Thursday, October 25, 2007

How Far Will Housing Prices Fall?

I often get asked "How far will housing prices fall?"

And I say "about 25%."

The reason I say that is because, unlike pretty much every other estimate I've seen that speculates on the future drop in housing prices, is that I actually have some research that would back it up. And that research is based in the simple concept of house price to rents or house price to incomes. Meaning, that housing prices tend to stay withing a certain multiple of the rents that could be plausibly be gotten from renting out that house or the incomes of people that buy the house.

Historically, houses have "traded" at a multiple of 17 times the rent they could have been rented out for. However, with the new and creative financing methods, allowing people who should have never been loaned money in the first place to (as I like to say) "rent their house from the bank" this artificially and temporarily increased demand for housing, driving the average house price to rents to 30. This would imply a nearly 45% devaluation in the future, but not all that increase was due to fleeting ARM and interest only loans. Some of it was due to long term interest rates dropping and therefore the price increase would be a bit more sticky on the way down, once the sub prime mess is cleansed from the system.

Similarly is house price to incomes. Incomes being the median income of the average US Joe. Normally houses traded at around 3.25 times a person's median income, jumping to nearly 4.75. This implies a nearly 33% drop in housing prices must occur in order to come back in line with historical averages. And seeing housing has already dropped 5%, I'm thinking another 25% would do the trick.

I'm just wondering if those banks, in all of their wisdom and genius, can handle a 25% drop in value of their collateral...actually, I don't wonder.

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