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If the Fed Missed This Bubble, Will It See a New One?


lennie_88
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Excellent article from the NYT.

http://www.nytimes.com/2010/01/06/business/economy/06leonhardt.html?dbk

 

These simple valuations of of housing seem very logical to me. I have never understood why one would buy when renting is comparatively cheaper (like it is now where I live- Victoria, BC) and risk free.

 

"By any serious measure, houses in much of this country had become overvalued. From the late 1960s to 2000, the ratio of the median national house price to median income hovered from 2.9 to 3.2. By 2005, it had shot up to 4.5. In some places, buyers were spending twice as much on their monthly mortgage payment as they would have spent renting a similar house, without even considering the down payment."

 

The ratio of median price to income in Vancouver was 8.4 in 2008, making the least affordable major market in the world according to http://www.demographia.com/dhi.pdf.

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This really puts the Canadian market into perspective.  Since this survey was done in Q3 2008, Canadian prices have gone up significantly compared to what has happened in other countries.  Toronto would be close to 6.0 now.  Looks like Australia housing needs a correction as well.

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Thanks, Lennie, for the links.

 

In my experience, the House Price/Income Ratio has the drawback of not taking into account interest rates and structural changes in the mortgage financing market. For example, it makes cross-country comparisons misleading when countries have historically had very different interest rate regimes. Thus, the HP/I ratio have historically tended to be lower in "high interest rate" economies such as Australia and the UK and higher in low interest rate economies like Japan and Singapore. So, where a ratio of 5 would be historically expensive in the UK, it has historically been cheap in Singapore.

 

Whereas in recent times global interest rates have converged, interest rates were quite diverse among countries in the 1980's and 1990's. This explains, to some extent, the upward trend in HP/I ratio in countries like Australia where there has been a structural shift downwards in interest rates.

 

The other question I have with the Demographia numbers is whether they use the actual median income for the cities measured. I have tried to find median income numbers for some cities before and they do not appear to be generally available.

 

Imo, the mortgage payment/income ratio is a much better indicator of affordability. If anyone has come across affordability studies that use this or a similar measure, it would be instructive to compare these with the Demographia study.

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Median household income seems more reliable in terms of housing affordability.  In Seattle, dual income households are the norm.  I would expect the price/income ratio to be higher in dual-income situations simply because... after buying food and clothing you have more money left for housing... and this tends to either drive prices higher in cities where it is trendy to live, or in suburbs you wind up with larger houses that are more expensive to build.

 

That's how I think about it.  There must be some way that housing can be priced at 5x or 6x incomes... it can't be fully explained by low interest rates, although certainly that plays a large role.  Low interest rates lead to higher principle payments on amortizing loans -- so having 1/2 the interest payment does not dictate 1/2 the mortgage payment.

 

 

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Keep in mind that for many comparitive purposes these numbers are not relevant.

 

The buyers/sellers of houses in the glitzy neighbourhoods of Vancouver, Hollywood, LA, etc. are not what most people would consider the locals. Its often the 2nd/3rd home of some wealthy individual, or its owned by a company renting it out to travelling execs, or movie stars, etc. that for business reasons, need the address as part of the 'image'.

 

Affordability is based on global comparitives (the neighbourhood is cheap relative to Singapore, London, New York, etc.) &/or whether the wealthy buyers in that market view the property as desirable (as they allready have more $ than they could possibly spend, price is not a consideration). Average joe just doesn't come into it.

 

If your city has a lot of these neighbourhoods, and/or the house prices are many times the 'average' price in your city; it will skew the number upward. Average joe interprets it as a bubble, when its truly just a measurement problem.   

 

SD

 

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Price to income measures affordability, not valuation.  Just because I can afford to buy something for a price of X doesn't mean it is properly valued.  For valuation of real property, the price to rent ratio is appropriate.  Obviously, price to rent ratios rose dramatically to the point where it made no sense (in many places) to own.  As I heard one observer put it, "why pay 6% of the cost of the house in interest when you can pay 3% of the cost of the house in rent."

 

And to answer the question, "If the Fed Missed This Bubble, Will it See a New One?", the answer is clearly NO.

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I agree that price-to-rent is a better measure of "valuation". But I also think that it would be foolish to think that prices are sustainable when people that live and work in the market cannot afford to buy. Florida and Arizona are good examples of what can happen when prices are bid up just because it is a very nice or trendy place to live without the incomes to support it.

 

This is a decent article on price-to-rent (has US specific examples): http://www.forbes.com/forbes/2009/0525/086-investment-guide-09-buy-or-rent.html

 

An excellent book related to this topic is “the Subprime Solution”, by Robert Schiller. One stat he referenced that has stuck with me is that over the past 100 years or so the average return on real estate is around 2-3% annually.

 

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Think in terms of the houses on the 'nice' waterfront going for 200K & the average joes house 3 blocks in going for 125K. The waterfront people stop buying; their house now sells for 140K (30% less) & joes house sells for 110K (12% less), the new 'average' price for that city.

 

The waterfront house sold for what someone else was willing to pay (for whatever reason). Joes house sold for maybe 3x the average worker income in that city.

 

The stats themselves ? Pretty meaningless

 

SD

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Think in terms of the houses on the 'nice' waterfront going for 200K & the average joes house 3 blocks in going for 125K. The waterfront people stop buying; their house now sells for 140K (30% less) & joes house sells for 110K (12% less), the new 'average' price for that city.

 

The waterfront house sold for what someone else was willing to pay (for whatever reason). Joes house sold for maybe 3x the average worker income in that city.

 

The stats themselves ? Pretty meaningless

 

SD

Sharper you have clearly one of the more analytical minds on this board however I have thought long and hard about real estate and relative valuations my thoughts lead me to the conclusion that we are in very dangerous territory re Vancouver real estate and that prices are about to turn dramatically negative and the "Big Mac" affordability ratio is in fact usefull and does pretty much describe relative valuations between markets. Is it perfect no but it will do.
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Ubuy: Agreed its highly likely that Vancouvers RE is over-priced, particulary the trendy areas where there's also some olympic impact. When those areas sell off the decline WILL probably be dramatic, and it'll also be much larger than in most of the other areas of the city. Yes, post olympics, most Vancouver RE will go down - but not equally.

 

The points I hoped to get across were:

1) There are multiple markets within any given city, & some of those markets have very little to do with the local employment conditions/affordability.

2) The index can be very misleading, & why.

 

Cheers

SD

 

 

 

 

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