Until recently the bubble in the housing market played a major role in stimulating economic growth and, now that the bubble has popped, housing is again taking center stage but this time in contracting the economy. Therefore, in order to estimate where the economy and the stock market are headed it is necessary to formulate an opinion on how low home prices could fall.
The house price-to-rental ratio is a useful indicator to evaluate how expensive homes are to purchase compared to simply renting. It’s similar to the price-to earnings ratio for stocks. Rental units are a substitute product to homes and the rational buyer will select the most affordable option. The price-to-rent ratio had been fairly stable until this decade when the ratio skyrocketed to uncharted territory.
The above graph implies that the ratio will need to decline by 30% from its peak to bring it back to its historical average. Now to determine how much home prices will fall in nominal terms, we need to estimate the future direction of rents.
The following graph by Calculated Risk shows that the rental vacancy rate remains near an all-time high at around 10% implying that there are an excess of 750,000 rental units that would need to be occupied in order for the rental vacancy rate to return to its historical mean. Thus, there will be hardly any pressure on rents to rise for the next few years.
Therefore, if rents don’t rise and the house price-to-rental ratio returns to its historical average then home prices will have to fall by at least 30% from peak to trough. Indeed, the Case-Shiller index is already down 18.4% from its peak so a 30% decline seems quite attainable, especially when one considers the nation’s huge glut of housing stock.
Consider that although new home sales have plummeted to levels typically marking cyclical bottoms, the 3-year rolling average of new home sales is still high pointing to the immense supply of homes that were constructed in recent years.
Graphic by Sudden Debt
Also, the following graph shows that the homeowner vacancy rate is 1.4% above its historical average and with about 75 million owner occupied homes in total, there are over 1 million vacant homes that need to be absorbed.
And it is worth watching the level of foreclosures which could greatly increase the supply of homes for sale during the next 2 years as a large wave of mortgages will be resetting at much higher interest rates resulting in possible default.
So the excess supply of rental units and vacant homes, and the increasing level of distressed sales is likely to cause home prices to fall by around 30% from its recent peak which would bring the house price-to-rental ratio back down to its historical average.