Thursday, August 23, 2007

Two Irresistible Reasons Housing Will Retrace to 1997 Prices

Two historically irresistible patterns suggest speculative-bubble housing values will eventually retrace back to their 1995-1997 levels:

the symmetry of speculative rises and retraces
the unbreakable links between income and housing values.

To get started, let's stipulate that the Great Housing Boom of the past decade was not a housing boom--it was a speculative debt-fueled bubble which happened to occur in the asset class known as real estate. As a speculative bubble, it shares the same characteristics as other speculative manias in tulips, stocks, toilet paper, etc. (Note that there is one key difference between worthless stock certificates and toilet paper: the TP has a practical use.)

Let's look at a speculative bubble in real estate which is finally running its course: the one which has unfolded in Japan over the past 15 years:

Please go to my main page at www.oftwominds.com/blog.html to view charts.

While the symmetry isn't perfect--the decline took 50% longer than the rise--for purposes of illustrating what lies ahead I've prepared a chart of California housing prices:



Speculative bubbles in the stock market tend to shoot up and then plummet in relatively short time spans. Here we see that the dot-com era bubble in NASDAQ took a mere 3 years to reach euphoric heights in which risk was banished, and a roughly similar length of time to give up all the bubble's gains, and then some.

Real estate trends stretch out over much longer time spans, and as a result we can foresee a lengthy, painfully drawn-out decline in housing values over the coming decade.

Just as stocks break free of fundamental metrics of value in speculative manias, so too do houses. But just as stocks retrace to historical levels of price-earnings ratios, so too will housing retrace to historical levels of income-to-value ratios. Historically, this is about 3-to-1: long-term, houses cost about 3 times household income. Since the median household income in the U.S. is abour $46,000, U.S. incomes would support house values of abour $125,000 - $140,000.

As I have noted before, my parents/step-parents each bought houses in highly desirable locales in the early 70s (Honolulu and Pasadena) at 2:1 (twice annual income) and 4:1 (four times a schoolteacher's annual income to buy in highly desirable Manoa Valley in Honolulu.)

As recently as 1997, friends were purchasing small homes in very desirable S.F. Bay Area communities for $160,000 - $175,000--four times a modest (for this area) household income of $40,000.

In other words, to return to a normal trendline, one that was in place a mere decade ago, even the most desirable areas will command no more than 4 times median income. That would put house prices in Honolulu, the S.F. Bay Area, West L.A., Connecticut, Northern Virgina, etc. at about $180,000 - $200,000 -- not $600,000.

New correspondent Jim V. provides an excellent overview of how the market could return to historical norms:

After reading yours and other blogs I now have a firm understanding of the housing bubble and credit crisis.

What I have not seen is a solution to these issue. I've seen statements saying millions will lose their homes to foreclosure. These are said in a manner like it is a foregone conclusion.

Here is an idea on how to prevent the foreclosures:

-If buying a house, first find out the medium family income for the area you are interested. Then offer 3 times that amount and not a penny more.

-If selling a house, do the same thing by pricing the house at 3 times the medium annual income for that area.

-Assessors should start re-assessing homes using the above guidelines.

-Institutions that service existing loans should immediately restructure the loans terms so that the principle amount equals 3 times the medium family for the area.

I've been reading that traditionally (in the not to distant past), paying 2 1/2 to 3 times your annual income for a house was typical.

An end must come to this idiocy and it will come from a grass roots movement.

Thank you, Jim. Well said.


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