Is SoCal housing overvalued or merely as expensive as usual?
Whether one considers SoCal markets overvalued or fairly valued depends on how fair value is measured.
What is the best measure of value in a housing market? The two most commonly accepted measures are price-to-rent and price-to-income, but both have a similar weakness: they don’t consider the impact of fluctuations in mortgage interest rates. During periods of stable mortgage rates near historically normal levels of 7 to 9%, both measures of value work quite well; however, during periods of very low or very high rates, both measures give false signals.
Trulia uses a combination of these methods to produce it’s estimation of value. Rather than correct for the weaknesses of both methods, Trulia’s methodology magnifies them.
Notes: To get our estimate of over- or undervalued prices, we averaged together several measures of prices relative to fundamentals, including the price-to-income ratio, the price-to-rent ratio (national only), and the deviation of price growth from trend. We compared current values of these measures to the long-term average, excluding the most extreme quarters from the long-term average.
As I pointed out above, their method would be workable if we had normal mortgage rates, but at 4% rates, their methodology makes housing look overvalued because they fail to take into account the increased borrowing power of low rates. While it’s true that housing is more expensive than normal based on price-to-rent and price-to-income, when you consider the ratio of payment-to-rent or debt-to-income, housing is not overvalued.
The reports I generate use current owner cashflow and a comparison to current rents to establish value. This number incorporates real estate prices, rents, and most importantly, interest rates to establish value. It’s susceptible to swings in financing costs, and it can be distorted by manipulative federal reserve interest rate policies, but in my opinion, it provides a more accurate measure of value because it reflects the reality faced by individual buyers active in the market. Very few buyers will pass on a deal when it’s cheaper to own than to rent just because mortgage rates are low; in fact, since many houses are currently undervalued when comparing owning to renting, low mortgage rates become an inducement rather than an impediment.
The longer term view of value depends on what people believe will happen with interest rates in the future. My methodology says today’s values correspond to the stable relationship between interest and rents. The Trulia methodology says prices are overvalued because current interest rates are so low. If interest rates revert to their long-term mean over the next few years, house prices will decline, and current valuations will appear bubbly in retrospect. However, if interest rates revert slowly over the course of another decade or more, this slow reversion in rates will not cause a price decline, and today’s valuations will not look so bubbly in retrospect.
So is the market fairly valued or overvalued? It depends on the yardstick of value you believe most appropriate.
In either case, whether interest rates move up slowly or quickly, at some point, interest rates will rise to their historic norms. Whether reversion to the mean happens quickly or slowly, house prices will not appreciate as quickly over the next decade or more unless something dramatic happens with wages, and given the lingering problems with unemployment, rapid wage inflation doesn’t seem a likely prospect.
By Tim Logan, October 1, 2014
Southern California’s housing markets are among the most overvalued in the nation, according to a new report. But the closest thing in this country to a housing bubble is actually in Texas.
That’s according to figures out Wednesday from real estate website Trulia, which issued its quarterly “bubble report,” which measures home prices against incomes, rents and historic trends in 100 big cities. Of the five frothiest, three are in the Southland.
Prices in Los Angeles and Orange Counties were each 15% above what economic fundamentals support, according to Trulia chief economist Jed Kolko. In the Inland Empire, they’re 11% overvalued.
Actually, Riverside County is still slightly undervalued.
That’s actually a bit below the levels Trulia recorded three months ago, probably because home price gains have slowed while incomes have climbed. But it’s a contrast from the nation’s market as a whole, which remains 3% “undervalued,” according to Trulia. …
Of course, any exuberance this time around is nothing compared to the mid-2000s. By the same measures, L.A.’s housing market was inflated 66% above fundamentals back in 2006. And we all know what happened next.
Using Trulia’s flawed valuation metric, prices do look overvalued.
Jed Kolko, October 1, 2014
Texas and California Metros Look Most Overvalued
The most overvalued market is now Austin, at 19%, followed by the California metros of Los Angeles, Orange County, San Francisco, and Riverside-San Bernardino. The California metros on the top-10 list were all significantly overvalued during the past bubble, ranging from 46% overvalued in San Francisco to a dizzying 87% in Riverside-San Bernardino. …
Are We Headed Toward The Next Bubble?
One test of whether it’s time to sound the bubble alarm is whether prices are rising faster in markets that are already overvalued. Price gains in overvalued markets are a sign that we’re headed for danger, while price gains in undervalued markets are probably just a sign of getting back toward normal.
To measure this, we compare the most recent year-over-year asking-price change from the Trulia Price Monitor with our Bubble Watch measure from 2013 Q3, one year ago. That’s because what matters is whether overvalued markets subsequently see faster price gains (remember that current Bubble Watch values, by design, incorporate recent price trends).
The scatterplot below shows the relationship. Hard to see a pattern, right? Actually, there’s a negative relationship, but it’s small (correlation = -0.07) and not statistically significant. At least we can say that overvalued markets are not systematically seeing larger price increases, though some individual overvalued markets like Austin and Riverside-San Bernardino did have big price jumps.
I like this method of looking at the change in valuation. If an overvalued market keeps moving up, trouble is brewing — as we witnessed in 2004 thanks to the Option ARM. What we’re seeing now is a combination of slow appreciation and collapsing sales volumes indicative of a weak market with slipping affordability.
Southern California housing sports some of the most expensive residential real estate in the nation; however, historically high wage growth and the chronic shortage of available housing is largely responsible for our unbearably high house prices. And while prices are undeniably high, they aren’t currently any more expensive than normal.