Home prices are irrelevant!

So argues Willem Buiter, a well-known monetary economist, in his FT blog. Why? The answer is that people usually live in their own house, hence:

As long as your endowment is positive, your wealth obviously increases when the house price increases. However, an increase in house prices means that the present discounted value of future rents has increased. As a consumer of housing services, now and in the future, you are therefore worse off. On average, in a country like the UK, people consume the housing services they own. Hence an increase in house prices does not make them better off. For financial assets like equity there is no corresponding “present discounted value of future equity services consumption” whose cost increases whenever the value of equity goes up. An increase in stock market values therefore unambiguously makes you better off.

But as regards house prices, regardless of whether a change in price is due to a change in risk-free discount rates, in risk premia or in expected future rents, you are neither better off nor worse off as a result of that price change, if you consume, now and in the future, the same contingent sequence of housing services whose present discounted value is part of the wealth you own. In that case, despite the increase in your housing wealth, once you have paid for the consumption of your initial contingent sequence of housing services, there will be nothing left to spend on anything else.

Great! So today's news of deepening falls in house prices in the U.S. can be happily dismissed. Move along, nothing to see here.

Back to reality, this is one of the most striking examples of ivory tower airy-fairy thinking I've come across in a while.

Now, Mr. Buiter's argument hinges on house prices being equal to the present value of future owner-equivalent rents. This simply does not hold up in real life. Judge for yourself:



There are many reasons for this. But in essence it comes down to the fact that people believe housing is real wealth. How else can one explain the decline ins the personal savings rate to almost zero in recent years?

So, yes, house prices do matter. How much? We'll find out soon enough.

How low will house prices go?

According to an FT/Thomson poll of economists, median house prices will fall a total of 3% between 2006 and 2009. This is an unprecedented fall.

Unusually for the FT, the article is very confusing. Median house prices is a statistic put out by the National Association of Realtors, not the government as they imply. In addition, the figure they give on median house prices for 2009, 235 K, makes no sense, as it is substantially higher than current or past levels.

Anyway, the point stands. Of course, this is only one out of a series of house price measures (see my guide). For example, the Case-Shiller index has already posted a decline of over 3%.

Inexistent sales of existing homes

Forgive the exageration, but no amount of NAR (National Association of Realtors) spin could soften the grim existing home sales numbers published today. In July, sales fell 9% year-on-year, couples with a 0.6% fall in the median price of homes sold and a rise in unsold home inventories to 9.6 months supply (compared to 7.3 months in July 2006). Notwithstanding, these numbers were in line with market expectations.

To give some perspective, here's the annual series of existing home sales:



Clearly, this series has seen extraordinary growth, expanding at an annual clip of nearly 3% since 1987, far above population growth. How sustainable is this? I don't have a good answer, but a good starting point is adjusting those sales by population growth (existing homes sold per 1,000 persons).



Taking the latest figure, sales per 1,000 persons stand at 19. If they fall closer to the 14-15 level seen in the early 1990's, sales could still fall another 20% or so (maybe the equilibrium level is higher due to demographic and income factors, but there's bound to be an undershoot and this was another period with soft market conditions).

This ain't over yet.

Behind the numbers: House prices

House prices have never fallen since the government started keeping records in 1950, according to this NY Times piece. Actually, they have never fallen since the Great Depression, according to the National Association of Realtors. But they have, in the early 1990’s and since June 2006, according to the Case-Shiller composite index. Confused?

I am (and so is the Times, as they confuse the NAR and OFHEO measures, see below). This is not surprising. The various home price measures differ greatly in coverage and methodology. Here’s a handy guide to the main ones:

OFHEO House price indexes

Calculated by the Office of Federal Housing Enterprise Oversight (the folks who regulate Freddie Mac and Fannie Mae), this index starts in 1975 and has national coverage. It geometrically weighs changes in the price of single family homes on which at least two mortgages have been taken out and bought by Freddie Mac and Fannie Mae. These This helps ensure that the houses included have comparable characteristics over time, avoiding biases resulting from changes in the composition of sales.

It does have two main limitations. VA and FHA mortgages are not included, as are those that exceed the federal loan limit of $417,000. More info can be cound here.

Case-Shiller indexes

Methodologically, they're very similar to the OFHEO indexes (weighted repeat transactions on single family homes). However, they're based on transactions as recorded in county assesor and recorder offices. The geographic coverage is much more limited, as only the largest 20 metropolitan areas are included. It does have the advantage that it covers high-end homes. More info can be found here.

New Home Prices

Published by the Census Bureau, these prices are by definition not comparable to the previous two indexes, as they only cover new houses (a small part of the total real estate market). Information can be found here.

NAR Indexes

The National Association of Realtors publishes information on median and mean prices of existing homes sold (for both single-family houses and condos/co-ops), based on a sample of national transactions. It is subject to biases resulting from changes in the type of units sold and does not adjust for quality (comparable characteristics, as the C-S and OFHEO do by using repeat transactions). The methodology is presented here.

Summary

The Case-Shiller indexes seem to offer the most accurate measure of trends in house prices. However, it does have the drawback of having limited geographical coverage. OFHEO indexes don't have this problem, but the exclusion of high-value housing is a very big flaw. Lack of quality adjustments clearly makes the NAR median home price indicator a much inferior alternative. In the end, they're fairly complementary and should all be analyzed. The following graph shows that the NAR and OFHEO measures produce similar results that are very different from the Case-Shiller index.



This Fed paper (PDF) provides much more information on this topic.