Where Are We In the Real Estate Cycle?

One of the biggest questions today is about the real estate cycle. Where are we? While it's not possible to determine with pinpoint accuracy where we are in the cycle and where the market is headed, we can look at data and get a general orientation. One of the most helpful data points in determining where we are historically is the Case-Shiller Index. But we will use three data sets to get a general orientation of where we might be. We'll look at the Case-Shiller Index, the National Price to Rent Ratio, and the Affordability Index. We'll start with looking at the Case-Shiller Index.

What is the Case-Shiller Index? The Case-Shiller Index was developed in the 1980s by three economists: Allan Weiss, Karl Case and Robert Shiller. Over time it has developed into a very well respected barometer of the U.S. housing market. The Case-Shiller index is really several indices. Here you can see three of them: The National Index, the 20-city Index, and the 10-city Index. The data for these are published on the last Tuesday of every month. These indices are tracking the pricing of single family homes. (The index has a two month lag on data, but is still useful for tracking where we are historically.) Take a look at the chart here which shows the price movements from 1987 to 2019.

The most noticeable observation is the peak price point in between the recessions of 2001-2002, and 2008-2009. The housing price peak occurred in 2006. According to the graph, current housing prices are equivalent to 2004 prices when adjusted for inflation. In nominal terms, prices are actually higher, but nominal prices do not take into account adjustments for incomes, and inflation, so we don't think it's more useful to look at the Case-Shiller Index in this respect. The chart on its face suggests that there is still room to run for the housing market, or that prices haven't hit the same, inflation-adjusted price level as we did in 2006.

Next we need to layer into our understanding the historical Price-to-Rent Ratio. This ratio compares the economic utility between buying and renting a home. This is calculated by dividing the price of a home by the annual cost to rent the home. For example, before the subprime meltdown, in 2007, I rented a home in Beaverton, Oregon for $1200/month. The market for this home valued it at about $400,000, or based on trailing market comparable sales. To calculate the Price-to-Rent Ratio we would divide 400,000/(1200*12) = 27.78. This was a clear sign to me at the time that even though I could afford to buy a home, the market was overvalued. I live in a neighborhood now where the Price-to-Rent Ratio is around 17.

Zillow lists the national median home selling price at $289,000. The national median rent rate is roughly $1200/month. This puts the Price-to-Rent Ratio at 20. This is a very crude figure and in reality each market needs to be evaluated on its own but it's worth noting that the index was at 27 before the subprime crisis. The coastal cities are showing very high Price-to-Rent Ratios currently as we sit here in September 2019. But there are some markets are currently showing ratios in the low teens. Once again, evidence that we need to be very careful in using a national statistic if we want to dig deeper into a local real estate economy. But generally speaking, we are not seeing the same kind of dramatic separation between the prices of homes and rent rates like we saw during the last real estate bubble.

Next we'll layer in to our quick study the affordability factor. Affordability is like an elastic band that over time will pull prices back to what the vast majority of what people can afford. This is true generally, but may not affect certain markets that are propped up by foreign investment and similar factors. Economists call this return to price normality reversion to the mean. The U.S. Census Bureau puts the median income at $59,000. If we use this income assumption to buy our national median priced home we observe that the median household can still afford the median home.

For example, with a 3% down payment (assuming an FHA loan), the principal and interest on a $280,000 mortgage (4%, 30 year amortized loan) is $1338. Adding taxes and insurance (assuming 1.25% on taxes and $100/month for insurance) the total payment is $1738. Annualizing this payment brings the cost of median home ownership to $20,856 which is 35% of $59,000. The home affordability index shows that home buyers are pushed pretty close to the limit, but the median home can still be within reach. However, this median home may be far outside of the city center and may not be realistic in many markets. A quick look at my market, which is Austin, Texas, shows me that I need to go pretty far out to get a decent home under $300,000. Incomes are a little higher here so that gives households some buying power.

I want to emphasize that using national data to understand local markets will always result is skewed conclusions. These tools need to be modified using local data to get the best results. This is especially important because United States markets do not move in lockstep through the cycle. Local chambers of commerce have good data on affordability and real estate agents are the best source for rent rates and pricing of the housing stock.

In Conclusion, the U.S. housing market is currently richly valued in terms of affordability, but not classically in a bubble overall. The coastal markets are clearly unaffordable and likely in a bubble. It's likely that without foreign investment in New York and San Francisco, those markets would be substantially lower in terms of price. Increasing incomes and low interest rates have kept housing in check. We haven't mentioned the lack of "liar" loans and "stated-income" loans in the system which have helped preserve housing prices from spiking into a bubble, but it's clear that it's not 2007. At least not yet.