One method used to evaluation residential real estate prices is the price-to-income ratio. Since people borrow the vast majority of the funds necessary to purchase residential real estate, and this borrowing must be financed from current income, the ratio of house prices to rent is a useful barometer of market valuation.
Since incomes and rents are closely related, evidence for the housing bubble that appears in the price-to-rent ratio also appears in the price-to-income ratio. National price-to-income ratios are quite stable. There has been a slight upward drift with the decline of interest rates since the early 1980s peak, but from the period from 1987 to 2001, this ratio remained in a tight range from 3.9 to 4.2. The increase from 4.1 to 4.5 witnessed from 2001 to 2003 can be explained by the lowering of interest rates; however, the increase from 4.5 to 5.2 from 2003 to 2006 can only be explained by exotic financing and irrational exuberance.
If national price-to-income ratios decline to their historic norm of 4.0, prices nationally will fall 9% peak-to-trough, bottom in 2011 and return to peak pricing in 2014. A 10% decline and a nine year waiting period would be difficult on homeowners nationally, but the magnitude and the duration will not be nearly as severe for most as it will be for homeowners in the extreme bubble markets like Irvine, California.
The volatility in price-to-income ratios caused by bubble behavior is clearly visible in the historic price-to-income ratios from Irvine, California. During the coastal bubble of the late 80s, in which Irvine participated, the price-to-income ratio increased from 3.7 to 4.6, a 25% increase. In the decline of the early 90s, price-to-income ratios dropped to a range from 4.0 to 4.1 and stabilized there from 1994 to 1999 before rocketing up to an unprecedented 8.6, a 115% increase. This new ratio was achieved by the extensive use of exotic financing, in particular negative amortization loans that rendered the new ratio inherently unstable.
If house prices in Irvine decline to the point where the price-to-income ratio reaches its average of 4.2, a ratio higher above this historic range of stability between 4.0 and 4.1, prices will decline 43% peak-to-trough, bottom in 2011 and return to the peak in 2029. The magnitude of this decline would be catastrophic to homeowners who purchased during the bubble. Twenty-four years is a long time to wait for peak buyers hoping to get out at breakeven.
Using the price-to-income ratio is a good predictor of the market bottom. The stability of the price-to-income ratio is more variable than the price-to-rent ratio, but it is still quite stable. The ratio deviates from its tight range only when irrational exuberance takes over a market. One such time was during the financial mania, the great housing bubble.
About the Author:
Lawrence Roberts is the author of The Great Housing Bubble: Why Did House Prices Fall?
Learn more and get FREE eBooks at:
http://www.thegreathousingbubble.com/
Read the author's daily dispatches at The Irvine Housing Blog:
http://www.irvinehousingblog.com/
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110
Date Published :
Jan 2 2009