Everyone has an opinion about where home prices are heading. Many of them are optimistic, which is exciting – but don't run out and start throwing money at real estate just yet. Much of this optimism is based on nothing more than hope. Rather than think wishfully, let's explore some data and see what is reasonable for US Home prices.

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How NOT to Analyze Data

An often cited measure of US Home Prices is the Case-Shiller Home Price Index. This index tracks how the average home price increases or decreases over time. The absolute number isn’t meaningful, but the change from year to year is.

This chart shows that index from January 2000.

I’ve heard some experts take this data and argue something along these lines:

In the chart above, we see that starting in 2007 we had a large drop in home prices and we’re now beginning recover. We can expect a more than 17% increase in home prices in the near future to recoup our losses.

Related: BP Podcast 030: Conservative Real Estate Investing and Starting Out with Kenny Estes

The Purchase Anchor Fallacy

One trap that everyone, including myself, falls into is what I like to call the Purchase Anchor Fallacy. When we purchase something, we create a psychological, and illogical, attachment to that price. When new information challenges this price level, we try and explain it away.

For example: say you buy a stock for $30. The market sells off and the now it’s trading at $25. Do you sell it? Assuming minimal transaction costs, you should keep the stock if you would buy it again at $25. Today’s price is today’s price and your decision should have nothing to do with historical prices.

That said, as humans we tend to bring the $30 purchase price into the picture. We tell ourselves that that the low price is temporary phenomenon and will fix itself before long. No one likes to be wrong.  At some level we think that loss isn’t “real” until we sell it, so if we hold it for another couple of days, the price could come back!

In real estate negotiation have you heard someone say “I need to get my money back out of it” or “that’s less than I bought it for?”  Something is only worth what someone is will pay you for it.  What you paid doesn’t matter.

The US Home Prices index example in the previous section is nothing more than the Purchase Anchor Fallacy being stated explicitly with percentages and a snazzy chart.

Supply and Demand of Return

Rather than using prices with no baseline, I like to start with fundamental economics. What determines home prices?

Supply and demand.

The demand is driven by the population.

The supply is not driven by the number of houses available.

In a specific area, housing supply and demand might set prices.  But in an aggregated index across for all US Home Prices?  Not so much.  At least not in the long run.  Let’s say the housing supply is too low, prices will increase in the short term. Someone like me will notice this and either build or renovate some homes.  These new properties will increase supply and bring home prices back in line.

The demand for RETURN sets US Home Prices.

Say you have some money to invest.  You can put it in real estate, but you’ll demand compensation for your time and energy.  If you think you’ll receive less than that return, you’ll just keep your money in the bank, or the stock market.  It’s this return which sets home prices.  Would you invest in a house house if you get a better yield from your savings account?

How can we measure this?  For a long term investor, their rate of return is determined by rents.  So let’s start there.  Do rental rates track well with home prices?

As luck would have it, the Bureau of Labor Statistics has calculated Owner Equivalent Rent since 1983 (this is not as far back as I would like, but it’s a start).

Up until the the beginning of the bubble in the early 2000’s, prices tracked rent very well.

This makes sense.  If you could rent a $1,000,000 home for $100 a month, you’d be silly to buy it.  Renting pushes the rental prices up and home prices down.  If enough people make this trade, prices and rent will fall  in line with “acceptable” returns.

Price to Rent Ratio

Let’s clarify things even further by dividing price by rent:

Now that's a sexy chart. The previous chart sloped up thank to the "miracle" of inflation. Since both prices and rents are in dollar denominations, when we divide one by the other we take inflation out of the picture and the bubble appears extra bubbly.

Notice anything strange in this chart? Today’s prices are above the norm set in the 1980’s and 1990’s.

Might this imply a further drop in home prices?  Perhaps.  But this ratio changes.

Changing the Ratio for US Home Prices

Our price to rent ratio is an approximation of the return the market demands, which can be affected by a plethora of things.  Here are a few:

Interest Rates. When interest rates are high, money is harder to borrow and there are other high yielding investments competing for dollars. Thus you will demand a higher return on your investment and the price/rent ratio should drop. The opposite is also true. That's the theory at least. Over our timeline, it's difficult to notice much impact:

Regulation. The idea is similar to interest rates, but more direct. If gobs of red tape forces you to invest more time and money into owning real estate, the ratio will drop.

Property Taxes. If Uncle Sam is taking more money out of your pocket, you will need a lower price to yield the same return, hence lower ratio.  Again, the opposite is true.

Wrap It Up: US Home Prices Aren’t Going to Rebound

US Home Prices are determined by supply and demand (as are most things).  Demand is driven by the population.  Supply, by returns.

Short term supply might be determined by the number of houses available, but it doesn’t take long to build a new home.  Rather, home scarcity is determined by how much return investors demand.  We approximated the demanded return using the price/rent ratio and found that home prices are either where they should be or a bit high.

Will the US Home Prices rise in the future?  Yes.  So will the price of sandals.  They’ll gradually increase thanks to inflation, not to “recover our losses.”

Do you agree or disagree? Share your comments below.

Photo: Bob_2006