How Big Is The Housing Bubble?
Kurt Brouwer January 3rd, 2008
This post from the WSJ’s Real Time Economics Blog is a rather complete survey of academic thought on home prices. Most of these studies indicate that home prices are still a bit high, but the studies differ on how much [emphasis added below]:
Houses, Rents and Bubbles (Real Time Economics Blog / WSJ, January 2, 2008, Greg Ip)
‘U.S. house prices “likely would have to fall considerably” to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists, according to an article in Thursday’s Wall Street Journal.
The study, which doesn’t necessarily reflect the views of Fed policy makers, suggests prices would have to fall 15% over five years, assuming rents rose 4% a year. House prices would have to fall further if the adjustment took place more quickly.
The U.S. study is by Morris Davis, an economist in the department of real estate and urban-land economics at the University of Wisconsin-Madison and until 2006 a staff economist at the Fed; and Andreas Lehnert and Robert F. Martin, staff economists at the Fed. It can be accessed at Mr. Davis’ web site here.
The study converts rents and house prices into a dividend-yield equivalent to make them comparable to stocks and bonds. But as with stocks, the yield can be inverted to generate a price-earnings ratio. At the end of the third quarter of 2007 that ratio stood at 28, or 47% above the 1960-95 average of 19. That ratio would thus have to fall 32% to restore equilibrium. That doesn’t mean house prices have to fall 32%; any combination of declining prices and rising rents that produces a ratio of 19 would do it, much as a combination of falling stock prices and rising profits can correct an overvalued stock market…
…Richard Green, professor of real estate, finance and economics at the George Washington University, reviewed the Morris paper on his blog and argues that land-use regulation “is surely more binding now than it was 20 years ago, meaning higher expected long-term growth rates in prices may not be unreasonable.” He also says the quality of homes may have improved in ways not fully captured by the decennial housing census, in particular through increased square footage. “That said, the paper is well worth reading -and should leave us a little more frightened than we were before.”
Mr. Davis has also offered an alternative way to measure home valuation. In testimony to the Senate Finance Committee he drew attention to the differing growth in the value of land and the physical structures on the land. Since physical structures reflect the cost of the materials and labor that go into them, then their price (adjusted for general inflation) shouldn’t go up much over time as is true of most manufactured goods. That means most of the rise in home prices is likely due to rising land values. The price of land, he estimates, is now 26% higher than can be explained by fundamentals. Since land is about 45% of the value of a home, that implies home values are overvalued by 12%, considerably less than the 47% implied by the price-rent ratio…’
Unlike securities that are traded every day, home prices are harder to quantify. The variance in estimates in these studies is so large that it calls into question the methodology. Nonetheless, I think it is fair to suggest that home prices are too high. However, that depends a great deal on where the home is. For more on falling real estate prices see Falling Home Prices Trigger Banking Crisis and Amsterdam Real Estate Near High Point of 1736 and Major Turning Point? - Robert Shiller.
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