Housing Bubble?

This morning, the New York Times ran an article about the surge in housing prices and asked if there was, in fact, a housing bubble. The answer: not really. Because in many towns, rental rates have been rising, this partly justifies the soaring cost of homes. In fact, when converted into a rental ratio (price of home/annual rent), this is much less of a bubble than the stock market was in 1999.

The article went on to indicate that some of the hottest markets have rental ratios between 20 and 35; much lower than price-to-earnings ratios on stocks in 1999.

I find this kind of weak analysis very amusing. The reason? Try to sell your home into a declining market and you will quickly find out. Stocks have (and must have for that matter) higher valuation metrics because of their liquidity. Furthermore, rents are ostensibly based upon personal income, which is probably a much more prudent measuring tool since rental rates fluctuate as much as housing prices. And, if you look at home values relative to median income figures, the statistics are much more telling.

Homes should sell at something like 3 X an area's median income. Of course, this is a rough estimate, but it should be based upon an individual's ability to service his mortgage debt. The above ratio, of course, assumes average interest rates. It also assumes that people aren't constantly cashing equity out of their homes (which is a significant problem, as families are relying upon this tool to fund consumption).

If you want to know what the average home in your part of town should be valued, look for the area's median income and median home price. In Portland, the median family income is $50,000. Therefore, the median home price should be about $150,000. In reality, the median home price in Portland as of about 6 months ago was about $185,000. This equates to approximately 25% overvalued. When this corrects (and it will), the decline generally overshoots the target. In short, when housing prices begin to fall, the decline will likely go to below $150,000. Maybe $140,000 or $130,000, causing value buyers to enter the market.

For some people, this will not be a problem. They don't need to move, have a fixed rate mortgage and aren't pulling equity out of their home. For some others, this could be devastating.