B of A: Reflated mini-bubble to peak in 2016

Lenders reflated the housing bubble to pass their bad loans to new bagholders. Current forecasts show lenders must complete the task by 2016 before prices peak.

buy a house or dieHow can you tell whether a market is overvalued, undervalued, or fairly valued? It’s more than an academic concern today because lenders, realtors, and even government officials push average families to buy houses ostensibly to gain the financial benefits of home ownership. Unfortunately, as the housing bubble rudely slapped an entire generation, most potential homebuyers today realize the housing market is volatile and manipulated, and it may not be the investment opportunity it once was.

Realistically, the only way potential homebuyers will gain peace-of-mind from their purchase is to either buy on blind faith — which burned millions last time — or gain understanding of reliable valuation techniques to avoid buying overvalued properties in overvalued markets prone to crash. Unfortunately, that’s easier said than done because there are competing methods of valuing houses and housing markets that produce conflicting results. Further, the NAr constantly bombards potential buyers with plausible sounding bullshit, so between the conflicting results from good analysis combined with the self-serving bullshit from the NAr, most potential homebuyers are left confused and uncertain.

Are we witnessing a new sustained housing recovery in California, or are we witnessing a new housing bubble? Trying to sort through the conflicting narratives is very difficult because each side in the debate has points supporting their position.

Some housing bulls postulate the dramatic increase in prices springs from sound fundamentals; rents and incomes increased, unemployment dropped, and distressed property sales returned to pre-crisis levels.bagholder

Some housing bears posit the dramatic increase in prices feigns the signs of market health while the patient is still very sick; prices moved up far faster than rents and incomes (nearly 10 times faster), unemployment lingers, distressed properties lurk in the shadows temporarily removed by lender can-kicking, and the demand depends on fickle investors and artificial government programs and federal reserve stimulus, both temporary measures.

So are today’s homebuyers tomorrow’s bagholders?

Methods of establishing real estate value

There are two main methods for establishing neighborhood or regional values, and the main difference between the two is whether or not they factor in changes in affordability caused by fluctuations in mortgage interest rates. The reports I generate use current owner cashflow and a comparison to current rents to establish value. This number incorporates real estate prices, rents, and most importantly, interest rates to establish value. It’s susceptible to swings in financing costs, and it can be distorted by manipulative federal reserve interest rate policies. Another method of valuation considers historic relationships of price-to-income and price-to-rent. Those measures fail to consider the impact of interest rates on affordability, so when interest rates are low, these measures claim prices are overvalued when in reality, the market may be at an equilibrium with current costs.

The debates today about whether or not housing is again in a bubble stem from these different methods of establishing fair value. Right now, the method that considers mortgage rates shows most markets, even the expensive ones like Coastal California are fairly valued, largely because the near record low mortgage rates make monthly payments affordable. The method that looks at historic relationships between price-to-income or price-to-rent shows the market is overvalued. So which one is right?low_interest_rates

The longer term view of value depends on what you believe will happen with interest rates in the future. My methodology says today’s values correspond to the stable relationship between interest and rents. The competing methodology says prices are overvalued because current interest rates are so low. If interest rates revert to their long-term mean over the next few years, house prices will decline, and current valuations will appear bubbly in retrospect. However, if interest rates revert slowly over the course of another decade or more, this slow reversion in rates will not cause a price decline, and today’s valuations will not look so bubbly in retrospect.

Many conjecture the United States may again be showing the signs of another bubble in housing. Mark Hanson and Nobel prize winner Robert Shiller warn of housing bubble, and I noted troubling evidence of a new Coastal California housing bubble; however, based on my analysis of current market pricing relative to historic norms, the bubble simply isn’t there — at least not yet.

Carefully examine the chart below. Note the orange line which represents the historic norm relative to rents in Orange County, CA. The period from 1993 to 1999 shows little or no deviation from this fundamental value. The bookend housing bubbles of the early 90s and 00s is apparent, and apparent also is the overshoot to the downside from 2010 through 2013. But if you look at where we are today, the market is fairly valued; yes, it’s expensive, but relative to rent, the market is right where it should be.


The stimulants that prompted the strong recovery rally back to fundamental value are slowly removed; the federal reserve tapers the interest rate stimulus through quantitative easing; the institutional buying wanes due to high prices; and more supply trickles on the market as loanowners emerge from under their debts — these factors, particularly the removal of the interest rate stimulus, slows the momentum of the market. If it doesn’t slow down, if house prices rise as quickly this year as they did last year, if stimulants are allowed to overcook the recovery, lenders could ripen another rancid housing bubble.

The blunt instrument of market stimulants

The tools available to politicians, bureaucrats, and bankers to reflate the housing bubble lack precision; market manipulators apply stimulus to all markets equally, not only to those in need. The strength or weakness of various housing markets differ, and stimulus succeeds most where it’s needed least.

The chart above comes from an analysis from Fitch ratings from last year. IMO, it’s one of the best analyses of the future of housing broken down by current market performance. The markets performing well today are overvalued based on price-to-income or price-to-rent, and they will be the weakest when market stimulants wane. The markets performing poorly are generally still deeply undervalued; these will continue to rise. This result will confuse economists looking at macroeconomic data because they have no concept of valuations based on individual markets.

Forecast Says U.S. Home Prices Are Overvalued, Will Peak In 2016

By Nick Timiraos, July 17, 2014

Note that this analysis relies entirely on their estimation of fair-market value; raise or lower their fair valuation line, and the analysis changes entirely. Compare it to my chart that shows the market at fair value, and there is no bubble and no future peak required to bring values back to a fair valuation.


The U.S. home price rebound has nearly run its course, and Americans should prepare for several years of home prices that don’t increase much, if they rise at all, according to a report published by bond strategists at Bank of America Merrill Lynch.

Reversion to the mean of mortgage interest rates will decrease buying power of tomorrow’s buyers. Unless incomes rise significantly to offset this decline in buying power, house prices will not rise, and they may even go down. Most housing bulls blithely assume wages will rise faster than mortgage rates remove affordability. I think they are wrong.withheld_inventory

Most economists expect home prices to rise around 5% this year, before rising at around 3% over the next few years. Home price increases in recent years have been driven primarily by supply shortages, and some economists have said that prices could continue to outpace income or rent growth if more homes aren’t made available for sale.

The only reason prices have gone up is due to restricted inventory. Though broad economic measures have improved from the depths of the recession, the economy is not strong, and fundamental demand remains weak, as evidenced by declining home sales volumes this year.

To be sure, U.S. home prices have been especially difficult to predict in recent years. Many analysts prematurely called a bottom in 2008 or 2009, and others called for continued declines in 2012, after prices had started rising.

Analysts Chris Flanagan and Gregory Fitter concede that their view is “well out of consensus.”

Rather than apologizing, they should wear this as a badge of courage. This fact alone gives them a better than 50% chance of being correct because the herd of economists is wrong most of the time.

They say that U.S. home prices, after being undervalued relative to household incomes by around 6% at the end of 2011, have now rebounded to levels that are 9.7% overvalued. Their model uses the S&P/Case-Shiller home-price index.

They estimate that home prices will rise another 3% annually in each of the next two years, well below the 9.5% annualized growth rate since the end of 2011, when the market hit bottom. That would leave prices around 12% above the “fair value” level implied by household incomes. The model then forecasts modest declines in the following years, resulting in net annualized home-price gains that are flat through the middle of 2022.

If we see reversion to the mean in mortgage interest rates, this forecast will prove correct. If mortgage rates remain well below long-term averages, prices will appreciate more than these analysts expect.

fundamental value anallysis.xlsx

So does this mean U.S. housing markets are in another bubble? If it is, it’s much less pronounced than in 2006, when home prices peaked at levels that were overvalued by nearly 59%, resulting in price declines of nearly 35% over six years.

Messrs. Flanagan and Fitter say that the regulatory framework enacted since the financial crisis in 2008 should largely prevent a return to the loose-lending standards that inflated the housing bubble.

Right they are. home_price_appreciation_fairy

Against that backdrop, flat home prices between 2016 and 2022 “seems to us to be a fantastic outcome and exactly what policymakers had hoped for when establishing the new regulatory framework,” they write.

I don’t think regulators were aiming for flat home prices, but they did want to prevent future housing bubbles. If that means flat home prices for a while, so be it.

Look for this report to be buried and forgotten because it contains no information realtors can use or buyers want to hear. People naturally gravitate toward rosy economic forecasts, particularly if it means they will make a fortune on home price appreciation. Most prefer to ignore a harsh reality.

They also point to recent home-price indexes that show that the pace of increases has already slowed, suggesting that the post-crisis boom in home prices witnessed over the last two years “is most likely over.A new period of “exceptionally low home-price growth” in which prices will rise by just 1% a year, on average, over the next eight years “most likely has started,” they write.

Today’s homebuyers should brace themselves for little or no appreciation over the next decade. If prices go up, consider it a bonus rather than a birthright. Today’s buyers have to finance the retirement of the Baby Boomers by overpaying for their homes because 25 years of falling mortgage rates inflated their value.

Home shoppers today are right to be concerned about another housing bubble. It wouldn’t surprise me at all to see a reaction bubble form over the next few years as housing stimulus designed to bring up the non-performing markets overcooks our market. (See: Overcooking a recovery ripens a housing bubble) The tools on this site are designed to help spot this bubble if it forms and direct people to the properties with the best cost-to-rent ratio available in the market. Perhaps the new mortgage regulations will prevent future housing bubbles, or perhaps not. It’s best to be cautious and prepared.

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