty years.

    Land is a natural resource like gold and oil. The value of land, and therefore the price of a house located on it, is based primarily on the proximity it provides to economic activity. Home prices rise faster in places where economic growth is stronger because land commands an economic rental payment. This payment rises faster than inflation in areas of strong economic growth like New York and San Francisco, as a growing number of people wielding rising incomes and net worths bid it up. Meanwhile, the economic rental payment remains flat or even declines in areas with weak economic growth.

    In other words, a POS cape in suburban New York or San Francisco costs three or four times more than the identical house in suburban Detroit or Cleveland because the value of the land differentiates the prices. Twenty years from now, the same POS will be worth four or five times more.

  11. RentinginNJ says:

    And drawing correlations between housing and commodities prices is absurd.

    And even if you do, what’s really important is the growing gap between incomes and housing prices.

    Sure, relative to gold, housing prices have been stable. 1,000 ounces of gold will buy roughly the same house today as it did in 2000.

    The problem is that salaries in terms of gold have dropped. Median household income has dropped from about 225 ounces of gold per year to 125 ounces of gold per year since 2000.

    Today’s incomes are simply not sufficient to support today’s housing prices, it doesn’t matter if we are taking dollars (housing price inflation with stable incomes) or in terms of gold (stable home prices with wage deflation).

  12. Stan says:

    Houses aren’t globally traded commodities like gold or oil. Gold and oil can find the markets where people will pay the most for them. Houses require a local buyer (with the exception of a few places with significant foreign travelers).

    In other words, a house is only worth what people who live there will pay, where gold and oil is worth what anyone in the world will pay (minus travel expenses).

  13. Bob says:

    That WSJ article was complete BS and it is amazing it made it to print. Anyone with half a brain knows that housing prices exploded because of interest rates that were too low and lending standards that were too lax.

  14. While I agree with David’s point about correlation of housing with commodities, and hence housing being undervalued, I think David is missing a key point. This key point is the affordability of housing which is going down substantially with the unfolding of sub-prime crisis. See my blog on this topic at: http://singhinderjeet.blogspot.com/2007/08/is-housing-undervalued.html

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