Housing fundamental value analysis: 6% mortgage rates kill appreciation
Fundamental value analysis predicts tepid home price appreciation as mortgage rates rise to historic norms. Will it prove a powerful tool, or a dismal failure?
I began writing publicly about housing issues in February 2007 on the Irvine Housing Blog, but I was a frequent commenter on housing blogs prior to that. Since my education and work experience were in land development, I formulated detailed analytical tools to measure market value. Based on my own analysis, the housing bubble seemed obvious, and I set out to make the case to anyone who would read what I had to say.
At the time, mainstream housing economists were busy denying the housing bubble. Most were collecting large fees to write reports in favor of large real estate purchases well past the peak of the insanity. Whatever analysis these housing economists were using missed the largest and most obvious housing bubble in human history.
In March of 2007, I asked a simple question: How inflated are house prices? This post was foundational to understanding the housing bubble because one of the main contentions of the bearish argument is that house prices were overvalued. To determine whether or not that premise was true, it was necessary to establish a benchmark for comparison, a concept I dubbed “fundamental value.”
Once determined, this fundamental value serves as a point of comparison to the prices at which houses are currently being bought and sold. If current prices are shown to be above fundamental value, it establishes that house prices are inflated, and it also provides a measure of the degree of that inflation.
The corollary argument made by housing bears was that inflated housing prices have not historically remained inflated and have for good reason fallen back to fundamental valuations at each market decline. If this corollary argument can also be demonstrated to be true, it provides a way of projecting the market decline we can expect to see in the future.
This simple idea still governs my thinking on housing today.
A few days after that post was published, I followed up with another simple question: What if Prices Dropped to Fundamental Value?
We have speculated a great deal on this board about the future of home prices in our area. The arguments all boil down to a simple conjecture: will prices fall to back to their fundamental values, or are prices going to remain permanently detached and inflated? I make no attempt to answer that question here. The chart link below is a graphical representation of what it would look like if home prices fall back to their fundamental valuations in Orange County.
In 2013, I updated the chart above to see how accurate my predictions were. I’ll let you judge the results.
From 2007 to 2009, I worked with Shevy Akason to further refine these ideas and figure out how we could bring this kind of analysis and understanding to ordinary homebuyers. The result was the first fundamental value report. One of the major advances was the development of the idea of current cashflow value, which is what I report on the site today.
After Shevy worked with several buyers it became apparent that fundamental value alone did not tell the whole story. The calculation for fundamental value uses the long-term average for mortgage rates rather than the current market interest rate. In an era of 4% rates, a calculation of value based on 8% rates makes houses look wildly overvalued, and it didn’t reflect the reality of today’s market.
The result was a compromise where we reported both the fundamental value (based on an 8% rate) and the current cashflow value (based on current mortgage rates). We reported this for several years, but over time, we felt it merely created confusion and fear. While it’s possible rates may revert to the long-term mean of 8% during the next 30 years, the likelihood of this occurring in a typical 7-year holding period is remote, so we dropped it from the analysis.
I still report on fundamental value, and it is a valuable tool for analyzing long-term trends in the real estate market.
The concept of fundamental value and current cashflow value is also helpful to understand why the federal reserve lowered mortgage rates so aggressively during the housing bust.
The concept of fundamental value and reversion to the mean is the main reason I believe home price appreciation will be below average for the next twenty years or so.
The concept of fundamental value is probably most valuable to long-term investors who purchase large tracts as “land banks.” As a result, housing economists embrace the concept and apply it to their own work.
by John Burns September 11, 2015
Is your market over- or underpriced? Here is a map of our over/underpriced conclusions today. We explain our methodology and the opportunities this creates below.
At 6% mortgage rates, nearly every market is overvalued.
To answer this question for our clients, we have studied the ratio of housing costs / income over time in every major market in the country, considering everything we know about each market to determine what the long-term ratio of housing costs / income should be. We call this the Intrinsic ratio, named after the investment concept of intrinsic value that has long been trumpeted by Warren Buffett and many other long-term investors. The Intrinsic ratio helped us wave a yellow flag in the early 2000s and a green flag in 2011.
The intrinsic ratio, what I call the fundamental value, signaled a bubble in the late 80s and early 90s, and in the early 00s when mortgage rates began falling below the mean, it signaled potential trouble ahead when rates revert to the mean.
This is still still a problem today (See: Price-to-rent ratio suggests housing is 30% overvalued)
Intrinsic value estimates require a long-term view with long-term assumptions, and our industry’s biggest assumption is what the long-term mortgage rate will be. We use 6.0%, which is lower than the historical average but much higher than today.
They ran into the same problem Shevy and I did back in 2009: when you plug in the actual long-term average mortgage rate of 8%, everything looks overvalued when prevailing rates are 4%. Their solution was to fudge the numbers until they got a result they liked. To their credit, the resulting analysis is better because the likelihood of a 6% rate sometime in the next 20 years is much higher, and the results have more meaning.
Our goal is not to help consumers with the buy decision, nor to help short-term investors. Intrinsic value analysis is designed to help long-term investors, such as those buying land to build a new home community or those investing in building products companies. Even if we conclude that homes are overpriced today assuming a 6.0% mortgage rate, the interest rate savings could still make it a great investment for a consumer.
Variations over Time
Home values deviate throughout the housing cycle from their Intrinsic value for many reasons, most frequently due to:
- Fluctuations in the economy
- Speculation based on appreciation expectations
- Capital availability
- Mortgage rates
Knowing the intrinsic value helps executives put today’s home prices into perspective. Intrinsic values also change over time as areas become more or less desirable. For example:
- San Francisco, CA has become permanently more expensive over time as it grew its economy and desirability and became much more supply-constrained.
- Detroit, MI has become permanently less expensive over time as demand has fallen, most obviously evidenced by a declining population.
Variations by Market
Our Intrinsic ratio conclusions range from a low of 15.0% in Detroit to a high of 65.0% in San Francisco. That means that over the long term the median-income household in the Detroit metro area should be able to buy the median-priced home using only 15% of their monthly income to pay for the mortgage, mortgage insurance, and property taxes*. Not surprisingly, homeownership is much higher in the Detroit metro market than in the San Francisco Bay Area, and the median-income household in the Bay Area cannot qualify to purchase the median-priced home.
At some point, I will apply my housing market analysis for Southern California to the entire country.
The following chart shows the Intrinsic housing costs / income ratio for many of the major markets in the country. Changing the definition of housing costs will change the percentages but not the conclusions nor the rankings from most expensive to least expensive. This is just one of many tools we use to help business executives make informed decisions.
* Metro division ** Combination of metro divisions
Source: John Burns Real Estate Consulting, LLC (Pub: Sep-15)
While the above analysis is interesting, it would be far more valuable to know how those values compare to past history. For example, #4 on their list above is Los Angeles, and although it is certainly expensive to live there, it is no more expensive than past history warrants.
Recognizing value relative to past norms is how to identify great investment opportunities.
Intrinsic Value Analysis Creates Opportunity
While unsophisticated people might panic, and alarmists may scream “bubble” in a few markets, wise executives know that Intrinsic Value is really a measure of risk. They know that Intrinsic Value incorporates a long-term view, assuming mortgage rates over the long-term are 6.0%. With mortgage rates today below 4.0%, and the bond market projecting that rates will rise less than 1.0% over the next 3 years, there is no reason to panic. Here is what some of my smartest clients are doing:
- Requiring higher investment hurdles in the overvalued markets than the undervalued markets, everything else being equal (which is rarely the case),
- Investing with a shorter term horizon than they did in 2012,
- Structuring deals with partners who have a more optimistic view, particularly if those partners are willing to fund operations,
- Shifting to deals that involve less cash and more option payments
In past cycles, plenty of money was made after housing became overly expensive, and plenty of money was also lost, but the companies who had structured their balance sheet and joint ventures appropriately for the high risk stage of the cycle weathered the storm best, and took advantage of the downturn. Opportunities abound.
The power of fundamental value analysis is making it’s way into the mainstream. The current prediction of fundamental value analysis is that home price appreciation will wane as mortgage rates rise. If this prediction proves true, the power of fundamental analysis will be difficult to deny.