While the housing collapse continues, with residential construction likely to decline for the remainder of 2008, there are reasons for optimism that the pace should soon begin to subside. Since peaking in 2Q 2006, the Case-Shiller national housing price index has fallen 16.2%. With reference to the long-run relationship between rents and home prices, roughly an additional 15% decline in home prices should be expected.

Tuesday’s morning’s release of the quarterly S&P/Case-Shiller Home Price Index gives occasion to review how rapidly home prices have fallen of late, how far they have fallen since peaking almost two years ago, and how much farther they are likely to decline. While the housing collapse continues, and it is expected that residential construction to decline for the remainder of 2008, there are reasons for optimism that the pace (of decline) should soon begin to subside. These indications include a drop in new home sales back into the range that prevailed in the U.S. prior to the current decade (see Figure 1), a substantial increase in housing affordability, a partial decline in home ownership rates toward historical levels, a well-established trend toward declining inventories of new homes, and a sizable decline in housing’s share of the economy. All of these observations suggest that much of the housing adjustment has taken place.

In recent quarters, falling home prices have suppressed housing demand, adding to the restraint stemming from tight credit conditions. The expectation of capital losses acts as a key incentive to delay home purchases. As a result, an estimate of how long and far home prices will decline is crucial to timing a housing recovery.

The release of the S&P/Case-Shiller figures for 1Q 2008 indicates that housing prices have continued to decline at an increasing pace, falling 6.7% in Q1 alone (see Figure 2). Since peaking in 2Q 2006, the national housing price index has fallen an aggregate 16.2%. Of course the degree of decline has varied widely across the nation, with declines ranging from 24.3% and 21.3% in Las Vegas and Los Angeles, respectively, to 6.0% and 5.1% in Dallas and Portland, Oregon, respectively.

To assess the remaining degree of price decline, we examine trends in home prices and rents. While other factors, such as interest rates, will also impact the behavioural relationship, rents and home prices should follow a common trend. The divergence of trends in home prices and rents is apparent in Figure 3, as by 2002, home prices were exploding higher relative to a measure of owners’ equivalent rent (employed in the consumer price index). Of late, prices have declined, moving toward re-establishing the long-run relationship between rents and home prices.

By examining the ratio of the two (see Figure 4), we can assess how much farther prices are likely to fall during the current collapse. Since peaking in 1Q 2006, the S&P/Case-Shiller national home price index has declined 21.2% relative to owners’ equivalent rent. Note that this drop has involved a 15.6% decline in home prices (measured from 1Q 2006, rather than Q2) and a 7.0% rise in owners’ equivalent rent. In order for the ratio to return to its average level of 2000, an additional drop (in the ratio) of about 17% is needed. Assuming about a 2% (cumulative) rise in owners’ equivalent rent in the next few quarters, an additional 15% decline in national home prices would be expected. At the Q1 rate of decline, the home price adjustment would be completed by year-end.

Of course, an overshoot is possible, and interest rate changes also complicate the picture. The calculations here are only suggestive, but they indicate that about half of the home price drop has already taken place.