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Don't Buy the Bubble Talk

By Lisa Scherzer Published: December 29, 2005

JUST BECAUSE THE HOUSING market has been on fire for several years, doesn't mean homeowners are about to get burned. In fact, housing costs are now only a bit above historic norms, and are not extreme even in boomtowns like Miami and San Diego, according to Todd Sinai.

Tell that to someone on the market for a new home and they'll think you've been renting an apartment on Mars for the past five years. But Sinai makes his academic home at the University of Pennsylvania's Wharton School, where he is an associate professor of real estate.

Sinai says home buyers should look at the annual cost of owning a house, not its price, when considering a purchase. And based on a recent study he did with Chris Mayer of Columbia Business School and Charles Himmelberg of the Federal Reserve Bank of New York, Sinai says homeownership costs are near the long-term average, relative to rents and incomes.

How does he figure? Traditional measures of housing values, such as the rate of appreciation, or the house-price-to-rent ratio, are misleading, Sinai says.

The study by Sinai and his colleagues examined 46 housing markets from 1980 to 2004, estimating the true one-year cost of owning a house and comparing it to rental costs and income levels. Naturally, the low interest rates of recent years have offset high prices by keeping mortgage payments down. Variable and interest-rate-only mortgages have also lowered the annual dues of homeownership.

That's why the most expensive U.S. markets are especially sensitive to changes in interest rates. In any city, the faster prices appreciate, the more they'll drop if mortgage rates rise. "The so-called bubble markets really are more sensitive to changes in interest rates, because they are markets where people are buying the right to live there in future years," says Sinai.

Although Sinai believes today's house prices are justifiable, he does see a slowdown ahead, especially if interest rates continue to increase.

SmartMoney.com spoke with Sinai about the state of the housing market and similarities between San Francisco real estate and growth stocks.

SmartMoney.com: Why did you look at the annual cost to live in a house in your study, rather than the price of the house itself?

Todd Sinai: We look at the difference between the cost to own vs. the cost to buy. The typical way people look at pricing of the housing market has been the cost to buy a house. What is the price to buy a house? I was having lunch with a colleague this morning, and she said, "Do you ever in your life think about buying a house for $1 million? To which my response was, "Do you ever in your life think you'd buy a stock for $50 a share?" It's an asset; assets have prices. But it has nothing to do with the return of the asset; I mean it's not an indicator of it, anyway.

The cost to buy is the sticker price. The cost to buy a car, say, an entry-level Mercedes may be $38,000. But the cost to own it may be monthly lease payments. The cost to own can be low relative to the cost to buy. As an example, we see higher-end cars on the roads now. It could be because people have more money. It could be lower financing costs. In the housing market we think the right thing to think about is what is the cost to own the house for a year. That's much different than what's the cost to buy the thing. Over the course of the year, maybe the initial price was $1 million and you sold it for $1 million. You let someone else own it... Looking at the price is somewhat misleading. Looking at cost, you compare it to how much it would cost to rent a house for a year. That's apples to apples. [if] housing is expensive relative to renting, then you really want to annualize the cost. It's important to look at the annual cost to own a house.

SM: What factors do you include to figure out the cost per year?

TS: [You figure out] the annual cost of financing. Take out a mortgage, pay real interest costs in the mortgage. Also you put equity into that house; you're giving that up to tie it into the house. So that should be counted. Then there's the usual tax benefit offset to that.... You may or may not get a tax deduction. Also property taxes and maintenance. There's a risk adjustment you want to put into that. And what capital gains you could expect. By analogy to that, what's my return on a stock? Dividend plus capital gain. In housing, the dividend is you get to live there, and there's appreciation in the course of a year. What is a reasonable long-run price appreciation I would get in that market? You basically say, how much would it cost to buy $1 worth of house? In Philadelphia, it's something like six cents for one year. If you're buying a $600,000 house, it costs $36,000 for a year.

SM: In what kind of case would a potential home buyer be willing to pay more for a house than they would initially?

TS: You can immediately see what affects that. If interest rates are lower, the cost is lower. If you're in a market where the house appreciation is higher, the capital gains are higher, and you're more likely to sell your $1 million house for $1.1 million later...

Once you realize that's what's going on with cost per dollar...what do people do? If there's a lower cost of ownership, are they willing to bid more for a house? People are willing to pay a higher price for a house, on a lower cost-per-dollar basis... That happens a lot in markets where it's not easy to build new housing. But in markets like Houston and Dallas, where it's easy to build, you can acquire land, and the cost per dollar goes down. People aren't going to bid higher. They can just get another house at a lower cost. [The lower cost per dollar] goes on in markets with lower supply.

The reason it's important is because there's a huge run-up in price but not in the cost of owning a house, because the cost per dollar is going down. Multiply the cost of the house by cost per dollar gets you the annual cost. Annual costs are not growing as rapidly as house prices. The reason is because interest rates are plummeting.

SM: Explain how some cities are more, as you say, "sensitive" to interest rate changes than others.

TS: Say real interest rates fell by three cents a dollar. So you go from 10 cents per dollar to seven cents. Then they fall again from seven cents to four cents a dollar. Going from seven to four cents, I'm willing to pay almost twice as much for the house and still have the same annual costs. You're operating on a much lower base. It's a bigger percentage change in house price.

One thing we've seen over the last 20 years is a linear decline in real interest rates (interest rates after inflation). But because each change is operating off an ever-lower base, it's an accelerating percentage decline in real interest rates. That means we should get an accelerated operating increase in house prices. There are two sides to that coin: What real interest rates giveth, real interest rates can taketh away. A small increase in real interest rates can change house prices a lot because you're operating off a smaller base.

Another thing that's been going on, another way you get a low annual cost of housing is if you expect the market to have high capital gains, high future price growth. You'd expect the price of rent to go up. If you have a higher expected capital gain, that total annual cost will be lower. What markets are like that? In San Francisco, over the last 60 years, real annual house price growth was 3.5% per year. The national average is about 1.5%. There are a handful of other places like that: San Diego, New York City, Boston... If you compound that over 60 years, it's huge... In markets like San Francisco, people should be willing to pay a higher initial price [for a house] because they expect to get more of the value back on paper.

As an analogy, San Francisco is like a growth stock because more of the value comes in the future. Whereas Philadelphia is like a value stock: The value is not going to go much higher.

SM: So, because of the real interest rates, house prices in markets like San Francisco are justified?

TS: In those markets like San Francisco, any given interest rate change is going to matter more there; it's going to have a bigger bite. San Francisco is starting at, I think, a cost per dollar of 2.5 cents; Philadelphia is at five cents. Suppose real interest rates go down by 50 basis points. In San Francisco it's now two cents. The same change in Philadelphia would bring you from five cents per dollar to 4.5 cents per dollar. That affects the annual cost of owning a house more in San Francisco than it does in Philadelphia.

The so-called bubble markets really are more sensitive to changes in interest rates, because they are markets where people are buying the right to live there in future years...

In San Francisco, because the value of housing is expected to go up more every year than in a place like Philadelphia, more of the value of owning the house comes from the fact that you get to live there in future. In Philadelphia you don't have to pay rent this year, and you don't have to pay rent in the future, but those rents aren't expected to go up much. The discount rate is going to go up more in the future... San Francisco is more susceptible to changes in interest rates. As with a stock, if interest rates go down, stocks' price-to-earnings ratio should go up.

The punch line is that at the end of 2004, when we did our study, we found that while prices have gone off the charts (relative to rent and incomes), the annual cost of owning relative to rents and owning did not. They were just at about their 20-year historical average. The reasons: There's been rental growth and income growth in a lot of these markets... The big thing that's going on is declines in real interest rates are offsetting increases in house prices. That offset was biggest in markets where price rises were the highest. Since then real interest rates have not gone down further.

SM: So you think all the talk of bubbles is unwarranted?

TS: It's not a bubble. People are having unreasonable expectations for future capital gains. I expect things to slow down. I would've expected price growth to slow down last year; since they didn't, they really should slow down now.

At the end of 2004 house prices are at levels they should be at. I think they should level out unless rents and incomes keep rising or real interest rates go down... In the nine months since then, house prices have grown in excess of rents and income and real interest rates haven't changed. So I don't think house prices [would be much higher]. It would make me uncomfortable if they kept rising. Then the cost of renting to owning would be higher.

Since the end of 2004, prices have been going up, rents have gone up a bit and real interest rates haven't really done anything. The cost per dollar really hasn't changed, and prices have gone up. So the annual price has gone up since the end of 2004; it's gone up faster than rent and incomes. They're above historical averages...

SM: What's your forecast for the housing market for next year?

TS: The only forecast I'd care to make is that if real interest rates go up significantly, then we should have relatively less price growth in markets most sensitive to interest rates. And we should have declines in prices in those markets... What we're seeing now, is that the market — by the measures I use — finally got to the point where annual costs are above its long-term average. That means the market was overpriced. It's tricky; economists think about bubbles differently from how lay people think about bubbles. [Rapidly increasing prices] is not the definition of a bubble... You could have a big price change without it having been a bubble. It's a bit of a fine distinction.

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