The Dangerous Disconnect Between Home Prices and Fundamentals

The Dangerous Disconnect Between Home Prices and Fundamentals

Jul 09, 2007 -- Today's home prices can best be described as a recession in the making, but are most often referred to as a bubble. Prices have grown so much in the last decade that they are now completely disconnected from the fundamentals that have historically ruled the real estate market. Today's prices are not sustainable and the graphs and analysis below demonstrate why.

By Ben W. (bdarbs)

The Disconnect Between Wages and Home Prices

Price increases are nothing new, since home values tend to go up over time. What makes this housing bubble different (besides the fact that it is the largest bubble in U.S. history) is the dangerous disconnect between home prices and the basic fundamentals that typically rule the housing market.

For example, increases in home prices typically keep pace with increases in wages. But this has not happened. National median home prices have increased by more than 45 percent in the last decade (when adjusted for inflation). Average wages per worker, on the other hand, have only increased by 10 percent in the same period.

As a result, for almost the first time ever, individuals who are making the median household income cannot afford to buy a median priced home.

In order to qualify buyers for loans, lenders loosened credit regulations and encouraged risky mortgage products like interest-only loans, negative amortization loans and ARM loans. This made it easier to get a mortgage, but admittedly much harder to keep it.

In recent years, a large portion of the buyers bought out of their price range. In many cases, their loan qualification was based on a teaser rate and/or an interest-only mortgage payment. Now that the interest rate is due to reset on these loans, millions will not be able to afford their mortgage and will likely lose their homes to foreclosure.

The Disconnect Between Rents and Home Prices

Also disconcerting is the disconnect between rents and home prices. At one point, the only thing that stopped most people from buying versus renting was lack of a down payment. Sure, it cost a little more each month to buy - but not much.

But thanks to the housing boom, everything has changed. Home price increases have far outpaced rent increases, rising 45 percent in the last ten years. In the same time period, rents, like wages, increased by only 10 percent.

Nationally, it now costs 60 percent less to rent than it does to buy. But for some reason, this hasn't stopped people from buying. Between 1995 and present day, the homeownership rate has soared. In contrast, the number of people who rent has declined for the first time since WWII.

Since we already know that rising wages and lower home prices were a factor, the increase in homeownership can be easily traced back to the lenders who loosened credit and mortgage lending restrictions. Thanks to these lenders, buyers who would have never stood a chance of getting a mortgage just a few years ago were now being approved for outrageous amounts of money.

(Of course, there is one other thing that may have encouraged people to buy during this time rather than rent: low interest rates. In a move that has been heavily criticized by some, the Fed began dropping interest rates after the bursting of the tech bubble. Low rates made it easier for people to qualify for high-priced homes, and also encouraged buyers to 'act now before it's too late'.)

See more rent vs. buy analysis here:

The Disconnect Between Home Prices and Home Sales

Although the disconnect between home prices and home sales was not present during the housing boom, it most certainly is now. The public has either lost interest or simply can't afford to buy into the current housing market. Home sales have slowed nationally, and are down significantly in cities within California, Florida, Nevada, Michigan and Ohio.

As a result, supply has now exceeded demand in most areas. It would take several months, and in some cases years, to sell all of the homes that are currently on the market. Yet, home prices are staying level for the most part - for now. If sales do not pick up soon, home prices will most definitely begin to fall.

Why is the Disconnect Between Home Prices and Fundamentals Dangerous?

Just ask Japan. The country experienced a similar housing boom in the 1980s and is still reeling from the damage caused when the bubble burst.

Almost every circumstance leading up to the Japan housing crash has been present in the U.S. during the last decade:

• Historically low interest rates
• Housing touted as a 'can't miss investment'
• Average home prices doubled
• Average home prices in the six largest cities tripled
• Lenders offered bad loans
• Government acted as a partner to industry
• Home price increases far outpaced wages and rents

After reaching peak values, Japanese home prices declined by an average of 40 percent. In the country's largest cities, the declines were worse, averaging 65 percent. Homes in Tokyo lost 80 percent of their value and are still on the downward slide to this day.

If you are wondering what will happen in the U.S. when the disconnect between home prices and fundamentals finally becomes too much and knocks the knees out from under the housing market, take a look at the chart above.

The changes that have occurred in the U.S. housing market in the last decade aren't much different than the changes that occurred in Japan's boom market. Home prices have doubled nationally. Prices in bubble states like California--where some of largest cities are also located--have almost tripled in the last 7 years. When you compare the U.S. chart (shown below) with the Japan chart (shown above), the similarities are clearly visible.

Note: We are compiling the data for the six largest U.S. cities to also include in this graph, so the graph below currently only represents the U.S. national average home price (equivalent to the bottom pink line in the Japan graph). We expect to have the new graph up soon, so please check back.)

When the crash occurred in Japan, prices fell to pre-boom levels. It is not at all unreasonable to think that home prices in the U.S. are about to do the same thing.

To learn more about the housing bubble and stay on top current housing market events, please read our daily housing bubble news here.