Wednesday, April 30, 2014

New Home Sales and Prices

The conventional view seems to be that housing is "bubbly".  Here is the monthly annualized change in the Case-Shiller 10 city home price index.

Home prices have been increasing by around a 10% annualized rate for two years.  (Case-Shiller is already smoothed enough that I don't see the need for a YOY treatment.  This is annualized monthly percent change.)Interestingly, while the Case-Shiller Index reflected much higher increases in the 2000s than the Census Bureau's new home price series, both series are moving up at a similar rate now.

Here is a recent post by Political Calculations on the topic.  Ironman is taking the bubble position.  Bill McBride at Calculated Risk is more optimistic.  He thinks that a recent downswing in new home sales is temporary, and that new single unit home sales will eventually recover back to about 800,000 - less than before the crisis, but about double the current level.  I think he expects home prices to settle down, but he doesn't think we have a bubble.

Ironman sees prices as a function of median income.  McBride sees a pullback because of the increase in mortgage rates.  I think both of these perspectives are subtly wrong, in that they both miss the importance of real long term rates on the intrinsic value of the home.

The Crazy, but true, Counterintuitive Effect of Real Interest Rates

Rent may be a function of median income, but home values should be a product of the discounted future value of those rents, which is highly responsive to the discount rate, especially when rates are as low as they are now.  One sign of this is the current low level of mortgage debt service - at 5, compared to a long-term level of 6.  This actually understates the depressed level of real estate credit, because given a stable expected inflation, lower real rates should raise the mortgage payment on a home with a given implied rent.  This is counterintuitive, but it's true.  The subtle mis-reading of thinking home values are a product of the mortgage payment is wrong.  When you divide interest rates into real rates and an inflation premium, and treat a home's value as the present value of future net rent payments that rise at the rate of inflation, the justifiable mortgage payment will decrease if expected inflation decreases, as we would expect, but it will increase if real interest rates decrease.  If you are skeptical, it's a simple model you can put in a spreadsheet in 2 minutes.

That's been a theme here lately.  Look how this subtle interpretive error completely reverses the interpretation of the housing market.  If you think that home prices increase because falling nominal rates lead people to bid up houses until they have the original mortgage payment, then that graph above of mortgage debt service looks like a rational market until 2005, when speculative froth caused people to be so irrational that they bid the price of houses up beyond that point to where they were making larger mortgage payments.  Your model of home prices would assume that there was no reason for this, and it would seem to obviously be a bubble.

But, if you see this counterintuitive effect of real interest rates, you would expect the low real interest rate environment of the 2000's to lead to higher mortgage debt service levels.  You would wonder what frictions in the home market kept the mortgage debt services levels from rising earlier than 2005.  Remember how homebuilders would hold lotteries to see who could buy homes at the listed prices that week?  Remember how homes would receive multiple offers above the list price?  That seems like an obvious bubble, doesn't it?  But, understanding this subtle change in interpretation, those activities now look more like a sticky price issue.  I find sticky prices to be a much more plausible explanation of those incidents.  There is a tremendous amount of  mental benchmarking in home markets - consider the use of comparables, etc.  When home prices need to move by more than 15% or 20%, it takes a while to get there.  These price inertias are so strong that home sellers were still underpricing their homes, even when they were surrounded by homes that had been bid above their list prices.  The housing market wasn't out of a rational equilibrium in 2005 and 2006 with prices that were too high; it was out of equilibrium in 2003 when prices were too low, because of sticky prices.

So, now, because everyone knows that the increase in mortgage debt service was a sign of bubble behavior, when mortgage debt service starts moving above 6% again, there will be a groundswell of demands for the Fed to pop the supposed bubble.  It's a shame.  This is a perfectly understandable misinterpretation, but it is a misinterpretation, and if we continue to take that interpretation seriously, we will continue to create undue economic hardship.

Regarding Current Prices

I don't see any relationship in the data between mortgage rates and home sales or prices.  At the time frame of the business cycle, the correlation can be positive or negative - rates tend to go up as the economy strengthens, and so do prices and quantities.  So, I don't see any reason to attribute monthly or yearly price fluctuations to mortgage rates, and I don't see any strong basis for this in the data.  However, what makes sense to me, and what I believe we can see in the data, is a long term relationship between home values and real long term interest rates.

Rising rates can create a drag on demand by locking some households out of the mortgage market.  But, this effect should be minimal at any level we will be seeing in the next several years.  Rates like we saw in the late 1970's - over 10% - can start to have noticeable effects, but even when those rates were in effect, home prices were rising because home values were bolstered by the low real rates of the time.  Home prices began to fall after 1980 when real rates jumped, even though nominal mortgage rates declined.

The funding mechanism is fairly arbitrary.  All of the public policy measures that we have to encourage mortgage funding have some marginal effect on the cost of funding.  The mortgage interest tax deduction is probably the most distortionary.  But, generally, the value of an asset is not a function of the method used to finance it.  I believe this general principal has been lost due to the high correlation between mortgage rates and the discount rate that should apply to the discounted cash flow value of homes, and the misinterpretation that comes from that confusion.

In any case, the current value of homes is not constrained by mortgage rates or by the intrinsic value of future implied rents.  The current value of homes has been constrained by the lack of liquidity imposed by tight Fed policy and the lack of capital from banks that has resulted from that liquidity crisis.

Here is a graph of price to rents (using both Case-Shiller (blue) and Median new home prices (red), 1987=1).  These were rising as real interest rates fell (shown here with an approximation using mortgage rates minus U. of Michigan inflation expectations and with 10 year TIPS).  I believe that Case-Shiller reflected the justifiable price of homes even near the top of the market.  (As a simple example, an asset discounted from 20 years in the future will increase by about 50% when the discount rate declines by 2% and by 75% when the discount rate declines by 3%.  This is the range of the change in long-term low risk real interest rates and the corresponding change in home
price-to-rent, as reflected in the Case-Shiller Index, over this period.)  Notice that home prices were declining slightly in 2006 and 2007 as rates rose.  This relationship broke down in late 2007 as the liquidity crisis intensified.  Price to Rent at 1.7 in 2007 was mainly a product of the interest rate environment.  The drop from 1.7 to 1 was a product of the liquidity crisis.  It is at 1.3 now.  Even if rates rise an additional 2%, so that 10 year treasury rates are at 5%, a Price to Rent ratio of 1.7 is justifiable.  At worst, it's somewhere between the Case-Shiller and the Medium New Home levels from the 2000s.  And, it could be a decade before 10 year treasury rates are sustainably above 5%, unless the Fed begins to allow inflation to rise above 2%.  So the market, when credit markets are functioning, will be reaching for Price to Rent levels 30% higher than current levels, and in the meantime, rent inflation is accelerating.  And, looking back at the first graph, there is no sign of home price growth subsiding when we look at the month-to-month Case-Shiller index.  Calls for a market top are getting ahead of the data because so many people are convinced that we have a bubble.

Political Calculations sees a market top in the March decline in new home sales.  It will be interesting to see how the data proceeds.  I suspect that we are seeing a temporary dip because much of the all-cash investor demand for real estate was essentially funded by QE3.  (Perfectly reasonably, IMO.)  Now that QE3 is being tapered, that demand is falling away, but the banks are just now garnering the ability to extend their own credit to replace the liquidity that QE3 was creating.  I think we will see bank credit continue to recover, but if it doesn't, my thesis could be busted by more liquidity problems.  Here is the weekly level of real estate loans at all commercial banks.  It appears to be rebounding over the past few months.  This may reflect the winding down of foreclosure activity as much as an increase in purchasing activity, but at least it is a move in the right direction, and it signals a willingness or ability for banks to add to their real estate exposure.  If this process takes a few more months to gather full momentum, home prices may look like they are beginning to moderate before they reassert their movement toward previous highs.

This could also reflect a lack of demand.  The relationship between price and demand is complicated on a durable asset.  I don't want to go down that rabbit hole right now, but suffice it to say, I'm not entirely confident with my understanding of exactly what is keeping real estate loans depressed at the banks.  Please let me know in the comments if you have insight.

A Caveat

I am considering being more bearish than Bill McBride on one factor, and that is the projected quantity of new home sales.  He expects a doubling from around 400,000 units to around 800,000 units.  That seemed reasonable to me.  But, looking at demographics, I'm not sure if that is sustainable.  To approximate the demand for single family housing units, I have compared the annual change in the number of males in the labor force to the SAAR quantity of new home sales.  (For male labor force I used the YOY change in the 12 month moving average, in an attempt to reduce noise.)  The labor force series carries an array of information regarding business cycle and demographic trends and plots remarkably well against new home sales.  (I used males because their age-specific labor force behavior has generally been stable for decades.)

Going forward, annual increases in male labor force participation are expected to remain around 500,000 per year for several decades.  There might be a cyclical rebound of an additional 500,000 or more over the next couple of years.  Also, baby boomers' movement out of the labor force may predate their movement out of single family units. Also, the excess capital associated with this demographic shift may move some homebuilding back in time.  So, we might get to that level of 800,000 units or more, temporarily.  But, I think it may be prudent, when modeling future cash flows of homebuilder, to base it on long term annual new home sales more in the range of 600,000.  I continue to see unexpected profits for homebuilders resulting from rising property values, but I think unit sales may remain significantly below where they were before the crisis.


  1. We would agree that the apparent market top that we're seeing now will likely be a short term phenomenon and also that it is being driven by "sticky prices". This is where the distorted production/sales mix for new homes that developed during the investor buying frenzy will take some months to unwind - at least until builders can switch gears to produce lower cost houses, which we think would be the main factor that makes prices sticky. It will simply take time for them to implement the changes they need to make in their market strategy to focus on producing a larger number of homes to sell at lower prices to match the demand of available consumers.

    Because of that, and the likelihood that we'll see some attempts to metaphorically add fuel and oxygen to the fire, we don't foresee the same kind of deflation phase that followed the peak of the first housing bubble. We should instead see something that's more short term and much flatter. The kind of thing we might expect to see that might boost the real estate industry are attempts to lower mortgage rates (adding fuel) and much more likely, loosening of recently imposed restrictions for mortgage lending (adding oxygen).

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