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06/21/2010

Safe House: The Housing Market and the End of the Recession


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A great deal of attention has recently been devoted to examining trends in the housing market and to predicting possible outcomes of the recession. If housing is at the center of the current storm, how soon will recovery in this sector offer the rest of the economy some shelter from the nasty weather? Inevitably, stabilization in the real estate market has to be achieved through reestablishing the broken link between real values and market prices.

RECESSIONS, INCOME, AND HOME PRICES

The NHP (new home price) index published annually by the US Census Bureau is a helpful measure of US residential real estate market valuations. NHP gauges the sector that arguably has the most impact on other industries, especially construction. This index includes sales financed through sources other than Fannie Mae and Freddie Mac; it is also less volatile than the S&P/Case–Shiller home price index or the HPI (housing price index) (Figure 1).

Figure 1: Comparison of Housing Price, S&P/Case–Shiller, and New Home Price Indexes, 1987–2008. 

Comparison of Housing Price, S&P/Case–Shiller, and New Home Price Indexes, 1987–2008
 
Shaded areas represent recessions. All three indexes are normalized to their 1987 values (set to 1) and adjusted for inflation using the CPI-U-RS as the Consumer Price Index, also normalized to its 1987 value. Sources: US Bureau of Labor Statistics, Federal Housing Finance Agency, National Bureau of Economic Research, Standard & Poor's, US Census Bureau.

Another useful measure of housing affordability is median family income, published by the US Census Bureau. Over the last 40 years, peaks in median family income have preceded recessions, while troughs have coincided with or trailed recessions (except in 2001). From 1967 to 2008, median new home prices in the US grew at the average annual rate of 2.38%, while median household income grew at the average annual rate of 0.65%, adjusted for inflation (Figure 2).

Figure 2: Evolution of the Median New Home Price and Median Household Income in the US, 1967–2008. 

Evolution of the Median New Home Price and Median Household Income in the US, 1967–2008
1967 values set to 1. Shaded areas represent recessions. 2008 data is based on estimates. Sources: US Bureau of Labor Statistics; DeNavas, Proctor, and Smith; US Census Bureau.

The spread between the rate of growth of new home prices and that of the median family income narrows during recessions. After reaching its all-time high in 2005, this spread contracted very significantly, and currently is at its lowest level in over 40 years (Figure 3). A historical view suggests that this could signify the proximity of the end of the recession.

Figure 3: Relative Difference in Inflation-Adjusted Growth Rates between the Median New Home Price and Median Family Income, 1968–2008. 

Relative Difference in Inflation-Adjusted Growth Rates between the Median New Home Price and Median Family Income, 1968–2008
 
Shaded areas represent recessions. Sources: US Bureau of Labor Statistics; DeNavas, Proctor, and Smith; US Census Bureau.

A precipitous drop in the growth rate differential between inflation-adjusted housing and income growth rates from 2004 through 2008 indicates the return of the home price growth rate to a historically more sustainable level (Figure 3). This is another indicator showing that the bottom is near or has already been reached.

MORTGAGE RATES, AFFORDABILITY

Using family income, NHP, and mortgage rate, an affordability ratio α can be constructed to gauge the current state of the housing market.

pa affordable monthly payment based on income (assuming a conservative underwriting ratio of principal and interest to total before-tax income of 0.28)
pr required monthly payment based on the mortgage amount, tenor, and rate (assuming a down payment of 20% on a conventional 30-year fixed-rate mortgage with monthly payments and no prepayment)
I annual family income
H home purchase price
rm mortgage rate

In 2008, housing affordability reached levels not seen since 1973 (Figure 4), thanks to rapidly falling home prices and low mortgage rates. As affordability continues to climb, the housing market is expected to improve gradually over the next few years.

Figure 4: Historical Inflation-Adjusted Home Affordability Ratio, 1972–2008.

Historical Inflation-Adjusted Home Affordability Ratio, 1972–2008
Shaded areas represent recessions. Sources: Federal Reserve; US Bureau of Labor Statistics; DeNavas, Proctor, and Smith; US Census Bureau.

In the past 35 years, year-over-year relative rates of change of mortgage rates have been substantially higher than those of median home price or family income (Figure 5). Historically, mortgage rates exhibit substantially higher volatility than home prices and family income, and are likely to remain a dominant factor affecting the affordability ratio.

Figure 5: Rates of Change of Mortgage Rates, Median Family Income, and Home Price, 1973–2008.  

Rates of Change of Mortgage Rates, Median Family Income, and Home Price, 1973–2008
Shaded areas represent recessions. Sources: Federal Reserve; US Bureau of Labor Statistics; DeNavas, Proctor, and Smith; US Census Bureau.

THE NEAR TERM

Based on historical data, the most likely scenario for the near future will reflect flat housing prices, low income growth, and a small increase in mortgage rates. It will result in a modest decline in the affordability ratio (Figure 6).

Figure 6: Rates of Change of Home Price and Affordability Ratio, Year over Year, 1973–2008.

Rates of Change of Home Price and Affordability Ratio, Year over Year, 1973–2008
Shaded areas represent recessions. Sources: Federal Reserve; US Bureau of Labor Statistics; DeNavas, Proctor, and Smith; US Census Bureau.

By historical standards, a substantial additional increase in the affordability ratio appears unlikely. If this pattern were to hold, housing prices could be expected to increase within the next two years but would subsequently grow at a lower rate. An increase in mortgage rates, spawned by an uptick in inflation and a decline in family income caused by the economic downturn, could slow the recovery in the housing market even further.

THE LONG TERM

An unprecedented drop in home prices has increased the affordability of the average house for the average family in the US, as measured by the affordability ratio, to historically high levels. This increase can be expected to lead to a subsequent increase in demand and, as a result, higher home prices. Historical data implies that the increase may be gradual, possibly hampered by rising mortgage rates and falling incomes. Since, historically, housing prices tend to “overreact” to market dislocations, it may take several years for the market to return to sustained growth.

REFERENCES

Beracha, Eli, and Mark Hirschey. March–April 2009. “When Will Housing Recover?” Financial Analysts Journal, vol. 65, no. 2. 36–47.

Case, Karl E., and Robert J. Shiller. 2004. “Is There a Bubble in the Housing Market? Cowles Foundation Paper No. 1089.” Cowles Foundation for Research in Economics, Yale University.

DeNavas-Walt, Carmen, Bernadette D. Proctor, and Jessica C. Smith. August 2008. “Income, Poverty, and Health Insurance Coverage in the United States: 2007.” US Census Bureau, US Department of Commerce.

Fabozzi, Frank (editor). 2005. The Handbook of Fixed Income Securities, 7th ed. New York, NY. McGraw–Hill.

Federal Housing Finance Agency. 2009. “House Price Indexes.”

Federal Reserve [Board of Governors of the Federal Reserve System]. 2009. “Contract Rate on 30-Year, Fixed-Rate Conventional Home Mortgage Commitments.”

Haines, Cabray, and Richard J. Rosen. 1Q 2007. “Bubble, Bubble, Toil, and Trouble.” Economic Perspectives. Federal Reserve Bank of Chicago.

National Bureau of Economic Research. 2009. “US Business Cycle Expansions and Contractions.”

Standard & Poor’s. 2009. “S&P/Case–Shiller Home Price Indices.”

US Bureau of Labor Statistics. March 2009. “Updated CPI-U-RS, All Items and All Items Less Food and Energy, 1978–2008.”

US Census Bureau. 2008. “Median and Average Sales Prices of New Homes Sold in the United States.”

–Daniel L. Chertok, PhD, CFA, is an investment analysis consultant with an international insurance company in Chicago, Illinois.

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