A few months ago, I wrote about CoreLogic’s ability to measure the “gap” between current house prices and the levels supported by market fundamentals. The reason for doing this was because there had been a lot of discussion of the risk of another housing bubble in light of the large price gains in many markets in 2013. Some have recently argued that a bubble in housing already exists because the home price growth rate has substantially outpaced the rate of growth of rental prices. Since owning and renting are considered “economic substitutes,” the theory would be that a significant difference in pricing should draw more demand to the less expensive option, therefore driving up pricing and removing the significant difference. This constant reversion to equilibrium between the two substitutes means any significant difference must be due to irrational exuberance on the part of the homeowner or renter.
Yet there is another way to look at the value of housing. Because most homeowners use their income to pay for a home mortgage, there is an established relationship between income levels and home prices. In the long run, home price growth cannot be sustained above income growth because housing would become unaffordable, demand would decline and home price growth would either slow or decline to realign with income levels. It is also important to note that income levels vary dramatically across markets, directly influencing fluctuating home price levels . A million-dollar home in San Francisco is very different from a million-dollar home in Columbus, Ohio.
We can use this fundamental relationship between market house prices and income levels to forecast future house prices. In each market, the gap between the home price implied by the income level, the fundamental home price and the actual or forecasted house price is measured as a percentage of the fundamental price. A composite measure of house prices relative to fundamental prices can be constructed as a population-weighted average of the largest 50 market gaps over time. We noted before that by doing the analysis this way, one can clearly see that home prices got well ahead of what was fundamentally supported in the early aughts, and that there was a significant overcorrection. The figure has been updated to reflect data through the end of 2013 and provides a home price forecast through the end of 2015.
The undervaluation of home prices relative to incomes may seem like a surprising conclusion from this figure, yet the proof is there. Rising interest rates and the “unlocking” of pent-up supply as home prices continue to increase are expected to slow the pace of home price appreciation. At the same time, continued improvement in the economy will modestly increase income growth. The net effect is that home prices are expected to remain slightly undervalued relative to income levels through the end of 2015.
Judging whether home prices are becoming “bubbly” cannot be done simply by looking at the acceleration or deceleration in rental price change versus current home prices. Doing so misses the point made earlier that much of the recent house price appreciation is a result of market correction for the significant undervaluation caused by the price declines in the late aughts. Instead, analyzing home price levels relative to fundamental prices leads us to conclude that there is no need to fear a bubble for at least a few years to come, if at all.
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