Fundamentals at a Market Bottom
All methods of predicting future price action rely on the same basic premise: prices are tethered to some fundamental value, and although prices may deviate from this value for extended periods of time, prices eventually return to fundamental valuations. This premise has been reinforced by market observation; in fact, many estimates of fundamental value are based on market action. Since many market participants believe in buying and selling based on fundamental values, there is also an element of self-fulfilling prophecy contained therein. The efficient markets theory is based on this idea, and although the behavioral finance theory is needed to explain the wide deviations from fundamentals real-world prices exhibit, both theories share the same notion of an underlying fundamental valuation on which prices are ultimately based. The challenge to market prognosticators is to select a fundamental valuation to which prices will return, and then extrapolate a period of time in which the return of prices to fundamental valuation will take place.
There are a number of ways to project how far and how fast prices will fall. One is to look at the price charts themselves and try to project reasonable trend lines to approximate bottoming valuations. This is not an accurate methodology as it is based on the assumption of a repetition of past performance without examining the reasons for this past performance; however, it does serve as a useful rough estimate. A more accurate and detailed method is to examine the variables that determine market pricing and see how changes in these variables impact resale values. This process involves assessing current fundamental values to make a statement as to where prices should be – and would have been if there had not been a residential real estate bubble – then estimating how long it will take for these variables to return to their historic norms.
The figure below shows the historic debt-to-income ratios for California, Orange County and Irvine from 1986 to 2006. It is calculated based on historic interest rates, median home prices and median incomes. Lenders have traditionally limited a mortgage debt payment to 28% and a total debt service to 36% of a borrower’s gross income. The figure shows these standard affordability levels. During price rallies, these standards are loosened in response to demand from customers when prices are very high. Debt service ratios above traditional standards are prone to high default rates once prices stop increasing. In 1987, 1988 and 1989 people believed they would be “priced out forever,” so they bought in a fear-frenzy creating an obvious bubble. Mostly people stretched with conventional mortgages, but other mortgage programs were used. This helped propel the bubble to a low level of affordability. Basically, prices could not get pushed up any higher because lenders would not loan any more money.
Changes in debt-to-income ratios are not a passive phenomenon only responding to changes in price. The psychology of buyers reflected in debt-to-income ratio is the facilitator of price action. In market rallies people put larger and larger percentages of their income toward purchasing houses because they are appreciating assets. People are not passively responding to market prices, they are actively choosing to bid prices higher out of greed and the desire to capture the appreciation their buying activity is creating. This will go on as long as there are sufficient buyers to push prices higher. The Great Housing Bubble proved that as long as credit is available there is no rational price level where people choose not to buy due to prices that are perceived to be expensive. No price is too high as long as they are ever increasing.
In market busts, people put smaller and smaller percentages of their income toward house purchases because the value is declining. In fact, it is possible for house prices to decline so quickly that no mortgage program can reduce the cost of ownership to be less than renting. The only thing justifying a DTI greater than 50% is the belief in high rates of appreciation. Why would anyone pay double the cost of rental to “own” unless ownership provided a return on that investment? Once it is obvious that prices are not increasing and even beginning to decrease, the party is over. Why would anyone stretch to buy a house when prices are dropping? Prices decline at least until house payments reach affordable levels approximating their rental equivalent value. At the bottom, it makes sense to buy because it is cheaper than renting. In a bubble market when the market debt-to-income ratio falls below 30%, the bottom is near.
Comparative rent is the primary method of evaluating the fundamental value of any property. The price-to-rent ratio links the cost of ownership with the cost of rental. This link is direct because possession of property can be obtained by either method. The cost of ownership encapsulates all of the financing terms and other variables associated with possession of real estate as does the cost of rental. Price-to-rent ratio fluctuates over time as changes in the cost of ownership and terms of financing makes financing amounts vary and house prices vary as well. Note how the market returned to the same price-to-rent levels at the bottom of the late 70s bubble and the late 80s bubble.
There was a coastal bubble taking off in the late 80s and collapsing in the early 1990s. The premise of prices reverting to fundamental valuations can be clearly seen in the changes in the price-to-rent ratio in Orange County. In the mid 1980s, the market was bottoming out from the first coastal residential real estate bubble associated with the inflationary times of the late 1970s. From 1983 to 1987, the price to rent ratio stabilized between 176 and 185, a range of about 6%. After the coastal bubble, prices stabilized in 1994 to 1996 in a range from 175 to 178. Projections using the price-to-rent ratio assume prices will fall again to the range from 175 to 185 before stabilizing. The reason prices stabilize in this range is because it is here that the cost of ownership approximates the cost of rental, and Rent Savers buy real estate and form a support bottom. If house prices in Orange County return to their historic price-to-rent stability range, prices will fall 22% peak-to-trough, bottom in 2013, and return to the previous peak by 2019; however, if rental increases do not sustain their 4.7% historic rate (which they are not), the bottom may be somewhat lower, and the return to the previous peak would be delayed. The assumption in the chart below is that prices would fall as fast as they rose. Since prices have fallen much faster (20%+ in the last year) it appears as if we will reach this price level sooner and thereby at a lower price.
Since incomes and rents are closely related, evidence for the Great Housing Bubble that appears in the price-to-rent ratio also appears in the price-to-income ratio. The volatility in price-to-income ratios caused by bubble behavior is clearly visible in the historic price-to-income ratios from Irvine, California. During the coastal bubble of the late 80s, in which Irvine participated, the price-to-income ratio increased from 3.7 to 4.6, a 25% increase. In the decline of the early 90s, price-to-income ratios dropped to a range from 4.0 to 4.1 and stabilized there from 1994 to 1999 before rocketing up to an unprecedented 8.6 – a 115% increase. This new ratio was achieved by the extensive use of exotic financing, in particular negative amortization loans that rendered the new ratio inherently unstable.
One of the fallacies many market participants currently believe is that the deleveraging we are all witnessing is a temporary condition and that buyers in the market will be able to leverage themselves at ratios seen during the bubble in short order. This is not going to happen. The loan programs that permitted this degree of leverage have proven to be failures. If they weren’t, prices would not be falling now and these programs would still be widely available. No, this deleveraging is going to be with us for quite some time (perhaps permanently).
If house prices in Irvine decline to the point where the price-to-income ratio reaches its average of 4.2 – a ratio higher above this historic range of stability between 4.0 and 4.1 – prices will decline 43% peak-to-trough, bottom in 2011 and return to the peak in 2029. The magnitude of this decline would be catastrophic to homeowners who purchased during the bubble. Twenty-four years is a long time to wait for peak buyers hoping to get out at breakeven.
Most market participants focus on price action. The price-to-price feedback mechanism largely responsible for bubble market behavior gathers its strength from an awareness of market pricing, and the widespread belief that short-term, past price performance is predictive of long-term, future price performance. It is a fallacy that is often reinforced in the short-term as irrational exuberance takes over in a market, but over the long term, short-term price movements rarely correspond to long-term price trends, and when they do, it is only by chance.
Predicting future prices based on price action is based on the premise that long-term price trends are reflective of fundamental valuations because they represent the collective wisdom of the market. As with all methods of predicting pricing, deviations from the long-term fundamental valuation almost always result in a return to this value. The weakness in this theory is in its failure to provide a causal mechanism. To note that prices return to long-term valuations without postulating why prices do this provides no mechanism for estimating when prices will return to fundamental value, and it provides no way to determine if there is a significant change to the market’s valuation to establish whether or not prices will return at all. In short, past price action itself is very limited in its ability to predict future price action. Despite the shortcomings of the methodology, predictions based on past price performance are widely used and often woefully inaccurate.
If the 4.4% rate of appreciation seen from 1984-1998 is repeated, then prices will decline 45% from the peak, bottom in 2011 and return to the peak in 2023. Since prices peaked in 2006, this method of price projection shows an 18 year peak-to-peak waiting time: not a comforting forecast for Irvine homeowners.
There will be much talk about where the bottom is over the next few years. The realtors will periodically call the bottom and issue forecasts of 4%-7% appreciation in coming years (an amount that covers their commissions). They will be consistently wrong until we do find a bottom, likely in 2010-2012. Here at the IHB, we will focus on the fundamentals of income and rent. I will not write a post saying “the bottom is here.” When we get closer to the bottom, I will start to find more and more properties at or below rental parity. When most of my posts start pointing out what good deals there are in the market, then we will be there.