USA: Is Real Estate Expensive?

The real estate market is at the heart of the U.S. recovery. The rebound and reactivation of this market are clearly visible on the evolution of home sales. This is the chart below.
The rebound since summer 2010 is spectacular even if it does not compensate, far from it, the drop observed since the beginning of the crisis in 2006/2007. Specifically, the recent downturn reflects the impact of rising mortgage interest rates seen since the late spring.

USA-en-2013-december-Homesales
Former Fed Chairman Ben Bernanke had increased operations and support to this market in order to ease its recovery. At the last operation of Quantitative Easing, almost half of securities purchased (USD 40 of 85bn) by the Fed  was related to assets that  financed real estate (MBS). One of the objectives of QE was also to push mortgage rates at their lowest in order to facilitate its financing.

This strategy is based on the fact that if there is a wealth effect, it is on real estate rather than on financial assets. The reason is simple. The largest asset for the average American household is its house (the average household has few financial assets) Therefore if the real estate price goes up, the household will perceive himself as richer. This will relax his budget constraint so he will be able to reduce his savings rate. It may possibly even borrow using his home as collateral. For Bernanke, the wealth effect is a major source of recovery in consumption and growth of the U.S. economy.

However, after all these steps to enable the market, is the real estate price expensive?
The price in absolute terms does not mean much. It must be compared to another price. The easiest way is to compare property prices and household disposable income. This then gives an idea of the effort required for households to purchase a house.
The ratio of house prices to household disposable income gives a good idea of real estate price, excessive or not.
I took  the Case-Shiller real estate price index and calculated the ratio to disposable household income. In the first graph below I have taken the two Case-Shiller indices: One with 10 cities beginning in January 1987, the other with 20 cities beginning in January 2000.
usa-en-2013-december-realestateratioThe index is based on average 100 in 2000.
The last two real estate cycles can be observed on the chart. The first cycle was in the late 80s. The downturn occurred in the second half of 1989 and the decline of the ratio lasted until 1997. Prices had been depressed for almost a decade.
The rebound started in 1999-2000. The end of the internet bubble in the early 2000s had led to a reallocation of resources to an asset that was perceived as more stable.
This increase in the ratio lasted until 2005. The property prices had then become very expensive relative to household income.
For the Case- Shiller index to 10 cities (most important), the ratio stood at 160 in November 2005. Index for 20 cities’ highest point was reached in December 2005 to 145. The increase relative to disposable income was quite dramatic: 60 % for the first index and 45 % for the second compared to an income which itself grew.

The index then decreased almost continuously until the beginning of 2012 to 83 and 79.
In November 2013 the 10 cities index stood at 98.4 which is almost the price before the housing bubble. The index in 20 cities is even lower at 91.
The rebound from the low point in late 2011 is actually quite limited and there is room for significant improvement. The price could be higher because relative to disposable income, real estate remains a cheap and attractive asset.

To enhance the recovery of this market, it is necessary to facilitate the development of credit. Bernanke’s strategy on the real estate market went through the credit instrument. On the graph below we see that credit growth is a prerequisite for the rise in the relative price of real estate.
By purchasing MBS the Fed has reduced the large amount of financial assets coming from the pre-crisis real estate bubble in order to facilitate the development of new loans. This allowed boosting the market immediately without being penalized by the excessive behaviors of the past. Once again the Fed has acted as a lender of last resort.
usa-en-2013-december-realestate-ratio-debtIn view of the ratio, the real estate price is cheap in the United States at the end of 2013. It is less expensive than in 2000 when the property was then a neglected asset. But more funding are needed to push the price upward.
This calculation on a back of an envelope is still too general because there are many real estate markets in the US. The real estate price has not the same profile in Los Angeles and Detroit but disposable income does not look the same also in both cities. This is for another study to come.

One thought on “USA: Is Real Estate Expensive?

  1. Pingback: Real Estate Price in France – Two simple measures of dearness | Philippe Waechter's blog

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