History of Fundamental Value
Why do I believe there are market fundamentals? And how do I calculate these numbers? Today we will look at the history of Irvine median home prices, IHB Current Cashflow Value, IHB Fundamental Value from 1975 to present.
Irvine Home Address ... 31 DEER Crk Irvine, CA 92604
Resale Home Price ...... $699,000
If you wake up and don't want to smile,
If it takes just a little while,
Open your eyes and look at the day,
You'll see things in a different way.
Don't stop, thinking about tomorrow,
Don't stop, it'll soon be here,
It'll be, better than before,
Yesterday's gone, yesterday's gone.
Why not think about times to come,
And not about the things that you've done,
If your life was bad to you,
Just think what tomorrow will do.
Don't Stop -- Fleetwood Mac
Why do we spend so much energy thinking about tomorrow's house prices? Well, Timing Does Matter.
I have felt an angst about how current cashflow value suggests prices are in a stable range when we know that real fundamental value is significantly lower. Also, Shevy recently challenged me with feedback he has been receiving about our reports. When we are showing people IHB Current Cashflow Value, we have been calling it IHB Fundamental Value. People were upset that perhaps we were taking advantage of interest rate manipulation by the FED to suggest prices were a good value. Shevy was upset with me because he said it is not who we are, and he felt our reports were not accurately reflecting our opinion of Fundamental Value. He was right.
In today's post, I am going to fix this problem by parsing terms of value, and I will demonstrate the power of these analytical tools by examining the long history of home prices and fundamental value since 1975. Also, I will show two updated pages of our IHB Reports.
To better understand the distinctions in value I am making today, I need to clean up and define some terms for you.
- Base Payment is current rent (or 31% of income) minus expenses of ownership. Base Payment is the amount of debt service available to repay a loan.
- IHB Current Cashflow Value is the value of the property derived from Base Payment applying current interest rates.
- IHB Fundamental Value is the value of the property derived from Base Payment applying a long term average of interest rates. The number I am using is 8.99%, the average interest rate since 1971.
For instance, (31 Deer Creek -- IHB Fundamental Value Report for Owner Occupant.pdf) if the current rent (IHB reports use comparable leases from the MLS) is $2,850, the Base Payment yields a IHB Current Cashflow Value of $690,000 and IHB Fundamental Value of $516,300. The difference between the value at a 5% interest rate and a 9% interest rate is remarkable.
History of Home Price and Value
The long history of home prices and values is a harmonic dance with the measures tethered in an ever more volatile relationship. It begins in the mid 1970s during a rough time for the economy, but a stable time for the relationship between Median Home Price, IHB Current Cashflow Value and IHB Fundamental Value.
Irvine, California, has endured three real estate bubbles since 1975. The first occurred from 1978 to 1981 when prices skyrocketed in an inflationary spiral. As usual, lenders were willing to fuel the fire. Prices stabilized briefly in the mid 80s before taking flight again. Valuations declined below Current cashflow value and bottomed at Fundamental Value in the late 90s. The fact that prices bottomed here for so long suggests there is durable market support at this price level.
Besides the statistical accuracy of Fundamental Value, I favor it because there is concrete reasoning for this level to be so strong -- owning is less expensive than renting on a stable cashflow basis. There is an identifiable microeconomic event creating the macroeconomic effect we are looking for -- bottoming activity.
(There is much information in the notes on the charts below, so examine them carefully.)
In 1978, inflation was running 14% per year. Lets say you borrowed with an astronomical 60% debt-to-income ratio. That first year, you would be eating Rice-a-Roni, but since you would be getting a 10% raise next year, and the year after that, and so on, your debt-to-income ratio is falling rapidly. By 1982 your income is 50% higher, and your DTI is now down to a very manageable 30%. This was the inflation calculus of yesteryear.
This big inflation hurdle explains why so many people think it is wise to really stretch to get into that first house. Back in 1978, that stretch meant three to five years of pain because inflation bailed everyone out. Now, if you stretch like that, you have 20 years or more of indentured servitude waiting for you. Just ask some Japanese landowners from their bubble how much fun that is. All those people working years to clean up the mess a number of foolish bankers made 30 years ago. We are traveling the same road.
The market bottomed after the first bubble from 1985 to 1987 when prices traded below both the Current Cashflow Value and the Fundamental Value. Prices took flight again in the summer of 1987, and they went up about 50% by summer of 1990 when prices became very high relative to cashflow measures. This rally was almost entirely psychological. People feared being priced out. The market bottom again from 1994 to 1999, while prices traded below Current Cashflow Value and at Fundamental Value for several years. Is that our future?
In examining these charts, I noticed something interesting that does have value for today's market. From 1975 to 1999, market pricing fell below current cashflow value on three different occasions -- just as it is doing today. The first time was 1985, and the intersection occurred while pricing was also below fundamental valuation. The time of crossover represented a bend in market direction; in 1985 it went from flat to up.
When prices went cashflow positive again in 1992, the market was heading downward steeply, and once it became less expensive to own, the rate of price decline slowed just as it has in today's market. The market did not bottom in 1992 because prices were still elevated from fundamentals. Interest rates went up in 1994 bringing cashflow value down again. When cashflow value went positive again later that year, the market bottomed and began creeping higher. No real estate recovery has begun with rapid appreciation.
Prices matched Fundamental Value very closely from 1994 to 1999, then conditions changed, and we inflated The Great Housing Bubble.
The precipitating factor for the housing bubble was the lowering of interest rates to combat the 2000-2001 recession. As interest rates went down, prices went up to match the new financing available. This increase in prices was rapid enough to excite irrational exuberance and already inflated prices went much higher. Lenders enabled the next push higher by eliminating loan qualification standards and peddling Option ARMs far and wide. The rest can be read in our library.
What is interesting for today is the current relationship between prices, Current Cashflow Value and Fundamental Value. We are at a price level that nearly matches Current Cashflow Value of $561,837 but is well elevated from the Fundamental Value of $375,885 -- which is the bottoming value I am most recently credited with predicting. The current market pricing intersecting with Cashflow Value is what has caused prices to fall more slowly or even tick up a bit this summer. As long as the Federal Reserve continues to backstop interest rates and keeps current cashflow values high, prices will hold at current levels pending the timing and quantity of future inventory processing and release.
Will the FED ease off and give us a protracted decline in a very wide "U" shape typical of housing market bottoms? Will inflation force the FED to allow interest rates to go higher? These are titanic forces beyond my ability to comprehend much less foresee. For now, it looks like a protracted "U" shape bottom perhaps at price levels above previous fundamental valuations. I will revise my projections as more data comes in.
Hedging is no fun. It was easier when the market gave unambiguous bearish signals....
IHB Fundamental Value Reports Revisited
With that lengthy preamble, I introduce a new page to our report and a new front cover.
Notice at the bottom in our summary area, we now have the Current Cashflow Value and the IHB Fundamental Value. My concern is that the report is becoming a mess of confusing numbers, but for those with that want to get into the financial details, it is all there including...
We have also added two new sections taking up a full page to show the impact interest rates will have on resale value and a comparison of FHA versus conventional financing as these are the most commonly requested scenarios. People are generally surprised that it is more expensive to own through FHA. Equity is cheaper than debt, so borrowing 96.5% is maximizing your expensive interest costs to minimize your inexpensive opportunity costs.
Irvine Home Address ... 31 DEER Crk Irvine, CA 92604
Resale Home Price ... $699,000
Income Requirement ....... $131,598
Downpayment Needed ... $139,800
Home Purchase Price ... $266,500
Home Purchase Date .... 11/25/1997
Net Gain (Loss) .......... $390,560
Percent Change .......... 162.3%
Annual Appreciation ... 13.2%
Mortgage Interest Rate .......... 5.20%
Monthly Mortgage Payment ... $3,071
Monthly Cash Outlays ............ $3,780
Monthly Cost of Ownership ... $2,810
Property Details for 31 DEER Crk Irvine, CA 92604
Baths 1 full 1 part baths
Size 2,125 sq ft
($329 / sq ft)
Lot Size 5,400 sq ft
Year Built 1976
Days on Market 211
Listing Updated 11/4/2009
MLS Number S570571
Property Type Single Family, Residential
Community El Camino Real
MODEL PERFECT FAMILY HOME WITH CUSTOM FEATURES AND UPGRADES THROUGHOUT. CUL-DE-SAC LOCATION WITH PRIVACY AND SPACE. NEW PAINT, CROWN MOLDING, WOOD FLOORS, NEW DUAL-PANE WINDOWS, NEW SOLID DOORS, NEW MASTER BATH, BRAND NEW SECOND BATH, NEW FRONT PORCH, NEW GARAGE DOOR AND OPENER. CORIAN KITCHEN COUNTERS AND MAPLE CABINETS. LARGE 15X30 STORAGE AREA ABOVE GARAGE WITH PULL-DOWN LADDER. THIS HOME HAS OVER $150K IN UPGRADES AND IS READY TO MOVE IN TO AND ENJOY!
I hope you find these enhancements to our reports, and I hope the interesting look at the history of home prices and values gives you insights into how this will all play out. The collective wisdom of the IHB community will come to the correct answer. I am in awe of power of astute observations to widen and deepen the conversation. So where do you think prices are heading? Are fundamental values still a market bedrock?
I want to invite you to our IHB Block Party from 6:30-10:00 tonight at JT Schmids at the District.