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A VERY GREAT READ BY DAVE BIGGERS, Founder and Chairman of A la Mode
November 9th, 2008 5:31 PM



What Now?

Historically, the relationship between household income and home values can forward impending boom-bust cycles, and may predict not hitting bottom until mid-2010.

Dave Biggers

by Dave Biggers

Dave Biggers is the founder and Chairman of a la mode.  With a REALTOR® mother and an appraiser father, he was pre-destined to be holding “the dumb end of the tape” with his dad while still in high school, and paid for college as a residential and commercial appraiser.  An engineering and economics major, Dave used his technical background and understanding of appraising to start
a la mode while still in school in 1985. 

Drop Cap Letter: It seems these days that all the news on the TV, the web, and in the paper is focused solely on charts and graphs.  Unfortunately, they all point down.  Incomes, consumer spending, credit, home values, the Dow, the Standard & Poor’s, and probably your 401(k) and checking account, all are headed in the same negative direction.  The only charts headed the other way are most likely your blood pressure, credit card balances, and past due billings from clients.

It’s easy to get caught up in the wild swings of the stock market and assume there’s no pattern to any of it.  I’ll have to admit, when it comes to stocks, I’m not sure there is a pattern, and I’m not sure that anyone has any data to reliably say where things are going in the short term.  The old models don’t work and the experts on Wall Street are proven wrong nearly every day.

Long term, however, stocks tend to be good investments.  After a series of bull and bear markets come and go, the overall trend is one of solid growth.   But since our news rarely focuses back past the last peak or trough — unless, of course, it’s to invoke fearful comparisons to the Great Depression — we tend to get extremely shortsighted and pessimistic regarding future performance during a downturn.  Conversely, during a bull market, the population as a whole tends to think the sky is the limit. 

If that weren’t true, we wouldn’t have such dramatic bull and bear markets at all.  We’d have a relatively stable market with swings in value tied to general economic growth or contraction.   But with a highly accessible stock market where buyers and sellers can fluidly enter and exit on a whim, values swing wildly on short term speculation.  News drives the swings in hourly increments.  Hence, the existence of “day traders”.

Stock markets versus real estate markets

But when it comes to real estate, things are more stable and tied to external long term factors.  Even the fastest flips generally take weeks or months to execute, and those tend not to drive whole markets.  Real estate is by definition illiquid, and is still largely driven by owner-occupants on a national scale.  Sure, you have local variations on that theme, but that also comes and goes.  There are a lot of non-owner-occupant condos sitting vacant and unfinished along both coasts as testimony to the folly that it’s sustainable to build a local economy around speculation in real estate designed to sell to “others”.  Eventually, the “others” have to be locals, because it turns out that every other city is targeting the same ephemeral “others”.  And now, with the credit and stock markets in panic, those “others” aren’t coming around any longer to drop their excess dollars, Euros, or pounds into those projects.

At least not yet.  At some point, transactions will pick back up as asking prices fall to levels that are viewed in a broader context as affordable by locals and investors alike.  Across Florida in particular, that very scenario is beginning to play out.  Multiple MSA’s are seeing transaction counts rise dramatically, but with median values dropping by 20%, 30%, or more from recent months and quarters. 

It might seem that it’s as volatile as the stock market, but it’s really not.  The key lies in those pesky homeowners.  As consumers, they only have so much money to spend, and it only grows so fast.  Whether it’s in markets for cars, groceries, or homes, prices can’t significantly outpace incomes over the long haul without a couple of things happening: Either behavioral changes have to take place, or financing has to be applied as leverage to reduce the price of the target product in monthly terms.

Cashe-Schiller Weiss Home Price Index versus annual rate of change in per-capita income.

The annual rate of change of the Case Shiller Weiss Home Price Index versus the annual rate of change of per-capita income, as reported by the U.S. Bureau of Economic Analysis, shows unsustainable growth in home affordability from 1997 to 2005, followed by the severe drop-off. Click the graph for a larger version.

Driving prices with leverage

For example, when energy costs spike, consumers make behavioral changes.  They drive less, they switch to more fuel-efficient cars, they install energy-saving light bulbs and windows, or they just stop doing other things that cost too much and free up extra spending power for energy.  Disposable income is a limited sum, and the expenses have to fit into the budget (unless they rack up credit card debt).  Consumption drops, wholesale prices follow, and eventually energy costs come back in line.  Supply and demand works.

But on high ticket items like cars, college, and homes, leverage is the key to unsustainable pricing increases, not behavior.  If a consumer has $1000 a month to spend and it only grows at 5% per year over time, the only way to have prices grow faster than that 5% is to apply financing tricks that get the same $1000 to pay for a higher-priced item.   You know what happens next in the housing market — we see “products” with terms like zero down, 125% LTV, 80/20, and so on. 
Thankfully, that too is unsustainable.  Over time, creative financing eventually comes home to roost, lenders start to fail, and demand drops again as financing dries up and homes become impossible to afford.  Home values fall back to levels sustainable over the long term by nominal income growth.

Home Values versus Per-Capita Income

Charting home values versus income

Click the graph for a larger image. This chart plots the Case Shiller Weiss Home Price Index (blue) versus the U.S. Bureau of Economic Analysis figures for per-capita income (red). Both are calculated using nominal (unadjusted for inflation) figures, but each benchmarked so that the values in the first quarter of 2000 are considered "1.0", and all values for each series before and after are relative to the benchmark date's value. 

Where the blue line is above the red, home prices are less affordable relative to per-capita income. Where the blue line is below the red, home prices are more affordable compared to per-capita income. Over long periods, home prices will temporarily fluctuate above and below income growth but in general track linearly to income.

A. This area represents the home price boom prior to the S&L crisis. Home values peaked at 0.80 relative to Q1-2000, in Q3-1989.

B. This area represents the home price bust and the period of the S&L bailout. Home values bottomed out in mid-1994.

C. The drop in income (red line) and the slowdown in home prices (blue line) are the result of the combined effects of the tech bust and 9/11. Subsequent lowering of Fed rates and loosening of underwriting standard drove the boom through late 2005.

D. The housing boom peaked in Q2-2006 at a Home Price Index of 2.21 relative to Q1-2000, meaning that homes had risen by 121% in six years. Income had risen to an index of 1.27 relative to Q1-2000, indicating a 27% increase over the same period.

E. The dotted lines indicate one potential path which home prices may follow in order to realign with income growth. Home values would have to drop between 17% and 26% from current levels to reach this equilibrium.


Charting the income versus home values relationship

This chart plots this relationship in crystal clear fashion.  The solid red line represents an index of real (not adjusted for inflation) quarterly per-capita national incomes as reported by the U.S. Bureau of Economic Analysis from 1987 to present, with the first quarter of 2000 used as the baseline value of “1.0”.  Incomes in the second quarter of 2008 are 1.41 compared to Q1-2000, meaning that per-capita current-dollar income is 41% higher than it was back then. 

The solid blue line represents the Case Shiller Weiss Home Price Index, similarly adjusted to a baseline of “1.0” in Q1-2000 for proper comparison to per-capita incomes.  As you can see, the peak of the CSW value index occurs in the second quarter of 2006, at a value of 2.21, indicating that home values were 121% higher than they were in Q1-2000.  But looking at the same point on the income chart, we see that by that time, per-capita income had only risen by 27% during the same six-year period.

That can’t go on long.  And it didn’t.  The home value index is now “only” 76% higher than it was in Q1-2000.  And it’s still headed down.  Logic dictates that it will continue to go down until it meets back up with — and probably overshoots on the downside — the predicted long-term path of income growth.

Home prices nationally still have to drop 17% to 26% from their current levels before reaching bottom in 2011. That time span would be a five year downturn, just like during the last major housing crisis.

As you can see, it’s happened before.  From 1987 to the present, incomes have generally followed a stable growth pattern the entire 21-year span of the chart.  But home values have risen faster, peaked, fallen back down below, and then slowly caught back up again in prior boom-bust-boom cycles.

Look at the late-80’s boom and the S&L crisis.  The Home Price Index peaked at 0.80 in the third quarter of 1989, stayed flat until the second quarter of 1990, and then fell until mid-1994, a five year downturn.  It stayed stagnant until incomes grew, excess inventory was purged, and the banking system’s overall health was restored by the Resolution Trust Corporation.

But look at the broader period from 1987 to 1999 on the chart and you’ll see that even through the turbulent S&L boom and bust period, home values and income stayed relatively coupled to each other.   The markets worked as expected, pulling values back down, bottoming out, and then gradually curving back upward in a near mirror image of the downturn. 

If the first period where the blue value line is above the red income line reflects decreased affordability, then the second period where the blue value line falls below the rate of income growth represents an equal period of comparatively affordable housing.

A new type of boom and bust

But from 1997 on, you can see the incredible run-up in home values beginning, where values completely decouple from incomes.  Not too surprisingly, that corresponds with the directive by the Clinton administration to Fannie and Freddie to alter their underwriting standards and purchase massive amounts of loans serving traditionally disenfranchised lower income groups, in order to encourage home ownership.   Fannie and Freddie created the subprime market almost overnight.

By late 1999, you can see home value increases pass back over to the topside of income growth, and then it shoots up like a rocket on its way to the moon, as first the tech boom and then incredibly loose lending standards and low Fed rates took over.  

Starting in 2001, a refinance boom was created by those dramatically lowered Fed rates.   But by 2003, that boom was coming to an end and scores of thirsty mortgage companies and Wall Street firms started looking for the “next big thing”.  Fannie and Freddie’s newly created subprime market appeared to be a potential gold mine. 

For a short time, until late 2005 and early 2006, it was.  Lending standards were driven not by risk but by the propensity to reach every possible borrower with some form of loan product.  Progressively more exotic instruments were devised to tap into the last remaining unexplored regions of potential homebuyers. 

It’s not surprising therefore that only a small dip following 9/11 and the tech bust mars an otherwise spectacular rise up to an equally spectacular flameout in 2006.  Queue the ominous music and play video clips of yards with “For Sale” signs, the Bear Stearns and Lehman Brothers logos, and a quick shot of the corporate offices of Fannie and Freddie, and you have the background for your own cable news show focused on that precipitous post-2006 drop off.

Just as you can’t avoid death or taxes, at least not permanently, the run up in home values couldn’t avoid the fact that over time, value growth has to correlate with income growth.   And indeed, over the past 40 years, they’ve both been averaging a growth rate of around 6%.  They only diverge significantly during the boom and bust cycles.

The bust from 2006 to present has been incredibly steep, but like its previous boom and bust cycles, it thus far roughly matches the slope of the run up the peak in the first place.

Looking to the future

So where does it go from here?  And when does it end?

If you look at the chart, I’ve plotted a defensible (though arguably optimistic) projection of the path that incomes and home values might follow before they realign in a sustainable pattern.   According to these numbers, values would have to fall down at least to the levels last seen in the middle of 2003, when the adjusted Home Price Index was at 1.46, or 46% higher than the baseline of 1.0 in Q1-2000.  With the index at 1.76 currently, that means values will probably have to drop another 30 points or more relative to Q1-2000, and it will probably take until at least the middle of 2010 before we see it bottoming out.  

If the correction falls further below the growth line plotted by income, which is quite possible and even likely, it could be a 45 point or more drop in the index relative to Q1-2000, with the timeline stretching to mid-2011 or later before a rebound. 

When you convert those point drops into percentages relative to current home values (as opposed to relative to Q1-2000), it means home prices nationally would have to drop from 17% to 26% from their current levels before reaching bottom in this scenario.  And perhaps not coincidentally, that 2006 to 2011 possible span would be a five year downturn just like we all experienced during the last major housing crisis and government bailout.

The worst case scenario 

Just as the S&L boom and bust mirrored each other, and the slope so far on the latest bust is the twin of the slope on the most recent boom, it’s possible that the overall value correction — the area of the curve where the blue value line passes under the red income line at the end of 2009 — could be much larger downward, mimicking the size and scale of the prior boom.

If that happens, the Home Price Index values could slide all the way down to the 1.0 range or lower, wiping out all the gains since the start of the century.   At the same time, the trough would occur sometime in 2012 or beyond. 

It’s unlikely, given the penchant for government intervention, that the trough would be allowed to fall that far.  We’d probably see substantial income stimulation and housing-related tax incentives designed to bolster home values for a softer landing.  However, the softer landing might flatten the value slope, causing the decline to be less severe but at the same time causing it to take longer to return back to parity with income.

GRM as an alternate metric

Every appraiser has studied Gross Rent Multipliers, or GRM, as applied to individual homes.   But on a macro scale, GRM also works well as a metric against which to measure relative housing affordability and therefore the amount that values have to come up or down before reaching historical parity with rents.  

In the same way that consumers have to adapt directly to energy costs because there isn’t a corresponding lending component, they also have to adapt to changes in rent since they can’t “mortgage” the rent.   They either can afford it, or they can’t, and therefore rents are more stable, reflecting income growth.   Calculating the national or local GRM using average or median rents versus home values over long periods of time results in a similar chart to the one shown here.

The silver lining

The good news — besides the fact that you can probably short national homebuilder stocks till at least 2009 — is that transaction counts will increase, and therefore the number of appraisals ordered will rise, long before the values hit bottom.   The values will only bottom when excess supply is no longer being absorbed at high rates and scarcity becomes the watchword.  To get there, inventory measured in months will have to go from double-digit levels to nine months or less.  At six months, markets start heating up substantially and the recovery is in full swing.

You can keep an eye on these metrics in your area to get a handle on your own personal business planning.  It’s easy to plot your own chart of local income versus local home value changes by simply using your MLS’s median home stats and the income growth statistics published by your state and county authorities.  Throw in a chart of inventory levels per the MLS as well as transaction counts, and you’ll have a great microeconomic business predictor.  It’s not hard to do, but it is hard to remember to do it regularly — and then to act on it.

The bad news, of course, is that after this market comes through its natural correction and flattening, all the charts and graphs in the world won’t stop lenders and homebuyers from doing the same thing all over again.

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Posted by Christopher Greco on November 9th, 2008 5:31 PMPost a Comment

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