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How Far Might Housing Prices Fall?

Our original thesis back in May 2005 was that Home prices could retrace as much as 25%-35% from the peak to re-establish a normalized pricing.

Now, a new study shows exactly how and why that might occur: Home Price to Rent Ratio:

"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.

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 study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6,600 a year) and the average home price was about $134,000.

But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%.

That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade."

That's a pretty hefty pull back over time, especially on an inflation adjusted drop.

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Note: The study was authored by Morris Davis, an economist 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.

The PDF of the study can be found here:  The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing.

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Sources:
Home Prices Must Fall Far To Be In Sync With Rents
GREG IP
WSJ, January 3, 2008; Page A2
http://online.wsj.com/article/SB119931831334463571.html

The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing
Morris A. Davis, Andreas Lehnert, and Robert F. Martin
Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison
Federal Reserve Board of Governors
December, 2007
http://morris.marginalq.com/DLM_fullpaper.pdf

Thursday, January 03, 2008 | 07:05 AM | Permalink | Comments (26) | TrackBack (0)
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Comments

If reversion to the mean follows its usual pattern, the rent/price ratio will have to RAISE a significant amount above its long-term average historical average.

Maybe Krugman et al. are right: a 30% house prices drop from its peak would be in the ballpark of the possible.

Aaaah! The beauty of unregulated free markets at work. It adds a spice to daily life.

Posted by: Francois | Jan 3, 2008 8:12:16 AM