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How Much Further Do Home Prices Need to Fall?

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I'll start by sparing you the details. Nationwide home prices need to fall another 10%-15%. If you want to know how I came to that conclusion, keep reading.

As much as possible, I try to follow Marty Whitman's philosophy that "rarely do more than three or four variables really count. Everything else is noise."

With housing, three variables tell you most of what you need to know: price-to-income, price-to-rent, and months of supply. So let's see what they tell us.

1. Price-to-income

Sources: Case Shiller Housing Index, Census Bureau.

Sources: Case Shiller Housing Index, Census Bureau.

Home prices have tanked measured against incomes. That's obvious. But two points here should stick out: One, price-to-income levels are still about 5%-8% above average. Two, the ratio is headed back up already. Don't get too comfortable with that. Since the ratio stabilized at an above-average level, the rebound is likely just a temporary blip caused by housing stimulus. "Temporary" is the key word there. You can't permanently exit the largest housing bubble in history at above-average prices. More on that in a second.

2. Price-to-rent

Sources: Case Shiller Housing Index, Census Bureau.

Sources: Case Shiller Housing Index, Census Bureau.

Prices against rents are actually back inline with average levels. That's encouraging. Four years ago, renting was far cheaper than owning. It's a much more equitable trade-off today. Embrace that -- it's what a normal market should look like.

Just don't get too excited. Supply is what's really important here. And it doesn't look good.

3. Months of Supply 

Source: Census Bureau.

Source: Census Bureau.

This chart is the most important. First, notice the recent spike on the far right. Both the spike and the drop to its immediate left are the result of the expiration of the first-time homebuyers credit. There was a massive buying rush before the deadline, which temporarily juiced sales. After the deadline passed, sales plummeted. Same goes for the drop and spike in late 2009, which shows a period when everyone thought the credit was about to expire, only to learn it would be extended. Congress has become the undisputed champion of creating obnoxious volatility.

The red line in this chart denotes six months, which is usually seen as a neutral level of supply. As a rough rule, prices tend to fall when there's more than six months supply, and vice versa. The temporary trip below six months supply earlier this year might explain why prices began rising.

But with the expiration of the housing credit, we're now solidly back above six months. If you want a good reason to expect housing prices to fall in the coming quarters, there it is. It's also a bad omen for homebuilders like KB Homes (NYSE: KBH  ) and Pulte Group (NYSE: PHM  ) -- there's simply too much supply out there to justify building more homes.

And the problem is actually deeper than it looks. This chart only shows actual on-market supply. What it doesn't show is so-called "shadow inventory," which are foreclosed homes that banks own but haven't put up for sale, or homes that are still occupied by homeowners who are about to get foreclosed on.

The size of the shadow inventory can only be estimated -- it's called "shadow" for a reason -- but credible estimates range between 2 million and 8 million units. Yes, that's a huge gap, which is testament to how uncertain things are. What's important is that inventory is still way too high. How high? No one knows. But it's high. And as long as that's the case, the housing bears have the ball.

To get inventory numbers back to healthy levels, homes need to be bought, of course. That happens when prices become so cheap that renters start buying, and to a larger extent when new households are formed.

Unfortunately, household formation is abysmal right now. Over the last decade, an average of 1.3 million households were created every year. In 2008, that dropped to 772,000. In 2009, it was a mere 398,000. What caused the drop? For one, the young and unemployed, especially new college grads, are living with their parents. Others are doubling-up with roommates. At a conference in Vancouver last week, analyst and blogger Barry Ritholtz noted that if you focus on household formation and new home construction at current rates, it could take as much as 12 years to absorb current inventory. Warren Buffett has quipped several times that best way to solve this is by encouraging teenagers to cohabitate, a program "not likely to suffer from a lack of volunteers."

Tying it all together
When I look at these three metrics, I see price-to-income levels that need to fall 5%-8%, price-to-rent levels that look pretty good, and a supply situation that's somewhere between bad and horrific.

Excess supply will cause prices to fall. How far? My best guess is 10%-15%. That would bring prices meaningfully below average against both incomes and rents, which would create a level where homeownership becomes affordable for new households and a better deal than renting. That's when you'll see real demand stabilizing the big picture.

And falling below average is, I think, a realistic expectation. Prices have to fall below average before buyers' animal spirits come back to life. That can last a while. Investor Vitaliy Katsenelson recently gave a great presentation where he notes that valuations "usually stay below average for eight years in a sideways cycle." He was referring to the stock market, but the theory should at least roughly extend to housing. Bubble wounds take time to heal.

Could I be wrong? Of course. Billionaire investor John Paulson, who called the housing crash, thinks home prices will rise 8%-12% in 2011, which explains why he's invested billions in Bank of America (NYSE: BAC  ) , Citigroup (NYSE: C  ) , and Wells Fargo (NYSE: WFC  ) . But I try to keep it simple. And my simple metrics make me think housing isn't out of the woods just yet.

Disagree? Sound off in the comments box below.

Check back every Tuesday and Friday for Morgan Housel's columns on finance and economics.

Fool contributor Morgan Housel doesn't own shares of any of the companies mentioned in this article. The Motley Fool has a disclosure policy.

Read/Post Comments (12) | Recommend This Article (31)

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 July 30, 2010, at 4:16 PM, Melaschasm wrote:

    Excellent article with many great points. It is likely that your 10% fall in prices prediction will come true. However, there is a major factor which you did not address.

    Commodity prices are already rebounding from their price collapse in 2008. Housing is in some ways like a commodity, and the same forces driving commodity prices higher could also keep housing at above average prices.

    There is a previous time in US history where the economy was stagnant, yet commodity prices were rising. I am concerned that we are about to see a few years of such unpleasant economic circumstances.

  • Report this Comment On July 30, 2010, at 4:29 PM, outoffocus wrote:

    "Commodity prices are already rebounding from their price collapse in 2008. Housing is in some ways like a commodity, and the same forces driving commodity prices higher could also keep housing at above average prices."

    I disagree. Housing demand used to "behave like a commodity" in that the price increases were driven by real organic inflation. In other words, wages went up, which increased affordability, which increased demand, which increased housing prices. The housing bubble threw that entire equation out of wack. Now we are dealing with an economy that has little to no growth, stagnant to falling wages, too much leverage, rising commodity prices, and high unemployment. All of this is stagflationary and will hurt housing in the short run.

    Also, as with any bubble, once the bubble pops, the asset in question often over corrects to the DOWNSIDE before returning to equilibrium and rising again (see oil as a recent example) . Thanks to all of the bailouts and stimulus, we never saw that over correction. The problem with that is we will never see a true sustained rise in housing prices until that correction happens. All the government did was delay the inevitable and potentially make it worse.

    10-15% drop is a fair prediction for a further drop in housing prices in the near term. But I see a more sustained drop over the next couple years before housing fully recovers. You can thank good ol Uncle Sam for that.

  • Report this Comment On July 30, 2010, at 6:39 PM, rd80 wrote:

    I agree that housing prices are still overvalued, but I think one of the three variables for housing should be mortgage rates since that determines the affordability for most buyers.

  • Report this Comment On July 30, 2010, at 7:43 PM, hcshew wrote:

    I think price to income ratio is a little simplistic because it ignores the effect of interest rates. The real measure of affordability is PAYMENT to income ratio, which inherently takes into account the predominant interest rate. House prices in the 80s and 90s had to be lower because the predominant interest rates ran 8-10% for fixed rate loans. The same home in an era of 4-5% interest rates can be twice as expensive and still be as affordable.

    I would be interested in seeing a chart that compares the trend of payment to income ratio. I suspect that that would show homes today to be cheap!

  • Report this Comment On July 30, 2010, at 10:59 PM, thedavidfactor wrote:

    I think the interest rate is more then compensated by the increase in consumer debt over the same time period. Consumer Debt is at the highest levels in recorded history and that negatively impacts the affordability of payments more than interest rates positively impacts affordability.

  • Report this Comment On July 31, 2010, at 12:56 AM, xetn wrote:

    The simple answer as to how much further house prices should fall is: until people start buying them without government subsidies and no sub-prime loans.

    Just as an aside, the same formula could apply to job creation; letting the wage rate (which is nothing more that a price) adjust until there was job for essentially every job seeker. We should end the minimum wage which destroys jobs for people without adequate education and/or job experience.

  • Report this Comment On July 31, 2010, at 8:45 PM, matthew2219 wrote:

    While I think Ms. Morgan writes a good analysis report, since we are always interested in "What is Buffet buying now" I think I would have to go with billionaire John Paulson who made 4 billion when the bubble burst and is now seeing an improved housing market.

    Now it could just be wishful thinking on my part because I have a house in Southern California that I would dearly love to sell. Anyone interested?

  • Report this Comment On August 01, 2010, at 9:23 AM, JFT45 wrote:

    I believe those averages are skewed by data from cities where excessive speculation occurred and the bottom subsequently dropped out in a big way. In Wilmington, DE, for example, where I live, excessive speculation did not occur and prices have seen a modest increase even prior to the stimulus. A surprising number of new suburban and urban homes (excluding condominiums) ranging in price from 450K to well over a million dollars are being built and sold by the likes of Toll Brothers. Some are sold before ground is broken suggesting demand is reasonable and inventories, especially in the city, is low. So, it would seem, at least anecdotally, that one needs to be careful when analyzing overall data. A different picture might emerge when using the above metrics to analyze local or regionally collected data.

  • Report this Comment On August 02, 2010, at 9:19 AM, TicoHombre wrote:

    @JFT45 I believe you hit the nail squarely on the head. Those graphs at best can be considered national "averages" and ignore local markets (which to a large degree is what the real estate market is).

    I live in the 2nd largest city is OK and we've not seen any significant deflation in housing prices. Of course, we saw only a little of the "all boats rise with the tide" scenario during the bubble years. Prices here are stable to rising. I think a few large markets can really scew the graphs.

    Thanks for the input and insight.


  • Report this Comment On August 02, 2010, at 2:55 PM, TheDumbMoney wrote:

    Even within hard-hit areas like SoCal, there is a huge difference between places like Riverside, and places like South Pasadena. Or to take NorCal: the difference between Marin, and Oakland. Or to take even Vegas, the difference between the outlying golf communities/suburbs, and prime condos on/near the Strip. The overall point is good though. The reality is likely that in certain areas, prices may fall another 20%, and others none at all. Also keep in mind that the bank inventory, the shadow inventory, may well remain held by banks for a long, long time, which they can do because of Fed policies, recapitalization, etc. They no longer have as much incentive to sell at firesale prices. So that may not be as much a worry as we think. Also, at some point, there is going to be a spike in demand as all those youngsters living with their parents leave and/or get kicked out. That may take a couple of more years to happen, but it will shorten any 12-year draw-down period, because at a certain point, unless these people never do form households, household formation will rise far above average, to make up for the current lag.

  • Report this Comment On August 03, 2010, at 12:09 PM, syedkhalid wrote:

    The above thought is smart and doesn’t require any further addition. It’s perfect thought from my side.



    <a href="" rel="dofollow">Stock Value</a>

  • Report this Comment On August 04, 2010, at 4:52 PM, mDuo13 wrote:

    As one of those college grads still living with his parents, I can vouch for the accuracy of many points in this excellent article. Personally, I'd like to move out but I'm saving first because I'm not utterly confident about my job situation for the long run, and I'd rather save first and spend later. It helps that I don't expect housing prices to skyrocket again right away.

    I think that John Paulson may not have to be wrong for this article to also be right. I suspect we'll see a slow climb this year but there's also a pretty good chance that now or soon, there will be another slide. If and when the economy starts producing jobs in good quantity again, THAT'S when housing prices will really start to pick up again.

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