Are Houses Finally Cheap?

A handful of early signs suggest America’s housing market is on the mend. Construction starts and new house sales were up nicely in June. Prices rose from April to May, the first monthly increase in nearly three years.

Time to buy, then? Perhaps, but be cautious about how and where you shop.

I’m no evangelist for the financial merits of homeownership. Two years ago I argued here that house prices in the U.S. had grown so bloated that renting had become a better deal than owning. Since then, prices have plunged 30%, or about 36% after inflation. Nationally, they still seem too high, as I’ll show in a moment, and May’s gain could prove illusory -- SmartMoney’s Aleksandra Todorova points out that it disappears after adjusting for seasonality, and that the numbers probably got a temporary boost from government freezes on foreclosure proceedings.

Still, a handful of major markets now look affordable, and all of them are closer to sane.

Before you look at Table 1, allow me to try to convince you of something: Houses are ordinary goods. They’re wood and stone and metal and plastic, and not much else. They don’t spend their days dreaming of ways to become more valuable. They just sit there. Such being the case, house prices over long time periods should track inflation, which is, after all, a rise in the price of ordinary goods (or a drop in the value of the money that buys them). To nitpick, house prices should actually lag inflation by an almost imperceptible amount, since houses aren’t consumed like oil and aren’t as durable as gold, but rather decay like cars, only much more slowly. Yale economist Robert Shiller studied house prices from 1890 to 2004 and found they outpaced inflation by just 0.4 percentage points a year. That’s a small enough difference from zero to be attributable to the crudeness of early data, to bubbly 2004 prices or to government-created demand shifts along the way, such as down-payment subsidies, tax incentives for those who borrow to buy houses and so on.

Table 1 shows the race between house prices and inflation since 1987. Houses behaved like ordinary goods until around 2000. That year the Federal Reserve began a three-year campaign to reduce core interest rates from 6.5% to 1%, which brought mortgage rates down, too. A giant bubble ensued. Encouragingly, house prices are now converging on the inflation line, where they would have been without the bubble. For the two lines to rejoin, house prices don’t necessarily have to fall further. They could flatten for a couple of years and let inflation catch up. (Of course, they could also overcorrect.)

House buyers perhaps don’t care about the historical relationship between houses and inflation. They care about whether they can afford their mortgage payments, and about whether buying is a better deal than renting. The National Association of Realtors publishes an affordability index that says terrific things about buying houses now, but to use it is to take buying advice from people who are paid to sell. I prefer to roll my own.

Table 2 shows the trend of two price ratios since 1987. The blue line is the ratio of house prices to rents and the red dots show the ratio of house prices to median household incomes. Income figures are only available through 2007, so I gave America a 3% raise for 2008 and another 1.5% increase for 2009 through May. (Don’t think I haven’t noticed how hard you work around here.)

The two trends track each other closely because neither rents nor incomes has done anything exciting since 1987. The chart movement is dominated by changes in house prices. Again, we see a bubble, a bust, and the approaching -- but not quite reaching -- of a normal level of affordability.

In April 2007, when I wrote my rant on renting, there was little reason to compare local markets. So out of whack were prices that just about everywhere within an hour’s drive of a big city was a bad deal. Now, however, things are mixed.

Table 3 shows price/rent ratios for six markets -- ones for which local price and rent data were available for each month since 1987. The lines are a bit crowded, but two trends are clear. First, some are shifted higher than others over the whole period. That suggests that Miami residents, for example, can generally get a good deal on rent relative to house prices, while San Francisco residents (who pay dearly either way) might as well buy.

Second, some of the lines have plunged harder than others of late. For those who wish to buy in Chicago, Miami and San Francisco, there's good news: The froth seems to have been let out of the market. Meanwhile, New Yorkers, Bostonians and Angelinos might want to wait. Of course, averages are just that. Careful shoppers can find good deals in expensive markets, while imprudent ones can overpay just about anywhere.

Renters, take heart. I’m still one of you. I’m not shopping yet. Prices aren’t at once-in-a-lifetime lows. They’re returning from (hopefully) once-in-a-lifetime highs. But for those for whom the pride of home ownership beckons, the payoff might soon be calling, too.