Home Prices to Continue to Decline – When Will We Reach Equilibrium

Photo by gruntzookiIt’s been a long time since I’ve played economist. It really doesn’t take much training because all economists don’t really know how to predict the future. Economics is all about assumptions.

As we’re looking to buy a home in Seattle, WA, we’re finding that home prices are still expensive. There’s a big disconnect between listing price vs. actual value. I pulled data from the Standard and Poor’s Case-Shiller index. Lets assume that the methodology for developing the index is correct and a good representation of home values in Seattle (first assumption). My second assumption is that homes should appreciate by the rate of inflation. The real estate mantra is location, location, location. Prices in up and coming neighborhoods should in theory increase more than homes that are already priced in the demand for hot neighborhoods. As an investment vehicle, homes are suppose to track inflation in developed neighborhoods and in up and coming neighborhoods, prices should appreciate to reward investors for the risk. Thirdly, improvements to homes from remodeling, renovation, and enhancements should add equity to homes, but only as a fraction of the original investment.

If we focus only on the index and assume that the period between 1990 and 1997 is a good representation of normal growth, we can extrapolate the “correct” growth in home values. This is shown in the flow line below. The grey line represents actual home prices with the recent “bubble” in home values. When the bubble popped in 2007/2008, we see a sharp decline in home values. Macroeconomic factors such as joblessness rate, rising national debt, and expectations of increasing tax rates creates uncertainty. As uncertainty in the state of the economy increases, buyers are less likely to take on the risk of home ownership.

If we assume the blue line represents a more realistic model of growth in home values, home prices will need to either do two things:

1. Decline – the prices should drop until it reaches the support blue line and then track that line. The question is how fast will it drop and what artificial policies will be enacted to keep such a sharp decline. If the decline is too sharp, everyone will lose faith in the ponzi-scheme system and the system collapses.
2. Flatline – alternatively, home prices should stabilize and stay flat until it intersects the blue line. Based on my assumptions, this could take upwards of a decade to reach a stable price point.

A rebuttal to this model is that there’s only so much land and population increases will create demand. However, there are unforeseen alternatives. People could move. Technology allows people to be less location dependent. There’s no need to live central to the city for jobs. New housing policies could push for high density homes. There’s no specific reasons why home prices need to appreciate more than inflation.

In my future analysis, I’ll look at the impacts on generational changes (baby boomers retiring) and first time home buyers influx.

Disclaimer: The analysis presented above should be used for entertainment purposes. Please do not use it to make financial decisions. I am not a home owner and have financial interest in seeing home prices decline.