Home prices still high in real terms

Using the S&P Case Shiller index for 20 major cities, US house prices in October were back at April 2004 levels and down 23% from their peak in July 2006. But bear in mind that October’s data is for deals agreed over the summer, mostly before the post-Lehman panic and the sharp deterioration in the economy. Deals being done today are likely at least another 10% cheaper though we will not have the data until the spring. The question is where might the bottom be? One approach is to look at house prices adjusted for consumer prices and ask how low house prices could go if they return to previous cyclical lows. Unfortunately, with consumer price inflation very low and falling, almost all of this adjustment will need to come from lower nominal prices. Assuming the market is today down 33% from the peak, (10% lower than the October level) there is potentially another 17 percentage points to go, which translates into about 25% off today’s level.

Some people question whether house prices need to go back down to previous lows in real terms. There are arguments that the average size of houses has increased (true) and that mortgage rates are lower (true) and that real incomes are higher (not really true in the US for the median family over the last 20 years). But long-term data compiled by Robert Shiller shows that the real house price in the US was on a flat trend between about 1950 and 2000, which suggests that expecting a return to prior cycle lows is perfectly reasonable1. Indeed there are several arguments which suggest that prices could even overshoot these levels on the downside; a reaction to the biggest US housing bubble ever, a response to the credit crunch which is making it hard for potential buyers to obtain a mortgage; and the serious problem of finding down-payments now. Time will tell, but analysis of the supply and demand picture is not encouraging for those looking for a trough in house prices soon.

Supply is still much too high

All the measures of housing inventory are still elevated whether measured in numbers or in relation to (admittedly) low sales. We can break out supply into foreclosures, completed new houses and owners seeking to sell. Foreclosures reached 2.97% of total mortgages in Q3 compared with a normal 1-1.5% and, despite government efforts to stem the flood, little has been achieved so far. More than 12% of sub-prime mortgages are now in foreclosure and the number of Alt-A mortgages in trouble is rising rapidly too. Recent figures showed that even where loans are modified (with lower interest rates and in some cases reduced principal) more than half of borrowers are delinquent again within 6 months. This is partly a reflection of the weak economy but is also because borrowers are reluctant to service a mortgage when the house value keeps falling. The supply of completed new houses is also still high. Although housing starts have recently fallen to low levels, the number of completions is still running at over 1 million, reflecting the natural delay. Also, even though most new houses are built to order, cancellation rates have been high in the last 2 years, leaving builders with inventory to shift. Both foreclosure sales and many new home sales are “forced” sales in that the bank or developer needs to sell. Some of the existing home inventory may not be “forced” and people may be reluctant to sell for low offers, so some of these house could come off the market, but then in many cases those people will stop looking to buy another house. Another statistic gathered by the government is the number of vacant homes for sale and this is running more than a million higher than normal. Some may be new homes and foreclosures but some are probably existing owners who have already moved out and need to sell.