Where should home prices be?

What are we to make of the recent increases in housing prices in the United States?  Is it a harbinger of a renewed surge in the real estate market and a possible, albeit as always short lived, revival of the overall economy?

I don’t claim to have the answer here, but I do think a reasonable case can be made that housing may be at the beginnings of a fairly strong upswing in prices.  I start by observing that the world in which we live continues operating in the neoliberal mode.  I take this to mean, among other things, that the laws of finance, capital, and property rule.  If true, we can make a few fundamental assumptions: 1) inflation will be low due to a lack of worker power; 2) real median income will not increase for the same reason; and 3) asset prices will tend toward a value determined by its capitalization at some “market” determined interest rate.

When it comes to housing, the third assumption assures that real income will not increase due to declines in interest rates.  The opposite is also true.  Any benefit to lower rates should be completely offset by higher home prices.  The cost of higher home prices isn’t borne by existing home owners, of course, but by those not in an ownership position.

Let’s observe the following graph (click on it for full size):

We start in 1985, a year solidly within the neoliberal era and comfortably after the decimation of the 1979 Volcker shock.  The graph presents data points at five year intervals.  The blue line shows us the Case-Shiller Home Price Index and we can easily observe the bubble around 2005 which is now showing a slight recovery.  How should we evaluate today’s level?  Is it reasonable?

At a first pass, it would seem logical to expect housing prices to remain at some constant multiple to nominal median household income.  This would assure no change in real income as the percent allocated to housing remains constant.  The red line illustrates this level, showing what housing prices would be if they increased from 1985 step by step with nominal median household income.  Comparing this income index to actual prices, we find that housing is overvalued by about 24%.

But in a neoliberal world of finance, this shouldn’t be the end of the story.  Mortgage interest rates, as reported by the Federal Housing Finance Agency, have dropped from a whopping 12.43% in 1985 to 3.49% today.  Since an average of about 75% of the price of a house is financed, we should expect housing prices to rise considerably given this drop in rate.  If they didn’t, then real income would increase considerably as new homeowners would be able to afford either a nicer house or would have more available for basic living.  The basic fundamentals of neoliberalism should prevent this.

The green line shows calculated housing prices since 1985 based on both the change in nominal median family income AND the decline in interest rates.  We start with the financed portion of the price (75%) in 1985 at the then existing 12.43% rate and then capitalize that interest outlay at the future lower mortgage yields.  What we find through 2005 is what should be expected – a narrowing of the spread between actual prices and the expected capitalized price.  The capitalized price, in fact, slightly exceeded the actual price before it collapsed in the current crisis.  But the spread between the two has widened significantly and the capitalized price is now well over twice the actual price.

I don’t think housing prices will double anytime soon since the Fed would certainly raise interest rates out of fear of a new “housing bubble”.  But even if mortgage rates increased to the level they were back in 2005, 6.07%, the capitalized value would still be 388, well above the actual 269.

This is a simplistic analysis but I think it does lead to an interesting conclusion.  I wouldn’t at all be surprised if our exit out of this crisis, like so many in the past, comes about through a new housing surge.  It will be temporary of course and the losers as always will be those who don’t own property.  Such is the way capitalism survives for another day.