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The dynamics of overpriced markets.

It used to be that home prices only went in one direction--up. But in the brave new world of mortgage banking, housing prices have proven they can just as easily go the other way. Now there's a tool to help pinpoint badly overheated markets, where housing prices are way out of whack with local buying power.

In the last 10 years, during a long economic expansion and then a nagging recession, home prices in local markets have become a bigger concern to mortgage lenders than ever before. The reason is local home prices have become more volatile than ever and no one knows quite what to expect next.

Instead of the nice, steady price appreciation that warmed the hearts of mortgage lenders in the past, there have been dramatic increases, extended decreases, and stagnation. While the average home price in the U.S. has increased 3 percent to 5 percent each year since 1980, home price patterns in many local markets have been wildly different.

In Boston and New York, for example, home prices doubled in only three years. During the same period, Houston home prices dropped 25 percent. Nationally, home prices increased an average of 55 percent during the 1980s, but in Salt Lake City they rose only 10 percent. Home prices throughout the Northeast have recently turned down and the surge of prices in the West has stalled.

In the next few years, the most challenging markets will be those where home prices were flying high but now have faltered. And, significantly, there are many markets that fit that description.

We used to ask: How high will home prices go? Now, the more important question is: How far will they fall and what happens afterwards? In order to answer this question, we need a better understanding of the factors that drive home prices. Unfortunately there are few good tools available to help us.

One new factor to contend with is the element of speculation that has been added to the usual motives for buying a house. Speculation increases both prepayment risk (as buyers cash in successful speculations) and foreclosure risk (as they struggle to cope with unsuccessful ones.) It also undermines the underwriting process. In rapidly inflating markets, homebuyers are tempted to embellish the truth about their ability to carry huge mortgages, and mortgage bankers are more easily tempted to wink at slightly suspect enhancements to a borrower's profile, in the belief that higher home prices will cover all sins.

But as we have seen, first in the oil patch, then in the Northeast, and now probably in southern California, homebuyer speculation has a downside. And yet, we probably haven't seen the end of its allure. Furthermore, you can't get this genie back in the bottle. Home price speculation has now become a regular feature of homeownership. Just look at recent home price increases in Chicago (25 percent in two years, from 1989-1991), Seattle (50 percent in two years, from 1988-1990) or Honolulu (70 percent in two years, from 1988-1990).

The variability and volatility of home prices have made mortgage banking, obviously, much more difficult. In the 1970s, investing in residential real estate was a no-brainer--with rampant inflation, home equity values skyrocketed. In the 1980s, the job became a bit trickier, complicated by higher mortgage rates, a deep recession in the Southwest and crazy prices in the Northeast.

Now that we're in the 1990s, real estate and mortgage professionals must be prepared to deal with great uncertainty about future home prices, on the downside as well as the upside. That means first taking a more objective look at the economic forces that underlie local home prices. Income is one of those forces, and using local income it's possible to calculate an equilibrium home price that shows when--and by how much--a local home market is overpriced. We will also look at what happens in overpriced markets and develop some rules of thumb for evaluating prospects in both overpriced and recovering markets.

Some misconceptions

Today, several old rules of thumb seem far less useful than they once were in gauging the future course of local market prices. The idea that home prices only go up, never down, must obviously be discarded. Also, sales volume is no longer always a measure of the strength of local home prices. The general notion that lower mortgage rates support higher home prices is also open to question, as is the idea that inflation is the main force driving home prices.

Back in the 1970s, inflation was, in fact, a powerful force propelling home prices upward, and it has left us a legacy in the form of the expectation that home prices should normally increase 4 percent to 5 percent a year. Inflation also made homeownership more desirable as an inflation hedge.

But the year-to-year correspondence between inflation and home prices actually has actually been rather poor. Other forces have become more important, especially in local markets. Inflation can't explain the Northeast price boom of 1985-1988, nor the California home price increases from 1988 to 1990. In fact, home prices have increased faster than inflation: from 1975 to 1991, home prices rose 180 percent, while consumer inflation was 135 percent.

Mortgage rates also have an impact on home prices, but the effect is a lot weaker than the mathematics of mortgage payments would suggest. Higher mortgage rates in 1981 to 1984 were indeed associated with smaller increases in home prices (4.1 percent a year), while the lower mortgage rates that prevailed from 1985 to 1991 were associated with larger increases (5.5 percent a year). But the effect is much smaller than the change in rates, and the year-to-year correspondence is not very good.

Mortgage lenders frequently look for increased home sales volume as a sign that local market conditions are improving. But the long-held view that higher sales volume indicates firmer home prices must be revised. In recent years, the very opposite has been true in some markets, because of foreclosures and forced sales. From 1985 to 1988, during the energy recession, the volume of home sales in Texas increased, even as home prices were plummeting. And large numbers of foreclosures in distressed markets in the Northeast are now producing inflated--and misleading--local sales volume numbers.

Partly because of the speculative element in homebuying (especially with condominiums), markets with falling prices now yield large numbers of foreclosures and forced sales. The volume of such sales not only exacerbates price declines, but clouds the picture for analysts.

The central role of income

While inflation and mortgage rates have a hand in determining home price increases, the leading role in deciding these prices is played by income. In the long run, home prices depend on the ability of homeowners to make mortgage payments. When incomes rise, so do home prices; when incomes level off, prices level off too. Furthermore, income is the most important factor in explaining why there are price differences in local housing markets.

Of course, income isn't the whole story, either. As with mortgage rates, the effect of rising income on home prices in the last 15 years has been different than just the mathematics alone would suggest. While the median home price rose 180 percent from 1975 to 1991, average personal income rose more: 215 percent. On the basis of income alone, home prices today should be 20 percent higher than they actually are. Clearly, there are other factors at work, some economic, some social or psychological. For example, the very low U.S. savings rate probably restrains home prices because many potential new buyers don't have the down payment funds needed to buy.

Home prices in local markets

Most products cost the same anywhere in the country--but not homes. The average home can cost $50,000 in Saginaw, Michigan and $340,000 in Honolulu. These markets represent the extremes, but there are price differences among most local home markets in the country. Many factors contribute to these differences. The lack of availability of land for new construction is an important one for housing markets such as San Francisco, built on a peninsula, or such as New York, where the outskirts are already densely populated.

Very rapid population growth also puts pressure on home prices. That's certainly one reason why California home prices are so high. From 1980 to 1990, the population in the Los Angeles basin grew by 26 percent. In San Diego, it grew by 34 percent. Speculation also produces sharp differences, though only in the short run. In smaller markets there can be all types of special influences, from industrial relocations to declining commodity prices. The huge run-up in home prices in Honolulu, for example, is probably due mainly to big spending by foreign buyers.

But the fundamental economic reason why home prices are consistently different in local markets is that incomes are different. Markets where incomes are higher have higher home prices than markets with lower incomes. Per capita income is generally higher in the Northeast than in the South, and so are home prices. The same is true within regions. Per capita income is higher in Virginia than in North Carolina, and home prices are as well. Per capita income is 21 percent higher in Atlanta than in Montgomery, Alabama and home prices in Atlanta are 17 percent higher. Average income is 39 percent higher in Denver than in Salt Lake City and home prices in Denver are 22 percent higher. Of all the factors that affect home prices in local markets, income is the most fundamental, consistent and important one in the long run.

Local supply and demand imbalances

As with all other commodities, the price of homes in local markets depends on the balance between supply and demand. Supply is affected by the long lead time to plan and build a house, by the scarcity of land or by the scarcity of desirable locations. Demand is affected by many variables, including changes in income, population pressures, changes in fashion or financial speculation. A key point is that the demand for homes can change much more rapidly than the supply. It is, therefore, relatively easy for an economically dynamic market to produce a supply and demand imbalance. But the outcome of the imbalance depends very much on the type of factor that produced it.

When an imbalance occurs and home prices go up, mortgage lenders need to know whether prices will stay up, or come back down. When local home prices rise, homebuyers and mortgage lenders often can't tell if the increases are due to fundamental economic or social forces that will create a permanent increase in prices, or whether they are the result of short-term speculative imbalances that eventually will saddle them with overvalued properties and shaky mortgages.

While economic and population pressures provide the long-term support for home prices in local markets, speculative imbalances usually produce the dramatic short-term effects. The rapid price movements we saw in the mid-1980s, for example, were mainly due to temporary imbalances that initially had an economic foundation, but then developed into speculative bubbles. These are the most dangerous phenomena for real estate buyers and mortgage lenders because the rapid increases in homeowner's equity that seem to protect real estate investments are illusory and short-lived.

For example, in the mid-1980s income in the Northeast rose much faster than average. This quite predictably boosted home prices, but by a lot more than the income increase would justify. After the initial boost due to economic factors, the element of speculation entered the picture. Sales turnover increased sharply. The number of home sales grew at almost twice the national rate (for condos, it was triple the national rate), and home prices in Boston and New York doubled in only three years. The first buyers saw their home equity increase enormously, but the vast majority of buyers have since then seen their real equity--and, just as importantly from the speculator's point of view, the equity they had expected to acquire--seriously eroded. Developers and their lenders, on the supply side of the equation, took a financial bath when the speculative portion of the surge in demand subsided.

Optimists are always tempted to attribute rapid home price increases to the release of "pent-up demand", thereby implying that a market is reverting to its normal state. In fact, however, anything other than moderate price increases are usually due to abnormal, speculative market conditions.

Identifying abnormal market conditions

A successful mortgage lending strategy depends on being able to recognize abnormal market conditions. Using local income, it's possible to establish a baseline that allows one to identify when local home prices are out of line with the long-term economic forces that support prices. The equilibrium home price for a local market shows what the local median home price would be in the absence of speculative supply and demand imbalances. The premise behind the calculation of the equilibrium home price is that long-term, sustainable changes in local home prices must be supported by long-term changes in local income. By comparing the equilibrium price to the actual median home price in a local market we can estimate whether or not--and by how much--the market is out of balance.

The equilibrium home price incorporates both the long-term relationship between home prices and income, and the effect of changing mortgage rates. It also takes into account a phenomenon that reflects social, as well as economic forces, namely, that people with the same income in different regions of the country consistently allocate a different amount of their income to pay for housing. For example, in Cincinnati, Fort Myers, Florida and Omaha, the average income is about the same, but Cincinnati home prices consistently are 20 percent higher than prices in Fort Myers and 25 percent higher than prices in Omaha.

Even after one takes income differences into account, home prices in the South tend to be 20 percent lower than the national average and home prices in the Midwest tend to be 30 percent lower. On the other hand, home prices in California have usually been 25 percent higher than the average. The consistency of these regional differences makes income allocation a useful additional factor in analyzing local home prices.

For a local market, the equilibrium home price divided by the local average income is equal to the median U.S. home price divided by U.S. average income, multiplied by the regional income allocation factor.

EHP / local average income = (USHP / U.S. average income) x Allocation factor

The allocation factor is generally 1.00 in the Northeast, .80 in the South, .70 in the Midwest and 1.25 in California; within each region it's usually higher in large cities.

Overpriced markets

By comparing equilibrium home prices with actual median home prices, we can see various pricing patterns. In Columbus, Ohio, for example, actual and equilibrium prices have been virtually identical during the past 10 years, within a range of plus or minus 10 percent. In other markets, such as Houston and Oklahoma City, we can see price cycles, where home prices first climbed above, then fell below, the equilibrium price.

When the actual median home price in a local market exceeds the equilibrium price by more than 10 percent, the market is probably overpriced. In Boston and New York City, in a pattern typical for many Northeast markets, actual home prices began to substantially exceed the equilibrium home price in 1985 and have remained well above the equilibrium price since then. In Los Angeles, as in many California markets, actual home prices rose rapidly above the equilibrium price in 1988 and 1989. What happens with home prices once a market is overpriced, depends very much on what happens with the local economy.
FIGURE 6
Some Overpriced Housing Markets 1991
Albany NY 30%
Anaheim CA 25%
Bergen County NJ 20%
Boston MA 25%
Chicago IL 13%
Honolulu HI 32%
Las Vegas NV 12%
Los Angeles CA 28%
New York City NY 27%
Newark NJ 22%
Philadelphia PA 12%
Sacramento CA 23%
San Diego CA 23%
San Francisco CA 20%
Seattle WA 27%
Washington DC 18%


In overpriced markets, a drop in local economic growth often signals the end of price increases. As long as the economy remains healthy, home prices can continue to rise for several years. But as soon as the local economy stops growing, price increases come to a halt. In Boston and other Northeast markets, for example, prices continued to rise for four years in a row, until economic growth fell sharply in 1988. In southern California, falling economic growth in mid-1990 stopped further, broad-based home price increases.

It takes a severe local economic depression to really drive home prices down. When local markets have severe economic problems, home prices can drop well below the equilibrium price. Houston home prices rose rapidly in the late 1970s, then leveled off in 1983 when the local economy ground to a halt. But home prices didn't begin to fall until 1985, when the oil price bust plunged the local economy into a severe depression. Then prices fell 25 percent.

The more usual outcome in overpriced markets once they peak, is that home prices fall only modestly. Or they may languish for a number of years until income levels rise sufficiently to support them. This happened in California in the early 1980s, and in much of the Northeast in recent years. Despite a weak local economy, home prices in Boston, for example, have fallen only 10 percent. But they are still well above the equilibrium price and, therefore, will probably continue to drift lower, or they may just stagnate for a number of years. The amount by which they exceed the equilibrium price will determine the length of the period of stagnation.

The outlook

There are many overpriced housing markets today in the Northeast corridor and in the West (See Figure 6). In the South and Midwest, on the other hand, home prices are generally in line with local equilibrium prices. In Texas, Oklahoma and Colorado--states with recovering economies--home prices are currently below the equilibrium price and there is substantial room for price increases in the next few years.

In most Northeast markets, there is little sign of an economic recovery and in New York City, the local economy is still getting worse. Home prices have come down a bit but remain well above the equilibrium price. It's most likely that home prices in these markets will decline slightly or fluctuate slowly in the next few years. If the national economy slips back into recession, prices in these markets will fall another 10 percent.

In the West, the prospects are mixed. Economic growth in Seattle, Sacramento and Las Vegas slowed sharply in the past year, so home prices have probably peaked in these markets for the next few years. The evidence of the economic slowdown in these markets is clearly visible in the local employment growth numbers. In Seattle, the employment growth rate in 1990 was 4.6 percent, while in 1991 it was a minus 0.1 percent. In Sacramento, the employment growth rate in 1990 was 4.5 percent, while it dropped to a scant 0.5 percent in 1991. In Las Vegas, the employment growth rate soared by 10.8 percent in 1990, but the rate went to 2.9 percent in 1991.

The median house prices in these markets seemed to track the cooling of these local economies. In Sacramento, the median home price in 1990 was $137,500 and inched up only to $137,700 in 1991. In Seattle, the 1990 median home price was $142,000 and moved to $143,100 in 1991. In Las Vegas, the median home price in 1990 was $93,000 and rose to $101,400 by 1991.

Renewed growth in Las Vegas is quite likely and this well could push prices up vigorously again. The economic situation in Seattle is delicate. The lumber and aircraft industries were doing well until recently, but both could be starting on a downward cycle. Some evidence of the Seattle aircraft sector's current weakness is visible in the number of manufacturing jobs lost in the Seattle market from June 1991 to June 1992. During that time, total employment in Seattle's manufacturing sector dropped by 2.7 percent. Furthermore, in Seattle, 60 percent of the manufacturing jobs are in aircraft manufacturing. As far as the lumber industry goes, 84,000 jobs have been lost nationally in the lumber industry since 1989.

If this downward cycle for these two key industries occurs, Seattle home prices could easily fall 10 percent. Sacramento home prices, like the state government budget, are unlikely to go down, but the financial troubles of the state will limit further housing price increases.

The bad economic situation in southern California will be exacerbated by continuing cuts in national defense spending. So far, the recession has only led to stagnation in home prices in San Diego and the Los Angeles basin, but the abysmal economic prospects will probably drive home prices down during the next few years. In Honolulu (unless the Japanese stock market recovers), the insane home prices of recent times have only one way to go--down.

Monitoring local markets

The concept of equilibrium home prices is a very practical tool to help us understand the dynamics of home prices. By focusing on price movements not related to income, mortgage bankers can identify abnormal market conditions. Equilibrium home prices are easy to calculate. Charts of equilibrium home prices over a 10-year period give a clear picture of major price imbalances.

Mortgage lenders should also keep track of economic growth in local markets. This is easily done by monitoring the growth of local employment, and again, charts provide the best picture.

Used together, equilibrium home prices and economic growth can identify when a local pricing imbalance has occurred, when home prices are likely to peak, and what the prospects are once price appreciation has stopped.

Mortgage lenders don't need to be economists, but in a time when we can expect greater volatility and variability in local home prices, lenders need a practical understanding of how home prices can change.

Ingo Winzer is the editor of the "Quarterly Review of Real Estate Markets," published by The Local Market Monitor in Wellesley, Massachusetts. He is a graduate of M.I.T. and holds an MBA from Boston University's Graduate School of Management. The home prices quoted in this article are median home prices compiled by the National Association of Realtors.
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No portion of this article can be reproduced without the express written permission from the copyright holder.
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Title Annotation:housing prices as a major concern of mortgage lenders
Author:Winzer, Ingo
Publication:Mortgage Banking
Article Type:Cover Story
Date:Oct 1, 1992
Words:3750
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