Viewpoint

Home Market's Misery May Be 'Buy' Sign


A pall has settled over the U.S. housing market. The first-time home buyer's credit has dried up, and home prices are down 29 percent from their 2006 peak. On Dec. 9 the latest release of the Federal Reserve's Flow of Funds data shows the value of homeowner equity in the third quarter of this year at $6.4 trillion—52 percent lower than four years ago.

Judging by the learned consensus at holiday parties—where homeowners swap sorry tales of underwater mortgages and bleak sales—don't count on things getting better in months to come. Hanging over the market is an ominous combination of a weak economic recovery, near 10 percent unemployment rate, an inventory of 8 million or so distressed properties, and uncertainty over the legality of foreclosures by major mortgage loan servicers. Celia Chen of Moody's Analytics (MCO) expects the S&P/Case-Shiller home price index will drop 8 percent from the second quarter of 2010 to the third quarter of 2011. Morgan Stanley's (MS) housing analysts, led by Oliver Chang, figure home prices will decline somewhere from 6 percent to 11 percent before finding bottom.

But does that mean it's a bad idea to buy a home? I don't believe so, based on some dispassionate analysis. For the long-term homeowner (or patient investor), a home appears to be one of the better investments around, with minimal downside risk. "Housing is priced to earn its historic real rate of return of 0.5 percent to 1 percent and interest rates are low," says Morris Davis, professor of real estate and urban land economics at the University of Wisconsin-Madison. "Now may be a once-in-a-lifetime time to buy."

Renting vs. Owning

Think of the rental and ownership markets as competing for the household shelter dollar. Richard Green, director of the Lusk Center for Real Estate at the University of Southern California, says that equation clearly favors owning. Even more striking, Green says he's "hard-pressed to think of a time when owning on a cash-flow basis looks so reasonable relative to renting."

Take this back-of-the-envelope calculation: Green notes the median U.S. house price is $170,500. The most recent American Housing Survey data (2008) put the median rent at $808 a month and the CPI-Rent index has been essentially flat since then. The cash-flow cost of renting is $9,696 per year. On the homeownership side, Green assumes an interest rate on a 30-year fixed-rate mortgage is 4.5 percent and that the buyer makes a 20 percent down payment. He assumes the buyer could have made 10 percent on the downpayment if it was invested elsewhere, the so-called opportunity cost of capital. Property taxes are 1 percent of house value, marginal income tax rates (state and local) are 25 percent, maintenance costs are 1 percent per year, and amortized closing costs are another 1 percent per year. Taken altogether, the cash cost of owning is $12,162 per year. Looks like renting still beats owning, right?

Not really. The typical apartment is smaller than the typical house, 1,300 square feet for the median rental unit vs. 1,800 square feet for the median home. Thus, owning the median home is about 10 percent less per square foot than renting the median rental unit. "You need no home price appreciation to still be ahead financially with owning," he says. "Your after-tax, out-of-pocket cost of owning is less than the out-of-pocket cost of renting."

Morris Davis agrees housing is fairly priced compared with renting. The rent-price ratio is the equivalent of a stock's dividend yield, but with a home price rather than a stock's market capitalization as the denominator. Davis, along with economists Andreas Lehnert and Robert Martin, tapped into a national home-price database and created a rent-price ratio dating back to 1960. They found the ratio fluctuated in a fairly narrow range for much of the period from 1960 to 1995, averaging 5.29 percent. Yet from 1995 to 2006 the mass mania for housing drove the ratio down to an all-time low of 3.5 percent—a clear signal housing was overvalued and renting financially attractive. (The signal may have been clear, but it was ignored.) The ratio has since climbed back up to 4.86 percent in the third quarter of 2010.

Inflation Hedge

There's another trend working in homeownership's favor: "Housing is a hedge against inflation," says Davis. During the inflationary 1970s the annualized real rate of home price appreciation—that is, above inflation—was 4.35 percent for the decade, according to research by Davis and Jonathan Heathcote, economist at the Federal Reserve Bank of Minneapolis. In sharp contrast, from 1960 to 1970 the real annual return was 0.62 percent. Thanks to the potent combination of leverage and inflation, the average homeowner in 1970 earned a total real return on equity of 5 times by 1980. (The inflation-adjusted national median home price declined from 1969 to 1970, one of the few times that's happened before the recent housing market implosion.)

Of course the current rate of inflation is extremely low. The consumer price index for the 12 months ending in October has risen 1.2 percent. (The 0.3 percent drop in the shelter component of the CPI is one reason the index is so low.) The core rate of consumer inflation—the CPI minus volatile food and energy—is up a mere 0.6 percent over the same period. It's the lowest increase recorded since the index began in 1957. Federal Reserve Board Chairman Ben Bernanke has warned "inflation that is too low can pose risks to the economy—especially when the economy is struggling. In the most extreme case, very low inflation can morph in deflation (falling prices and wages), which can contribute to long periods of economic stagnation."

Little wonder the Fed would like to see a higher rate of inflation. Many Wall Street analysts and professional Fed-watchers believe the central bank will succeed, especially since it launched its $600 billion bond-buying program. The economic recovery should also allow more companies to boost prices over time, assuming a modest rebound and slow decline in the unemployment rate over the next several years. While the odds of a reprise of a 1970s double-digit inflation rate is extremely remote, even relatively modest rates of inflation cut into the cost of fixed-rate debt since borrowers pay back lenders with depreciated dollars.

The housing market bust has taken optimists to the woodshed many times over the past several years. The litany of negatives weighing on the market remains daunting. So the safe forecast remains "Plenty could still go wrong." But real estate market valuations suggest the odds may well favor the intrepid.

Chris_farrell
Farrell is contributing economics editor for Bloomberg Businessweek. You can also hear him on American Public Media's nationally syndicated finance program, Marketplace Money, as well as on public radio's business program Marketplace.

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