How Far Might Housing Prices Fall?

Our original thesis back in May 2005 was that Home prices could retrace as much as 25%-35% from the peak to re-establish a normalized pricing.

Now, a new study shows exactly how and why that might occur: Home Price to Rent Ratio:

"U.S. house prices "likely would have to fall considerably" to return to a normal relationship with rents, says a study by one former and two current Federal Reserve economists.

Home_prices_rentThe study, which doesn’t necessarily reflect the views of Fed policy makers, suggests prices would have to fall 15% over five years, assuming rents rose 4% a year. House prices would have to fall further if the adjustment took place more quickly.

The study tracks rents and home prices back to 1960 and found annual rents fluctuated at around 5% to 5.25% of home prices until 1995. At the end of that year, the average monthly rent was about $553 (or about $6,600 a year) and the average home price was about $134,000.

But starting in 1996, home prices started to grow much more rapidly than rents. By the end of 2006, they had more than doubled to an average of $282,000, while the average rent had risen 48% to $818. That drove the annual rent/price ratio down to 3.48%.

That means the rent/price ratio is about a third below its long-term average. To return to normal would require some combination of falling prices and rising rents. The paper suggests house prices would need to fall about 3% a year, if rents grew in line with their 4% average annual growth this decade."

That’s a pretty hefty pull back over time, especially on an inflation adjusted drop.

Note: The study was authored by Morris Davis, an economist at the University of Wisconsin-Madison and until 2006 a staff economist at the Fed; and Andreas Lehnert and Robert F. Martin, staff economists at the Fed.

The PDF of the study can be found here:  The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing.


Home Prices Must Fall Far To Be In Sync With Rents
WSJ, January 3, 2008; Page A2

The Rent-Price Ratio for the Aggregate Stock of Owner-Occupied Housing
Morris A. Davis, Andreas Lehnert, and Robert F. Martin
Department of Real Estate and Urban Land Economics, University of Wisconsin-Madison
Federal Reserve Board of Governors
December, 2007

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What's been said:

Discussions found on the web:
  1. Francois commented on Jan 3

    If reversion to the mean follows its usual pattern, the rent/price ratio will have to RAISE a significant amount above its long-term average historical average.

    Maybe Krugman et al. are right: a 30% house prices drop from its peak would be in the ballpark of the possible.

    Aaaah! The beauty of unregulated free markets at work. It adds a spice to daily life.

  2. D. commented on Jan 3

    I can’t believe we’re actually talking about the rent/price ratio again. Just a few years ago it was thrown out the window.

    I guess I’ll never understand why we throw out long used ratios in the first place. If we actually held on to them throughout the entire cycle, bubbles would not emerge.

    Often these ratios are economic equivalents of the law of gravity yet I don’t see many throwing out this law when it pleases them.

  3. m3 commented on Jan 3

    i think the way to stave off a huge collapse in home prices is a dramatic surge in rents.

    if rents rise fast enough, people will be forced to consider homes as an option.

    and it’s happening now. where i’ve looked, rents are up ~7%-8% yoy. i was considering selling my condo, but at the rate rents are rising, in a year or two my mortgage will be CHEAPER than the average rent!

    also, the fact that actual rent isn’t in the CPI means that real rents could go through the roof, and not affect the CPI in any meaningful way.

    just my $0.02.

  4. matt wilbert commented on Jan 3

    Gravity works faster than reversion to the mean.

  5. 2and20 commented on Jan 3

    nice how they try and paint the picture of a slow correction. never happens like that, if something is over-valued, it’s gonna go down quick til it gets to the right price.

    if the nasdaq had dropped 8% a year from march 2000 til now, it would be “fairly valued”. however, it dropped 70% in 18 months before beginning a climb back up.

    calling a 30% property fall seems pretty reasonable to me, might even turn out conservative!

  6. Marcus Aurelius commented on Jan 3

    We’re going to try to inflate our way out of the current national/personal debt spiral. After all, what’s a $750K average house when the effective minimum wage is $80K annually? I doubt wages will keep pace. Now, instead of careening down the mountainside in our recently, but no longer, shiny new sports car, we’re going to be careening down the mountainside upside down and backwards.


  7. Patrick commented on Jan 3

    With all the excess housing inventory isn’t anyone concerned there will be downward pressure on rents?

  8. Ragnar commented on Jan 3

    I doubt rents will keep pace with the 4% annual increase. That pace is only sustainable if incomes continue to rise significantly. Incomes won’t rise in an atmosphere of widespread unemployment and possible deflation.

  9. Sean commented on Jan 3


    Here’s something to consider.

    Current Average Annual Rent = 818 x 12 = $9816

    Current Fair Average Home Price = (1/5%) x 9816 = 20 x 9816 = $196K.

    1) The average home size has increased substantially over the years, and with mroe upgrades. Therefore I wonder if the average home price should be higher than $196K. Say adjusted size home price is $210K

    2) Rent increment of 4% going forward. I wonder if this is going to happen on a National basis. There are too many inventories now, and many more are coming due to foreclosures and ARMs. Many empty houses are for rent at a discount (cheaper than owning, as I read in many housing bubble blogs) instead of selling.

    Therefore, assuming no rent increment, and adjusted for home size, fair price should be $210K. Since market adjustment will not smoothly revert to mean, say the price will undershoot the fair price for a fair amount, that means we will likely see something like $190K.

    $190k/$282K = 67.4%, which means house prices will fall 33% easily, assuming no inflation going forward.

  10. zackattack commented on Jan 3

    Japan was 35%, top to (so far) bottom, lumping residential and commercial together.

    Many differences between those two, of course.

    But that’s my operative model. We’re not in 1990 USA; we’re in 1994 Japan. I’ve seen nothing to dissuade me from that view.

  11. comma8 commented on Jan 3

    Here in the Milwaukee metro – housing started to fall apart when the fixed mortgage rate bumped a percent, coupled with wild “profit taking” by the municipalities on equity appreciation. A lot of folks got hit with $300+ monthly incremental overhead right there. No speculators involved there at all.

    On a per 100k basis, a bump of 1pct on a 30-year fix costs buyers about $10k in spending power.

    $100 a month in increased property tax, common here the past couple years, costs you between $15k and $17k in buying power based on rate.

    I guess what I’m saying is that I don’t buy this slowdown as being symptomatic of free markets at play – a portion of the slowdown was engineered and the other was a unintended consequence of municipal spending gone wild. In the end, buyers who are buying money based on affordable monthly payments are finding that they can’t get as much money for principal when the added interest and municipal fees come into play. Less principal, less house – and we have stalemates with sellers trying to get 2005 pricing for the home itself (sometimes due to necessity as equity is leveraged to the max). Buyers are waiting or searching for affordable prices while sellers need to get 2005 prices on their homes. It’s really one heck of a market.

  12. groucho commented on Jan 3

    “With all the excess housing inventory isn’t anyone concerned there will be downward pressure on rents?”

    There already is in the post bubble areas. Even here on Long Island, “For Rent” signs are all over the place. I have never seen anything like it in this neck of the woods.(working class areas, not Hampton summer rentals)

  13. jkw commented on Jan 3

    I could believe that nationally, there will only be a 30% correction. But in the bubble markets, we are likely to get a 50% correction as a minimum. And that is assuming that the housing slowdown doesn’t lead to a recession. If we get a recession, the bubble zones are likely to see prices fall more than 70%. Which will bring them back down to where they were around 2000. Contrary to what many people are saying, now is not a good time to buy a house.

    The other possibility is that we will get large amounts of wage inflation, and house prices will merely stagnate. In order for this to work, we need inflation on the order of 10-20% a year, without going into hyperinflation. That would be a very delicate balance and a very dangerous move for the Fed to try to engineer. It is probably better to just accept the huge losses that American homeowners are facing.

  14. hpov2000 commented on Jan 3

    Serious question:

    How can Fed/Government cause wage inflation?
    In non-union situation, there is almost no way to force employer, correct?

  15. VJ commented on Jan 3

    In my recent experience, the banks and realtors had both been in SEVERE DENIAL as to the value of their properties, particularly REOs, but with their inventories mushrooming, the banks are now recognizing reality.

    Most realtors, however, are still hopelessly in LA LA land.

  16. david commented on Jan 3

    Isn’t the median price ~$210K now? Assuming price/rent drops back to “normal,” then a 190K is “normal” and that’s just a 10% drop.

  17. NC Jim commented on Jan 3

    Perhaps the “rents go up as prices come down until the historical balance is restored” model is an adequate analogy for the economy as a whole with rents=inflation and prices=deflation.

    If you assume the 4% rent increase to be inflation then the real price decline in the example is: (15% + 5*4%) = 35%

  18. JKB commented on Jan 3

    “How can Fed/Government cause wage inflation?
    In non-union situation, there is almost no way to force employer, correct? ”

    By raising minimum wage laws, decreasing the 40-hr workweek, letting contracts with wage schedules over market rates, and last but not least, wage and price controls, a la Nixon.

    Also, don’t forget that a large portion of wage compensation is in the form of medical and other benefits. An mandated employer insurance coverage would be a de facto raise in pay

  19. ef commented on Jan 3

    How does the average work when you have New York City verses some small municipality say in Mississippi, Alabama, Arkansas, etc. We ought to know that the US isn’t homogeneous. One realtor discouraged me from looking at the west side of our state because home prices hadn’t changed in decades and he suspected that wouldn’t change. That seemed like a great incentive to buy – something affordable for the long-term. Property taxes, insurance, and maintenance costs would be maintainable. I think where we are headed is a two-tiered economy, and these numbers aren’t much use to the rich or poor because they do not reflect reality.

  20. Johnny Vee commented on Jan 3

    A prediction of a 10, 20, 30 or 50% decrease in housing is based on current conditions and conditions always change. For example, when the Fed funds rate is below 3%, the cost of paying a mortgage will go way down. There are some predictions that Fed funds rate in the 1 to 2% range is possible if things continue to slide.

  21. AAA commented on Jan 3

    Please i need help . . . I am trying to buy a 4000 sqft house in north fontana So. Cal. it is listed at 525 but considering my offer of 480 . . . thought it was a good deal . . . well untill i read all of this stuff, HELP !!

  22. Pat Gorup commented on Jan 3

    Housing prices will continue to fall as homebuilders continue to add inventory.

  23. PTodd commented on Jan 3

    Housing was really just keeping up with real inflation (do not confuse this with the bogus CPI). Rentals lagged housing because the ability of people to pay rents was based on their salary, which kept up with CPI but their real wages have declined significantly adjusted for real inflation. Housing got around the ability of people to to pay with declining incomes by going with sub-primes, that was not an option for rentals.

    The real problem was not home prices, it is household income. Oil, food, health insurance, etc are all keeping up with inflation, why not housing and incomes?.
    Globalization and free international trade that allows us to export capital, capital goods and jobs in return for importing consumer goods paid for with debt, thats why.

  24. Manto commented on Jan 4

    Shouldn’t the chart be a spread over treasuries as opposed to a straight yield? Obviously in the 70s high rate environment you would need higher rental yield to be compensated than today.

  25. bjk commented on Jan 4

    Isn’t five years of inflation at 3.5% and no price appreciation equal to a decline of 20%? The signs point to a good decade of prices going nowhere. That is not the end of the world, that’s typical of the RE market. Prices go nowhere, then they trend, then they go nowhere. This isn’t Nasdaq 5000.

  26. Moti commented on Jan 14

    Just a comment on a comment by Francois: bubbles are a psychological/social phenomenon and not a “rational” (as defined by economists) phenomenon. The difference from gravity is that gravity hits us instantaneously (fortunately or not so I’m not sure yet) while economic forces take their time. Thus, the definition of free will is shown here: the longer the time between action and result, the more free will we have.

    And the more we pay for it…

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