Wednesday, January 02, 2008

Research: House Prices to Fall 15% or more

by Calculated Risk on 1/02/2008 07:59:00 PM

Added: Flipped Graph and added possible future paths (see 2nd graph)

From Morris A. Davis (Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison), Andreas Lehnert, and Robert F. Martin (both Federal Reserve Board of Governors economists): The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing

Abstract: We construct a quarterly time series of the rent-price ratio for the aggregate stock of owner-occupied housing in the United States, starting in 1960, by merging micro data from the last five Decennial Censuses of Housing surveys with price indexes for house prices and rents. We show that the rent-price ratio ranged between 5 and 5-1/2 percent between 1960 and 1995, but rapidly declined after 1995. By year-end 2006, the rent-price ratio reached an historic low of 3-1/2 percent. For the rent-price ratio to return to its historical average over, say, the next five years, house prices likely would have to fall considerably.
Rent Price RatioClick on graph for larger image.

Excerpt from Results:
If the risk premium to housing and the expected rate of growth of house prices were to return to their historical norms, we can use the rent-price ratio to gauge the size of the potential adjustment to house prices. Assuming nominal rents were to increase by 4 percent per year, about the average since 2001, a decline in nominal house prices of about 3 percent per year would bring the rent-price ratio up to its historical average, 5 percent, by mid-2012. That said, this is more of a back-of-the-envelope calculation than an actual forecast for house prices because we do not have a fully satisfactory model of the rent-price ratio.
This analysis assumes rents increase 4% per year, and house prices fall 3% until mid-2012 (a total of about 15%) If the price correction happened quicker, the nominal price drop would be greater (over a 25% nominal price decline if the correction happened by the end of 2009).

Price Rent Ratio This graph shows the Davis, et al., data plotted as a price rent ratio. The red line is the author's assumed path (a 15% nominal price decline through mid-2012). The green line is a 12% nominal annual price decline for the next two years.

If this bust follows the pattern of previous housing busts, the largest percentage price declines will in 2008 and 2009, followed by some smaller declines in the bubble areas for a couple more years.