How to Know When Your Home is a Good Investment

Why do prices go up and down?

Every high school economics student learns the Law of Supply and Demand, and it goes something like this:

Price = demand / supply

Strictly speaking, that equation isn’t right. By the time students get to Econ101 in college, they learn that demand and supply are curves and it all gets more complicated and the price is found at the intersection of these two curves and it gets so abstract so fast that most students just assume that they’ll never understand it, or it must be wrong.

Most of it is wrong.

It turns out that economics, unlike rocket science, is complex. So we can’t make predictions about prices in the same way that scientists can tell you when the next lunar eclipse will occur, or how to land a vehicle on Mars. There are just too many moving pieces in an economic system to make accurate price forecasts.

For most people, the biggest, most important purchase they will ever make is their home. Mortgage markets sometimes allow you to borrow 95% of the home purchase price (sometimes more), and that’s a lot of leverage. For some people, price appreciation of their home results in a big windfall of dollars when it’s time for them to sell. For others, price depreciation results in an enormous loss. So it would be great if economists could tell you, before you bought your house, if prices were going to go up or down.

They can’t.

And neither can real estate agents, who make money in both up and down markets (but generally do better in up, because they still charge commissions calculated as a percentage of the overall transaction). So most financial advisers will tell you not to bother with trying to figure it out. They’ll say something like, “Don’t buy more house than you can afford. Purchase a home because you want to live in it, not because you think you’re going to get rich owning it.”

Or, just rent. Because that’s another way to go.

The Federal Reserve Bank of St. Louis recently published an article that claims “Income Determines House Prices.” They compared the S&P/Case-Shiller home price index for San Fransisco to the per capita income data and found that higher incomes are correlated with higher real estate prices. They also considered that maybe population changes might influence prices, because it stands to reason that if more people move into San Fransisco, then maybe the demand for houses will go up, and prices will too. But that didn’t turn out to be the case.

What’s most important in determining real estate prices is how much money people have to spend on real estate.

The Fed thesis is captured in a ratio called the Housing Affordability Index, which is published by the National Association of Realtors. The last 12 months of data are publicly available on the FRED web site, and for Phoenix AZ it looks like this:

Figure 1. Housing affordability index for City of Phoenix, Arizona. Lower values indicate that homes are less affordable, while higher values indicate that there are more people who have enough income to qualify for the mortgages necessary to buy homes.

Right now, the index is at about 54, which mean that your typical (i.e., median) family in Phoenix has only 54% of the income they need to qualify for a typically (i.e., median) priced family home. That might sound to you like there aren’t many buyers left, because where the heck are families going to find the additional income they need to buy a house? And maybe you’d think that, until house prices or interest rates come down (or incomes go up), real estate in Phoenix is going to be a poor investment.

The problem with this reasoning is that mortgages are not the only source of funds that people use to purchase homes. Lots of buyers already own homes, and when they have equity in their existing homes, they can sell the home they’re in and use those funds to reduce the size of the mortgage they need to buy their new home.

As strange as it sounds, the historical trend of real estate prices is an important factor in determining the future direction of real estate prices.

Complex systems theory would call real estate pricing a positive feedback loop, meaning that higher prices go, the more pressure there is for them to go higher.

Until they don’t, because it is the nature of a positive feedback loop to accelerate the down trends, too.

Figure 2. The S&P/Case-Shiller Home Price Index shows that Phoenix real estate prices still haven’t recovered to their 2006 levels.

The peak of the Phoenix housing market came in 2006, before the collapse of Lehman Brothers and Bear Stearns in 2008 — almost two years before the onset of the Great Recession. Right at the 2006 peak, both per capita incomes and home prices were still rising… so what could have brought the market down?

Figure 3. increasing home prices depends on increasing home prices. Until they collapse.

As it turns out, the positive feedback loop that feeds itself depends on faster and faster growth in prices. This is the definition of a “bubble,” and once that rate of growth begins to slow, as it did in late 2006, the whole system can no longer rely on price appreciation to fuel demand. The market has to be supported by incomes, rather than the increased equity in existing homes. And by 2006, prices had moved up so much faster than incomes that there weren’t enough buyers left to support the inflated prices.

Figure 4. A positive feedback loop graph increases exponentially over time… until it collapses.

That’s when the bubble pops, and price collapse ensues (Figure 4).

The data in Figure 5 takes a longer-term look at housing affordability. Unlike the Housing Affordability Index from the National Association of Realtors (Figure 1), Figure 5 uses data made available by the Federal Reserve to divide per capita income in by the S&P/Case-Shiller home price index (both for the Phoenix metropolitan area). This ratio isn’t tied to median incomes or median prices. It sums up the whole market.

Figure 5. A longer term look at housing affordability that divides per capita income by the S&P/Case-Shiller home price index. The troughs indicate when homes are least affordable, and represent a bad time to buy.

Figure 5 gives us a sense of how much per capita income is available in the city, relative to home prices. When the graph dips, we can expect a shortage of demand, because there is less income available in the city to pay for higher home prices. When the graph peaks, we know that there will soon be plenty of buyers in the market with the ability to purchase homes.

According to Figure 5, the market in Phoenix at the end of 2016 was right about as affordable as it was in 2001, after the burst of the dot-com bubble. (The 2017 personal income data has not yet been published by the Federal Reserve, so Figure 5 is a little bit out of date already). Compared to the last twenty years, the market at the end of 2016 looked neither over- nor under-valued. That’s not a compelling reason to buy a home, or a rental property, as an investment, but it shouldn’t have discouraged buyers that are hoping to get a fair price for a home they want to live in for awhile.

However, since 2016 we can see that prices in Phoenix have continued to go up (Figure 2) and housing affordability as measured by the ratio of median incomes to median prices has turned down (Figure 1). Further home price appreciation in Phoenix, if it’s going to take place at all, will have to be fueled by the equity effect — i.e., home buyers who are using the equity they’ve accumulated in their existing homes to help them qualify for mortgages they use to purchase new homes. But we can see from the S&P/Case-Shiller index (Figure 2) that even in 2018, Phoenix home prices have yet to recover to their 2006 levels. That means some homeowners in Phoenix may still owe more on their mortgage than they can get from sale of their homes — even after 10 years of making payments. To get the positive feedback loop from equity to really kick in, we’ll need to see prices rise higher still.

The most recent monthly report on existing home sales is discouraging.

With sales (demand) down, inventories (supply) up, and interest rates rising, further gains in home sales will have to be fueled by rising personal incomes, or the entire positive feedback loop of home prices may come crashing down (again).

The latest Case-Shiller data (July 2018) indicates that prices are still rising in US metro areas, despite the headline. The problem, according to the article below, is that incomes are rising at slower rates than prices — meaning the fuel for further market gains is running out.

Figure 6. The 2015 movie ‘The Big Short’ dramatized the 2007–2008 collapse of the US housing market, and the default of mortgage lending companies.