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For a long time I’ve been making graphs that measure San Diego home prices in comparison with both local incomes and rents. While there are obvious limits to cramming an entire county’s worth of diverse housing stock into a single metric, I think these graphs are an important because they provide a first swipe at determining whether the San Diego housing market as a whole is cheap, expensive, or somewhere in between.
As of year-end 2010, the answer was most definitely “somewhere in between.”
The following graph shows a historical plot of San Diego County’s home price-to-income ratio — the value of a typical San Diego home (as measured by the Case-Shiller index) divided by the county’s average income.
According to the price-to-income ratio, San Diego housing in aggregate is now slightly undervalued at 5 percent below the long-term median price-to-income ratio. (By “long-term median” I am referring to the midpoint of all monthly price-to-income ratios since January 1977).
The price-to-rent ratio — calculated by dividing the typical home price by the average San Diego rent — is a little above its historical median, but only barely, by just 1 percent.
These divergences from the median ratios — 5 percent below and 1 percent above — are quite small in the scheme of things. At the peak of the bubble, for instance, the price-to-rent ratio was 82 percent above its median! So on the whole, these ratios are telling us that San Diego homes are, in aggregate, right at their fair value based on historical relationships with rents and incomes.
While home prices may be middle of the road, mortgage rates are ridiculously low. As a result, the ratios of monthly payments to rents or incomes are very near all-time lows. The payment-to-income ratio (which is calculated like the price-to-income ratio above, but uses the typical San Diego home’s monthly payment rather than its purchase price) is 39 percent below its historical median:
And the payment-to-rent ratio is 32 percent below its median:
Monthly payments are certainly near rock-bottom levels in terms of their historical relationships with incomes and rents. People sometimes intrepret this fact as an indication that San Diego homes are underpriced. This is not correct. The level of mortgage rates does not dictate whether homes are expensive or cheap — purchase prices do. This is borne out by logic (interest rates fluctuate all over the place, so they shouldn’t be considered when calculating long-term sustainable price levels) and by the historical data (price-to-income and price-to-rent ratios have tended to converge onto their median levels throughout vastly different interest rate environments).
When it comes to predicting the future path of home prices, we should look to the price-based valuation ratios (the first and second graphs). There is an inexorable pull to the center in these ratios — a “reversion to the mean,” as we numbers nerds call it. When the ratios get too high, they want to go lower, and when they get too low they want to go higher. This is exactly what we would expect, because moves away from the center in the price-to-income or price-to-rent ratios indicate that housing is becoming either too expensive or too cheap in comparison with the fundamentals. And markets always come back to their fundamentals eventually.
Right now the price ratios tell us that there is effectively no pressure, either upward or downward, coming from valuations. There are other factors that could affect home prices going forward, such as employment, economic growth, the foreclosure backlog, and the potential for an interest rate spike (while mortgage rates don’t dictate sustainable price levels, sufficiently large rate changes could certainly impact valuations in the short term). But there is no pressure coming from reversion to the mean, because valuations are at the mean already. This is good news in that there is no dangerous overvaluation to contend with as there was in the mid-2000s; it’s bad news in that there is plenty of room for valuations to decline should other market factors turn more negative.
The payment-based ratios (the third and fourth graphs) don’t tell us much about valuation pressures, but they can tell potential home buyers how much they would be paying on a monthly basis were they to buy with a mortgage right now. When we consider that the median historical monthly payment has, compared to incomes and rents, been roughly 50 percent higher than it is right now, the answer there is “not much.”
Thus, despite the facts that San Diego homes are not particularly inexpensive, and that further home price declines are very much a possibility, it could potentially make a lot of sense to buy a house right now if certain conditions are met. But that is a topic for the next article.
Please contact Rich Toscano at rtoscano@pcasd.com and follow him on Twitter at http://twitter.com/richtoscano.