As I’ve said before, I don’t think people should think of a home as an investment. If it were, it would be the only one that regularly springs leaks, begs for a makeover, and falls apart over the course of 30 years (maybe sooner depending upon your builder). Regardless of what the National Association of Realtors would like you to believe, a home is simply a lifestyle purchase, with some pretty hefty financial considerations. Therefore, the timing of when to buy a home should be largely influenced by lifestyle goals.

That doesn’t mean that there aren’t times when it’s prudent to wait for homes to “go on sale” – such as the last few years. But trying to pick the absolute bottom of the housing market is a fool’s errand. And it’s not just because you don’t know where the price of housing is going. You also have to figure in the impact of mortgage rates, which can have an even bigger impact on the cost of housing than the price of the house.

Let me demonstrate. Consider the purchase of a $500,000 home with 20% down and a 5.1% mortgage. Your monthly payment would be $2,171.80. However, if mortgage rates go up by 100 basis points to 6.1% then the price of the home would have to drop to $458,386 in order for you to have the same monthly payment with the same down payment. That’s an 8.3% price drop. So you have to ask yourself what is more likely at this stage: that housing prices will drop another 8.3% or that mortgage rates will go up by another 100 basis points? How about another 200 basis points?

Look at where Chicago housing prices are right now relative to their long term trend. I’m not saying that they are a steal but they are certainly fairly priced relative to where they have historically been. Now look at mortgage rates. Recently they have been at the lowest level in the past 50 years! I pulled the data below from the Federal Reserve and since that series doesn’t go past April, 1971 I estimated the prior data back to January, 1962 (light blue line) based upon the rate on 10 year treasuries. That estimate is a bit crude but the conclusion is still the same since 10 year treasuries are now at lower rates than they were in 1962.

Actual And Estimated 30 Year Fixed Rate Mortgage Rates

But what about this debate that rising interest rates will depress home prices? Well, let’s look at the period from the 60s to the 80s when 30 year rates went up from around 5% to 18%. According to the theory, during that period, home prices would have dropped by almost 52%! Well, they didn’t.

I’m trying to avoid repeating the realtor’s mantra of “now is the time to buy” because it really does sound lame and self-serving. However, the fact of the matter is that current conditions are extremely favorable for buying.

However, about a month ago one of my clients sent me a link to a BusinessWeek article on the impact of interest rates on home prices. In this article the author, who is the founder and president of Home Warranty of America, claims that the data just doesn’t support the notion that rising interest rates depress home prices. Although he doesn’t provide the direct analysis in his article he does provide links to several data sources so that you can do your own analysis. However, I would like to point out that this is not the first time I’ve heard this claim and I myself have glanced at the data before and found this to be true – especially in the late 70s and early 80s, which is the time period referenced by this author. During that time period home prices rose, despite interest rates that approached 18% ?!?!?! Or at least home prices didn’t decline like you would have expected.

Well, last week a spirited debate transpired on Cribchatter about this very topic. This has to be one of the longest threads in Cribchatter history with 234 comments. The people who argued that higher interest rates would push home prices down were initially arguing based upon the same logic I articulated above. However, eventually both sides of the debate started to link to various studies and articles that proved their point of view. Like most academic endeavors, when someone makes a career out of spending grant money they can prove anything they want so it’s not surprising that there are plenty of studies to support either side. Personally, I got a headache from following the debate, not to mention that it was full of insults.

However, I would like to point out a few things:

• Many of the articles referenced as proof that higher interest rates depress housing prices were nothing more than opinion pieces, based upon financial logic, or were based upon anecdotal data. Hardly real studies. Nevertheless, several legitimate studies were referenced to support this thesis.
• There could be several logical explanations as to why higher interest rates would not depress home prices as expected:
  • Buyers assume they can refinance at a lower rate in the future
  • Buyers have other financing alternatives, including adjustable rate mortgages and higher down payments. (I remember buying our first home in the summer of 1984 and an ARM was a no-brainer.)
  • Higher interest rates are usually associated with inflation and inflation pushes up housing prices
  • Buyers assume that if interest rates are higher now they will go down in the future and that will elevate home prices
  • When rates go up buyers shift their focus to the lower end of the spectrum but demand at every price level is replaced by demand shifting down from a higher price level – except of course as you get to the higher levels there isn’t as much replacement demand as exiting demand
  • When rates go up buyers simply allocate more of their income to interest payments.

For further reading you may want to check out some of the referenced studies and one that I have been meaning to read for a while:

• What Moves Housing Markets – demonstrates that interest rates do not affect home prices. “…our results provide evidence that changes in risk-free interest rates may not have done much to change housing valuations over the 1975 to 2007 period.”
• The Effect of Real Rates of Interest on Housing Prices – demonstrates that real interest rates do affect home prices. “This ebb and flow of real interest rates appears to explain market price levels.”
• Assessing the Role of Income and Interest Rates in Determining House Prices – demonstrates that interest rates do affect home prices. “Our results support the existence of a long-run relationship between actual house prices and the amount individuals can borrow.”
• Why do House Prices Fall? – demonstrates that interest rates do not affect home prices. “Interest rates appear to play a relatively minor direct role, though they may play an important indirect role.”

Now that he’s no longer getting a paycheck from these folks his outlook for housing is not nearly as optimistic as it once was:

My views are quite different now. I’m pretty bearish and have been for the past year and a half. Home prices will continue to drop. I think we’ll see a very modest recovery in sales activity in 2009. But we’ve still got excess inventories, a bad economy and a credit crunch that will push prices down further, another 5% to 10% more. It’ll take a long time to get back to the peak prices we saw in many markets.

Barry Ritholtz actually has a far more colorful assessment of this turn of events on his Big Picture blog: David Lereah is a jackass.

No surprise that the NAR is also getting in on the action with their 4 point plan for government handouts to the real estate industry. More on that another day.

Unfortunately, all this is a bit like trying to build a city below sea level in the path of numerous hurricanes. Wait a second…don’t we do that also? The fact of the matter is that sooner or later nature has to take its course. Home prices have to seek their natural level. They expanded at above-trend rates and now they need to return to the trend line, which is a bit below where they are now. Driving this was an unnatural growth in home ownership levels above the norm of the last 40 years as demonstrated in the chart below from the Federal Reserve Bank of St. Louis.

It should be no surprise that during this period the affordability of homes declined.

Now, as the real estate market attempts to cope with these imbalances, we find buyers and sellers at a stalemate and transaction volume has dried up. Politicians can pull all the rabbits out of the hat that they want: tax credits for homebuyers, Fannie and Freddie support for the mortgage market, government purchases of mortgages, etc… However, they can’t stop the ocean from seeking the lowest level. Nothing will return to normal until prices return to normal. And normal prices will be a good thing. For instance, homes can once again be affordable for people with good paying jobs.

During the last 10 years or so the country made poor financial decisions to put too many people in their own homes and to build bigger homes than people really needed. Instead of investing in our infrastructure we invested in granite countertops and marble showers. So today we find ourselves with vacant homes, collapsing bridges, and roads full of potholes. If the government wants to stimulate our economy they would be better off investing in our infrastructure than in more homes.

Speaking Of Potholes

While perusing David Dalka’s Internet Marketing Blog the other day I noticed several links to sites for reporting potholes and even filing a claim for vehicle damage from potholes. Sounds like a great idea. However, I attempted to file a claim about 6 months ago using the process outlined on one of those sites after my car was nearly swallowed by a giant sinkhole. OK, maybe I’m exaggerating a little bit but I did blow a tire. After dutifully taking my pictures, attaching a receipt, filling out the form, and sending it in I’m still waiting. However, I wouldn’t let that discourage you. Maybe if they get enough forms in the mail they’ll have to do something about it.

This new feature was created based upon three simple facts:

1. When it comes to real estate everyone is an expert – or at least they think they are
2. A group of people can produce better estimates or answers than the average individual (that’s actually a fact)
3. Chicago homes just aren’t selling these days and it’s often because they are mis-priced

Enter prediction markets, which are sort of like futures markets – you know, where all those traders yell at each other about pork bellies. It is said that you can get a more accurate weather forecast for Florida by watching orange juice futures than you can by listening to the national weather service. Well, that shouldn’t be a surprise. After all the NWS is part of the government.

Participants in a prediction market buy or sell “contracts” with either real or virtual money based upon their outlook for certain events – e.g. who will win the presidency. The investment activity influences the value of the contracts, which represent the predicted outcome. For instance, right now Obama contracts on Intrade sell for $.65. If you buy these contracts and he wins you get $1.00 for every $.65 you invested. If he loses you get nothing. Therefore, a contract value of $.65 represents the consensus view that he has a 65% chance of winning.

The really cool thing about prediction markets, just like the financial markets they emulate, is that over time the people who are really good at predicting stuff end up with more money. And people with more money in these markets have more influence over the consensus prediction.

So we thought we would apply this concept to estimating home values in the Chicago area. Here is how it works. When you sign up with Price This Home you receive 5,000 virtual prediction dollars which you can then invest in various home price contracts. For each contract you either buy it in the belief that the ultimate sales price is going to be higher than the current prediction or you sell it in the belief that the ultimate sales price is going to be lower. The market price then moves in proportion to the size of your investment and you either make or lose money based upon how accurate your prediction is.

We are starting out with just a few homes in the market but if there is a lot of interest we will add more. Give it a try and have fun!

In general, trying to time any market is a risky proposition since you don’t really know until after the fact whether or not you bought at the bottom or sold at the top. It’s especially tricky with real estate because you have to really time the size of your mortgage payment, which is a combination of prices and interest rates. It doesn’t do you any good to buy at the bottom if interest rates have jumped up and more than offset the impact of declining prices. For instance, from May to June interest rates have shot up 60 basis points, which is enough to raise your mortgage payments by 6.6%. I also maintain that you shouldn’t look at a house as an investment in the first place because first and foremost it’s a place to live. Do you really want to spend the next 7 years of your life in a house that you picked based upon its assumed appreciation potential?

But let’s move beyond how I think you should be looking at the Chicago real estate market and let’s try to answer the question you are going to ask anyway. I can offer you three different sets of data that might shed some light on where Chicago is in the home price cycle.

First, the stock market is usually pretty good at predicting the future. Stock prices usually reflect what is about to happen to the economy, bottoming in advance of an economic bottom. For this perspective we can look at the S&P Homebuilders index over the last 5 years.

As you can see this index peaked in the first half of 2005 so it did a pretty good job of predicting the housing meltdown more than a year in advance of the peak. Unfortunately, there is no evidence that it has bottomed out yet. The groundhog has seen it’s shadow.

Another financial market that provides a glimpse into the future is the futures exchanges. It is often said that the best weather forecast for Florida comes not from the national weather service but from the orange juice futures market. For Chicago home prices we can look at the futures prices for the Case-Shiller home price index for Chicago, which show a decline until sometime in 2010. As of April the index was at 150.4 and the May 2010 value is 125, which amounts to a projected 17% further decline over the next 2 years. But one has to be careful in leaning too heavily on futures prices. Although the futures markets might be the most accurate forecast on average that doesn’t amount to always being accurate. For instance, for the past year oil futures have been predicting flat oil prices out into the foreseeable future and you all know how accurate that forecast has been.

Finally, if we go back to the long term trend in Chicago housing prices we can see that home prices overshot the long term trend for several years. By looking at the deviation of prices from the long term trend one can conclude that prices should come down by an additional 13%.

OK. So there you have it. Three different techniques that all say that Chicago home prices have not bottomed. Of course, that doesn’t mean prices will come down further. All 3 of these prediction methods could be wrong. Furthermore, even if it is true that prices are still too high they don’t necessarily have to come down in order to get back in line with reality. They can simply stagnate at this level until inflation catches up with them. It all comes down to how quickly sellers get real.

One more note for the sophisticated investor. If you really want to speculate on the direction of housing prices in Chicago or if you want to protect yourself from future price changes you can buy or sell the Case-Shiller futures on the Chicago Mercantile Exchange. For instance, if you want to sell your house but think that prices are going up in the future you could go ahead and sell at today’s price and then buy futures which will gain if home prices in fact go up. That way you can separate the investment aspect of home ownership from the living aspect.

Just a quick reminder that the price tiers are defined as follows:

• Low – Under $227,766
• Middle – $227,766 – $348,054
• High – Above $348,054

Prices peaked approximately in September 2006 and have since declined between 9% for the low tier to 12% for the middle tier. That puts home prices back to where they were in December 2004. When you look at it that way it doesn’t seem quite so bad, does it?

I wish that over the last 8 years I had recorded all those debates with people who kept insisting that Chicago real estate never goes down.