Calling the Bottom

by Osman Parvez

The New York Times recently ran a story on how economists calculate the state of the housing market. The article focused on methods for determining over or under valuation, in an effort to indicate where the bottom lies.
Models built on these variables show that while some markets – such as California – are on a road to recovery, others – such as south Florida – have a way to go.

These signs cannot possibly tell the whole story, especially since they point more toward where prices should be valued than where they will be. But these measures are nonetheless helpful to anyone buying, selling or borrowing against their home sweet home.

“Anybody who says they know when it’s going to end with confidence is delusional,” said Karl E. Case... “But yes, you can get a sense of where things are going.”
Despite the obvious flaws to these models, I thought it might be helpful to discuss them briefly and suggest a few sources for more information. Should you decide to do the analysis, most of the data needed can be found within this blog.

The first model takes a look at the price-to-rent ratio, the cost of owning relative to renting. This is a common method, but it's often argued that renting isn't a direct comparable to owning. Rental property conditions can often be subpar. Raising a family in an apartment is quite a bit different than raising a family in a home. There are emotional factors. Plus, the impact of large numbers of student rentals in a community like Boulder also tends to skew things. The typical rule of thumb that student landlords use is $500-550/bedroom, minimum. It goes up from there based on location and the quality of the property. Non-student rentals run an equally wide range of prices, mostly dependent on location. For polling rental prices, Craigslist is your friend. If you're simply trying to figure out whether you should buy or rent, try using our model.

The second method examines per-capita income – to see if people can afford the homes they are living in. In 2005, the median income for a 3 person household in Boulder was $78,300 (source: City of Boulder). This is substantially higher than surrounding areas. High unemployment has a large effect on this model. As of June, unemployment in the Boulder MSA was 4.7%, compared with 5.7% nationally (source: BLS).

The third model in the article is based on appreciation rates. For your research on this, I suggest looking at the research index. Both the Basic Home index and the Luxury Home index will give you the longer term trend for appreciation rates in Boulder. Take your assumed base rate of appreciation and project out from a historical date, say 2002. The gap, if any, will tell you how far the market has to fall.

Unfortunately, these models don't take into account today’s mortgage rates. The Columbia Business School’s newest, unpublished analysis, attempts to account for this. According to preliminary results, Denver comes in at 5% overvalued. Compare that with Phoenix or Miami, for example, which both come in at 13% overvalued. The study says that Detroit is 12% undervalued.

In addition, a relationship to consider is the inventory-to-sales ratio, a measure of absorption. This is possibly the most unbiased model, based directly on supply and demand. It's also the statistic most discussed in this blog. We publish an updated analysis each month, for most cities in Boulder County. It includes a chart for inventory-to-sales.

Now before you get carried away with all this analysis, let me remind you of one thing. There is no crystal ball in real estate. Attempts to call the bottom or the top are generally met with failure. Those that manage to do it with any accuracy are lucky, not necessarily smarter than the rest of us.
…some experts argued that it was silly to try to build a mathematical model for the market’s overvaluation. Too much is unknown, they say, to make any predictions.

“I try to avoid house price forecasting,” said Paul S. Willen, senior economist and policy adviser at the Federal Reserve Bank of Boston. “Let me just say this, as an economist, that asset pricing is something we’re exceptionally bad at.”
research assistance: Evan
image credit: Justin

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The ideas and strategies described in this blog are the opinion of the writer and subject to business, economic, and competitive uncertainties.   We strongly recommend conducting rigorous due diligence and obtaining professional advice before buying or selling real estate. 

Please Note

This document contains forward-looking statements. You are strongly cautioned that investment results are subject to business, economic and other uncertainties. There are no guarantees associated with any forecast and the opinions stated here are subject to change at any time. Always consult your financial advisor before making an investment decision.