Home Prices- and why everything is always about the math

Homes have always been characterized in terms of investments, but in actuality, home prices in real dollars were relatively flat for almost a century. This raises a number of questions for economists; will there be a reversion to the mean? Has something intrinsically changed about homes? Is “this time” different? In places like Los Angeles, San Francisco, New York, San Diego, Boston, Seattle, and other large cities home prices have risen much higher than the median value of homes across the US. If there were to be an adjustment the effects could be quite devastating. The causal for such an adjustment could be a reversal in the reason for the significant rise in prices over the recent past, higher interest rates.

The chart below illustrates 70 years of historic homes prices in real dollars using the Schiller Price Index. Since about 2000 the relatively flat price of homes starts an upward trajectory that departs quite significantly from earlier observations.

Since we know that the median salary has not changed much since 1990 in terms of purchasing power,[i] how is this rise in prices possible? Since 1990 the monthly mortgage payments for home of median or mean value were relatively flat, in unadjusted dollars, with a percentage of standard deviation of less than 21%. Basically, home prices have reflected purchasing power, or the monthly payment.

By pricing houses to reflect buyers’ payments, lower interest rates have resulted in sellers raising prices to a level that meets the buyer’s monthly payment threshold. However, interest rates can move in both directions, and since 1990, except for one instance, every time interest rates (10-year US Treasury) have increased 10% or more (11 times) there has been a flattening or decline in home prices within one quarter. Keep in mind there has only been one instance during this period when there were two consecutive quarters of increases exceeding 10%. The other thing that we must keep in mind is the relative changes. The 10-year US Treasury now yields about 3.0%, in 1990 it was yielding over 10%, at the same time home prices in 1990 were less than $125,000, today median home prices are about $313,000.

Since home buyers and sellers have no control over interest rates and are constrained by what they can afford in terms of a monthly mortgage payment, there is only one variable that they can adjust, home sales price. Interest rates, as most home buyers understand, is a significant determinant of monthly mortgage payments. The difference of just 1%, say a 3% interest rate on a mortgage payment for a median priced home versus a 4% interest rate, results in a 13% higher monthly mortgage payment. The only way this can be mitigated is to drop the price of the home, in the example above this would require a drop in home price of almost the same percentage as the payment change, to achieve a similar payment.

Of course, there are regional considerations when discussing home prices, but given the historic prices in some of the metropolitan areas mentioned earlier, the effect of rising prices on homes, and in turn owners equity, could be quite disturbing.

[i] https://www.pewresearch.org/fact-tank/2018/08/07/for-most-us-workers-real-wages-have-barely-budged-for-decades/