Where Will Housing Prices Go Next?

The key to recovery is jobs. That much is clear. But what really drives a job recovery? While many factors play a role, the state of housing is near the top.

Few things can alter the behavior of banks, and the confidence of consumers and businesses, like the strength of housing -- or lack thereof. Our current mess started in housing. And while it may not end there, it can't end until housing picks itself up off the floor.

So whether you're Beazer Homes (NYSE: BZH  ) or Microsoft (Nasdaq: MSFT  ) , Donald Trump or Joe Schmo, you want to know where home prices will go next. Like all forecasting, no one has a clue exactly what might happen. But looking at a few broad indicators, we can get a decent look at where we stand.

I examined three of what I think are the most important housing metrics -- price-to-income, price-to-rent, and months of supply -- to gauge the current state of the market. Here's what I found.

Price-to-income
An asset is worth what those who demand it can reasonably afford to pay. Looking at home prices in relation to income, then, is probably the single most important statistic in determining value.

I took the Case-Shiller National Home Price Index and compared it to the national median income provided by the Census Bureau. To make the scale easy to interpret, 1987 is calibrated to 1.00, with subsequent years' value compared proportionally:  

Year

Price-to-Income Ratio

1987

1.00

1988

1.03

1989

1.05

1990

1.06

1991

1.02

1992

1.02

1993

1.00

1994

1.00

1995

0.96

1996

0.94

1997

0.93

1998

0.93

1999

0.95

2000

1.00

2001

1.09

2002

1.17

2003

1.27

2004

1.39

2005

1.53

2006

1.64

2007

1.55

2008

1.33

And the last three quarters* of 2009 ...

Year

Price-to-Income Ratio

Q1 2009

1.08

Q2 2009

1.11

Q3 2009

1.15

*Assumes 2008's income.

While we're waaay below the ridiculous peak in 2006, note that today's level is both creeping back up, and not historically low by any means. When you're fixing the damage of a bubble, value should fall below normalcy in order to dispose of excess inventory -- just like Best Buy (NYSE: BBY  ) and Ford (NYSE: F  ) use sales to clear out their shelves or showrooms. That's how markets work. This table also illustrates how reasonable it could be for prices to drop considerably more without even falling below the levels of the late '90s -- hardly a period of financial famine.

Price-to-rent
A house is a place to live, and nothing more. Its value should be strongly correlated to rental rates, since both renting and owning provide the goal of shelter.

I took the Bureau of Labor and Statistics' owners' equivalent rent metric and compared it again to the Case-Shiller National Index. Once more, the base year (1994 in this case) is calibrated to 1.00:

Year

Price-to-Rent Ratio

1994

1.00

1995

0.98

1996

0.98

1997

1.07

1998

0.99

1999

1.04

2000

1.20

2001

1.25

2002

1.31

2003

1.42

2004

1.56

2005

1.76

2006

1.88

2007

1.80

2008

1.52

And the past three quarters of '09 ...

Year

Price-to-Rent Ratio

Q1 2009

1.22

Q2 2009

1.14

Q3 2009

1.17

Like the trend in price-to-income, today's level is down considerably from the insanity of previous years, but it's by no means "low" compared to non-bubble territory. Another 10%, 15%, or even 20% drop in this metric wouldn't be unprecedented, even in just the past 16 years.

Inventory, months of supply
We built too many homes in past years. Now, through foreclosure, strategic defaults, and a fear of buying, those extra homes are stacking up, waiting to be sold. So an important metric is the amount of supply. This is often reported in the number of months it would take to sell all for-sale homes at the current sales rate:

Year

Months of Supply

1990

7.0

1991

9.4

1992

5.2

1993

5.4

1994

5.9

1995

6.8

1996

6.4

1997

4.7

1998

4.0

1999

3.9

2000

4.3

2001

3.8

2002

4.2

2003

4.0

2004

3.8

2005

4.4

2006

5.3

2007

7.2

2008

9.6

And for '09 ...

Year

Months of Supply

Q1 2009

12.4

Q2 2009

10.4

November 2009

7.9

Source: Census Bureau.

As a rule of thumb, six months' supply is typically deemed healthy. One year ago, we were more than double that -- today, we're fairly close.

But this table can be misleading. The true inventory has to take into account the "shadow inventory" -- inventory banks and other owners intend to sell, but choose not to, either because they think prices will rise, or they don't want to acknowledge losses. Last month, First American CoreLogic estimated the shadow inventory market at 1.7 million homes, compared with 3.8 million on-market listings as of September. If those numbers are correct, the real supply could be close to 50% higher than this table suggests, with supply far exceeding 10 months.

Moving on
These metrics show that housing is far better than it was even a year ago, but still not obviously cheap. When you compare the apparent value metrics to what could be a vicious shadow inventory, it's quite reasonable to assume that we haven't seen the bottom.

This, too, doesn't mention temporary factors propping up prices: The $8,000 homebuyers' credit, the Federal Reserve's purchases of mortgage-backed securities, the foreclosure prevention plan, and so on. Many of these plans are scheduled to expire this year. When they do ... watch out. I don't think it'll be the end of the world, but the impact it'll have not just on banks like Bank of America (NYSE: BAC  ) , Wells Fargo (NYSE: WFC  ) , and JPMorgan Chase (NYSE: JPM  ) , but consumer and business confidence, could be substantial.

What do you think? How's the market looking in your neighborhood? Fire away in the comment section below.

Fool contributor Morgan Housel doesn't own shares in any of the companies mentioned in this article. Best Buy and Microsoft are Motley Fool Inside Value selections. Best Buy and Ford are Motley Fool Stock Advisor recommendations. Motley Fool Options has recommended a diagonal call on Microsoft. The Fool owns shares of Best Buy. The Fool has a disclosure policy.


Read/Post Comments (9) | Recommend This Article (21)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On January 07, 2010, at 2:47 PM, sckboyspotatrain wrote:

    I agree; there is no whereto go but down.

  • Report this Comment On January 07, 2010, at 3:47 PM, Ibeatmykids wrote:

    I think this article is awesome. I think for some reason our government insists on making bubble after bubble.

  • Report this Comment On January 07, 2010, at 3:50 PM, AvianFlu wrote:

    Prices:

    Up in nominal terms (maybe)

    Definitely down in real terms

  • Report this Comment On January 07, 2010, at 4:17 PM, astewboy2 wrote:

    And can I say that ignoring the first metric (able to afford a home) lead to the latest mess, but no one wants acknowledge that we've delayed the inevitable and probably made it worse because now our "recovery" will vanish.

  • Report this Comment On January 07, 2010, at 4:18 PM, astewboy2 wrote:

    Oh, and here's another comment for 20 cents for the Marshall school.

  • Report this Comment On January 07, 2010, at 7:43 PM, TMFTypeoh wrote:

    Dead on with this article!

    Obviously, all real estate is local, and i have thought for years now that you should simply take the average income for a town, multiply by 3, and that you be your average housing price.

    So, if the average income is 60k, the average housing price should be 180k. Until these number work together, stay away from buying a house.

  • Report this Comment On January 08, 2010, at 10:53 AM, mkeneipp wrote:

    Thank you for this article. Pulling together information of this nature and providing a data-based perspective makes for excellent reading.

    More of this, please!

  • Report this Comment On January 12, 2010, at 2:37 PM, FreeMortal wrote:

    I'm actively looking for a house now and I'm one of those infuriating people that doesn't want to pay full price for anything. Looks like time is on my side. I can wait all year.

  • Report this Comment On February 20, 2010, at 12:13 PM, rockhound1 wrote:

    I would be buying at this time in the Cape Coral Florida area but find that even tho I could find some great house prices, it is the property taxes that cause me to refuse to invest. There were some great deals awhile (10 months) back...a three bed 2 ba 1800 sq ft plus two car for around twenty five to thirty five thousand. The taxes were around twenty five hundred to thirty five hundred.....that's 10% that's outrageous...What will it take for the counties to downsize on their massive top bubble period build ups in manpower and equipment and cut out the pretty but unnecessary beautification projects. There are many many projects (new roads, bridges, fire stations, schools, police stations, post offices, city and county facilities, detention centers, parks and recreation all with new and excessive expenditures for vehicles and equipment based on future revenues)that were entirely overfunded and none of the recipients is willing to give up enough funding to help shrink the tax base. Yep we voted for a change and got one just not the right one.

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