How Inflated are House Prices?

One of the main contentions of the bearish argument is that house prices are overvalued. To determine whether or not that premise is true, there must be some way to appraise the fundamental value of a house. 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 is 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.

The fundamental value of all housing prices is comparative rents. Rents define the fundamental value of real estate because rental is a direct proxy for ownership; both rental and ownership provide for possession of property. In a normal real estate market, when prices go up and the cost of ownership exceeds the cost of rental, people choose to rent rather than own, and the resulting drop in demand depresses home prices: The inverse is also true. Therefore, the proxy relationship between rental and ownership generally keeps home prices tethered to rental rates.

Rental rates tend to keep pace with wages because you normally pay rent out of current income. As people make more money, they compete for the available rentals and drive prices up at a rate about 1% greater than the overall rate of inflation. There are times when supply and demand issues in local markets create fluctuations in this relationship, but as a rule, rents track wages pretty closely.

Since house prices are tied to rents, and rents are tied to wages, house prices are indirectly tied to wages. When house prices increase faster than wage growth, the price levels become unsustainable, and if the differential is too great, you get a bubble.

Two Levels of Buyer Support

There are two categories of buyers that will enter the market and purchase real estate without regard to appreciation: Rent Savers and Cashflow Investors. These are the buyers that will buy houses even if prices are declining; therefore, they are the ones who call the bottom. Rent Savers are buyers, like me, who enter the market when it is less expensive to own than to rent. It doesn’t matter to these people what houses trade for in the market in the future. They are not buying with fantasies of appreciation. They just know they are saving money over renting, and that is good enough for them.

Cashflow Investors have a different agenda; they want to turn a monthly profit from ownership. For them, the cost of ownership must be less than prevailing rent for them to make a return on their equity investment. Cashflow Investors form a durable bottom. If prices drop low enough for this group to get into the market, the influx of investment capital can be extraordinary.

In a declining market, a market where by definition there is more must-sell inventory than there are buyers to absorb it, it takes an influx of new buyers to restore balance. Since it is foolish to buy with the expectation of appreciation in a declining market, the buyers who were frantically bidding up the values of properties in the rally are notably absent from the market. With the exception of the occasional knife-catcher, these potential buyers simply do not buy. This absence of buyers perpetuates the decline once it starts. Add to that the inevitable foreclosures in a price decline, and you have an unending downward spiral. It takes Rent Savers and Cashflow Investors to enter the market to provide support, break the cycle and create a bottom.


Calculating a House’s Fundamental Value

Let’s evaluate the fundamental value of a house I found at 51 Sanctuary with a rental rate of $5,000 a month and a purchase asking price of $1,589,000. Assuming both the rental rate and the asking price are reasonable in today’s market, how much could you afford to pay and keep the cost of ownership to $5,000 a month using a conventional 30-year mortgage? The first debatable, simplifying assumption I am going to make is that the income tax savings will offset the cost of taxes, insurance and HOA fees. The second debatable, simplifying assumption I am going to make is that you could obtain 100% financing at 6% interest. IMO, both of these assumptions do not change the math significantly except in cases of exceptionally high HOA fees. To end up with a monthly payment of $5,000, you would be limited to a mortgage of $834,000. If you were willing to put up a 20% downpayment (and give up your interest at the bank) to purchase this property, you could pay $1,000,000. How does this house price compare to its fundamental value? If you factor in a dead-money downpayment, this house is overvalued by 58.9%. If you assume 100% financing, this house is overvalued by 90.5%. If mortgage interest rates rise, the numbers get even worse. At 7% interest, which is closer to historic norms, the mortgage is limited to $750,000 making this house more than 100% overvalued.

So what about the Cashflow Investor, how low do prices have to go before they buy? They can borrow $580,000 at 6% with a $3,500 a month payment. This leaves $500 a month for vacancy loss and expenses and $1000 a month to provide a return on their investment. If they put $120,000 down, they would be getting a 10% return on their money ($12,000 / $120,000 = 10%). This puts the purchase price at $700,000. To the cashflow investor, this house is 127% overvalued.

As you can see there are two price areas where new buyers enter the market, depending on the assumptions used and the costs specific to the property, these numbers can vary, but they will fall within general ranges. Rent Savers will pay from 180 to 150 times monthly rent, and Cashflow Investors will pay from 120 to 150 times monthly rent based on today’s financing terms. If credit tightens, and mortgage interest rates go up, these ranges will decline making prices seem even more inflated.

In summary, I would argue that house prices in Irvine are at least 60% overvalued and probably closer to 100%. Price declines of 35% to 50% are required to bring prices back in alignment with their fundamental values. Since price declines of this magnitude will take time, and since rents and wages will continue to rise while home prices are declining, expect price declines of 30% to 40% over the next three to five years before new buyers will enter the market and form a durable bottom.