Warren Buffett promises that housing will recover in 2011, economists predict whatever you want, the Wall Street Journal predicts many more years of slump. We have commented on the housing market before, siding with the Journal, because the facts seem to be on their side. That was several months ago and it is time for another look.
|House Price (green), Housing Starts (blue), New Home Sales (red)|
First the numbers: The chart at right shows data from 1987 to present for the median price of a single family home (top), the number of new houses being constructed (middle) and the number of new homes sold (bottom). Home prices fell about 2% from a year ago, housing starts and sales are near a 20 year low. Existing home sales don’t paint a much brighter picture. There is no sign of a housing recovery.
This is not surprising. Foreclosures are flooding the market and will continue to do so for quite some time to come. This depresses prices, which in turn prevents builders from building, because they can’t make money, and buyers from buying, because they expect even lower prices in the future.
Some people have argued that we must be near the bottom of the housing bust based on the ratio between typical rents and the median price of a house. The chart at left shows the Rent to Price ratio over time computed as described here.
In the early ’60s, average annual rent payments were between 5 and 6% of the median price of a house. At the peak of the bubble, the ratio was just above 3.5%, indicating that home prices had gotten far ahead of rents. Now the ratio stands at about 4.7%, a value that seems reasonable in relation to the recent history, but still low compared to the ’60s and ’70s.
Fluctuations in the Ratio
Many factors influence the Rent to Price ratio, but the availability of home mortgages is likely to be one of the biggest contributions. If mortgages are readily available, a renter can become a home owner at will. This will tend to lower the Rent to Price ratio because high rents would cause people to buy houses, which drives up the price of houses and caps the level of rents that people are willing to pay.
Much of the decline in the Rent to Price ratio since the late ’60s is likely to be a result of privatizing Fannie Mae and launching Freddie Mac, the two Government Sponsored Entities (GSEs) that guarantee the vast majority of all US home loans. As soon as Freddie was created in 1970, and Fannie rechartered as a public for-profit company in 1968, they worked hard to grow their business by guaranteeing as many home loans as they could.
Their 40-year effort to give everyone a home loan increased demand for houses and reduced demand for rentals, which lowered the Rent to Price ratio. The bubble finally popped in 2006, when the home-ownership rate reached a record of nearly 70%, and homes were nearly twice as expensive relative to rents as they had been before Fannie and Freddie went on their lending spree.
Factoring Probable Outcomes
So is the Rent to Price ratio back to normal now? Probably not. Freddie and Fannie have been taken over by the government (at exorbitant cost to the tax payer) and congress seems to be unable to find a way to unwind these failed experiments.
Whatever the future holds for the GSEs, it is unlikely that they will continue buying up mortgages the way they have been. If the government stays involved in the mortgage market at all, it will probably be along the lines of Fannie Mae’s operations from 1938, when it was founded as a government service, to the late ’60s, when it was privatized.
If that happens, the Rent to Price ratio will probably return to the ’60s level of around 5.5%. Assuming unchanged rents, that would require another 15% drop in housing values.
In reality rents and home prices will change in response to the availability of mortgages, inflation, and many other market forces, but given the likely demise of readily accessible mortgages, the Rent to Price ration does not indicate that the housing bust is over.