It's strangely hard to find a good answer. Googling yields "housing is overvalued (2011)", ... "housing is overvalued (2014)", ... "housing is overvalued (2018)" but with no particularly rigorous explanation on why, nor the difference between "overvalued" and "yep, that's normal now".
Most people who have done a lot of options trading have seen this in practice: if you're trying to sell a really thinly traded option RIGHT NOW, most of the time the latest price is a higher than the price you'll get. That's because there was only one buyer at the time, and someone else got that person's bid. So now you'll have to go to the next-most-interested buyer, and you'll probably need to lower your asking price a bit because otherwise he or she would have been the most recent buyer.
All of this is masked in heavily traded markets. But it's a lot more apparent in housing. However, that's complicated by the fact that people REALLY HATE lowering their asking price, so instead of seeing prices drop, housing markets typically just see volume go down. And recent lower transaction prices are often dismissed by sellers ("That person was just desperate to sell, I'm going to wait for someone to pay what my house is worth").
From there, you can start stacking additional costs and savings on both sides of the argument. I've done that math, too, and found that, at least in my area, that only makes buying look even worse.
That said, in a lot of places (e.g., small towns and suburbs), it's slim pickings for apartments that aren't basically bachelor pads or eyesore cookie cutter developments. If I didn't live in a major metro area, I'd probably be buying, too.
For example, a house worth $500,000, with a 5% ROA, would need to net $25,000 a year. Assuming expenses are 1% of the value, you would need to charge $2,500 monthly rent, to get a 5% ROA.
The question is then, how does that ROA compare to other options? That answer to that question determines whether the house is overvalued.
Also I think comparing to the stock market is a bit disingenuous as the revenue stream from renting is fluctuating a lot less (though the market value of your house might), because leases are usually at least year-long.
What is also nutty, a mortgage on an investment property is almost always a bad deal. Just to be clear. If you were to use a mortgage at 500k, 20% down, this would be the math: [1]. To break even you would need to charge 3k.
Long story short, it is hard to find a renter of a 500k house for 3,300. In SF, 500k wouldn't buy a one bedroom. In the suburbs, 3k a month renter is a hard find.
What matters are what returns you can get with the money from the mortgage.(Opportunity cost)
Ex. You own an investment property you bought for 200k, it returns 10% per year. The only available investments to you are the stock market which returns 3%. Mortgages are 5% should you get a mortgage? Obviously no.
Same situation but the stock markets are returning 15% per annum. Obviously yes.
You make money 2 ways with a property: income and capital appreciation.
However, intrinsic value and market value are frequently out of whack. You can see this in the stock market: stock prices change within fractions of a second, but nobody should believe that the company's intrinsic value is actually changing second-by-second.
Calling an asset "overvalued" is a judgement call. Same with calling an asset undervalued. You have to do your own analysis to make that interpretation. And when you see something that's undervalued significantly, you buy that asset!
If the interest rate for a 30 yr loan is 1% vs 10% that will change the appropriate price to rent ratio.
IMHO, it’s genuinely difficult to establish the underlying value of a property beyond comparing it to similar recent transactions (which doesn’t answer the original question).
It’s possible you meant looking at rents in the area as a baseline of how “productive” my SFR is.
"Stocks are overvalued." How do you know? "The price to earnings ratio is too high." Now the question is, how good a measure is the price to earnings ratio? Is the "right" price to earnings ratio determined by the historical average, or does "right" change with changing circumstances?
I don't have any solid answers about whether stocks are overvalued. (My personal guess is that, in a time of very low interest rates, a high P/E ratio makes the rate of return on stocks comparable to the rate of return on bonds, and so stocks may in fact not be overvalued. But I'm not an economist or a stock trader, and I could well be wrong.) My point is that there are some at-least-somewhat-objective measures of whether some things are overvalued.
In the end, it’s just another layer on top of the speculation that the price will come down in the future.
The case against the P/E ratio boils down to "this time it's different". That can in fact be true... once in a while. Not nearly as often as it's claimed, though.
That doesn't mean that P/E is absolutely correct - just that it's somewhat better than random noise.
For housing you could compare to: cost of renting, cost of in-fill construction, salaries in the area, cost of alternatives (eg moving, to other neighborhoods or cities).
I think these housing headlines are also basically asserting that prices will fall, which clearly hasn't been true, but is a valid statement of belief.
Usually when something is overvalued it means that the value it has been given is higher than what people are willing to pay, resulting in a product which has been assigned a value nobody is willing to pay. This is not always that clear cut, as some things have different values to different people. What is overvalued and probably overpriced for one person might be well within reason for someone else.
The housing market is very dependent on the location you live in so wihtout further information it's hard to say if a house is "overvalued". The price is normally closely related to the property price, so while housing might not be overvalued, property prices could very well be.
Then there are different considerations regarding the longevity of your assets (aka your house). Most things you buy are rather short lived, this is not the case for property, which can be inherited over multiple generations.
You also have to consider that the amount of land is limited (within cities) and owners/sellers are not necessarily companies trying to make a profit, so "normal" supply/demand doesn't necessarily apply in these situations and producing more (land/property) is just not doable. This also means that renting prices usually increase similarly to housing prices.
There are lots of other variables here to consider but even regarding only a few of them its already really hard to say what a house or property is "worth", so what you should much rather be asking is "what are people willing to pay/how much can they pay". If that is your question you could look at default rates and newly approved credits to determine whether people are able to pay for their house.
Real estate just as any other market instrument can be objectively overpriced.
Asking price is often set higher to pad for negotiation, as giving a discount is a phychological incentive for a buyer.
As for 'overvalued', that's seems to be a subjective concept. Value is static until it's exercised. If you hold a $100 in your wallet, it does not matter (save for a fear of losing it) until you show someone else that you have it, as basis for some value transaction.
Can you overvalue a $100 ? Sure, make it a collectible, put a celebrity's signatue on it etc. Provide future reasons for it to hold a higher value. Use it as a basis to borrow $200 (even though that $100 may have being borrowed itself).
In a way, real estate has become a fiat just as the actual currency is. While the dollar is a short-time instrument so its value could be exercised immediately, real estate functions as a long-term instrument to transact for a future value. That value is in form of taxes for government, interest for banks/lenders, rent cash-flow, or a potentially higher selling price for the owner.
As for the owner-occupied house, it can be seen as being more a liability than an asset.
Do you believe that a newly listed property does not hold your expectation of its future value? Well, the seller has not promoted that value to _you_ convincingly enough.
Everyone telling you that housing prices in Silicon Valley are "overvalued" really are saying "it's too expensive for me". But they have no data to back it up, so they're declaring something with no proof or evidence. In order to do that you need a model to show you what a fair price should be based on the model, and how the market has deviated from that model.
But in most cases, "overvalued" and "undervalued" are meaningless terms for when someone can't afford something, or someone doesn't want to sell something at a lower price.
Two examples: I can invest $1m into one or multiple properties. Depending on the location, I will get some yield on that capital invested -- e.g. 5% per year from capital appreciation + rent.
There are other locations where the return might be less than 5%, or more than 5%. But there are generally are reasons for that (the yield of investing in property in NYC will be lower than if you invested in say, Kiev Ukraine). It's risk reward.
Tax policies, for example, might incentivise local owners (who actually live in the property) to buy property where it is unrealistic for an investor to make money on -- if yields are 1 or 2%, one could say it's overvalued (unless we are talking about unique buildings in prime locations that are unlikely to ever decline in value).
Now a different situation: assume the stock market has declined by 40%, but property prices have not. One could say property is overvalued then (i.e. not the best asset to invest money in). As the spread between valuations and yields between different assets increases, some assets could be overvalued when comparing them to others.
This is a class on valuation. Very interesting and teaches a lot of important concepts.
But in the end "value" is highly subjective so there is no clear method to determine if something is overvalued.
But my home doesn’t generate cash flows, so it’s impossible to say the home is “over valued” because there is no objective benchmark. Perhaps someone is selling my great grandfathers homestead. it will be “valued” more highly by me, and I may “over pay” because I want that property. Or there is only one property available per year in a small neighborhood and I must have it. The value is psychological.
At a market level, look at the percentage of household monthly income spent on housing to gauge the market’s mood. If that strays from historical norms, it’s possible that the market is temporarily overheated.
Keep in mind that historical trends are distorted by the recent zero-interest rate policy from the Fed, too.
https://www.pewtrusts.org/en/research-and-analysis/issue-bri...
The other problem is that free markets are self correcting. Home buyers can bring down prices if the majority simply believe they will drop and refuse to offer asking price. So, anything believed by the majority of purchasing power becomes self-fulfilling in dragging prices in that direction.
With the current housing prices, the majority of purchasing power believe that houses are under valued, which is why prices continue to rise. Prices will continue to rise until the majority of purchasing power believes that houses are over valued. Only history and an arbitrary future reference point will tell us if they were right or not.
The use of the term "correcting" gives the free market way too much credit. Especially given that, as you note, there is no objective mechanical principle at work besides mass hysteria.
It would be better simply to say that _free markets fluctuate a lot_.
Over price housing and you get more homeless. A self-correction in a free market would be violent possession by the homeless; or the wages of murder squads increasing; or increase in thefts/frauds in order to afford rent.
Release harmful effluent from your factory and you might kill your customers. So, eventually you'll have noone to sell to.
Paying low wages, eventually all the people will either rebel or die and you'll have to increase wages or find a different way to steal value from others.
See, self-correcting.
Over-valued could be that players in the market are able to raise the price through, for example, manipulation of scarcity (actual various types of scarcity may be the only way?).
Or it could be that the seller seeks a certain profit that is [viewed as] excessive compared to the labour and material costs. The product is desirable, but the capital holders control the price ensuring large profit whilst keeping low wages for those who are actual creating the value.
House prices in the UK were hugely inflated by the buy-to-let market which increased scarcity of buying options whilst simultaneously increasing rental costs in order to cream off more wealth from the poor tenants and pass it to the middle classes. Rentals became overvalued because now the cost includes not only the cost of provision of a home but the unnecessary cost of paying your absentee landlord an investment premium. The middle class cornered the market, by generating an artificial scarcity of affordable housing.
The more wealthy can buy high street property -- keep rents high, occupancy doesn't matter because they get a reasonable return in asset value just by sitting on the property. High Street rentals are over valued.
1) One component of housing is how much money banks are willing to loan for the house. So 'easy money' environments will boost prices, apart from the quality and size of the house, the desirability of its location, and the circumstances of the buyer. In the mid 2000's, a lot of loans were made based more on bank's willingness to lend than on the other factors.
2) To hold on to a house, someone has to pay the carrying cost. If the carrying cost goes up past the ability of the owner, the house is sold or foreclosed on (or rooms are put on AirBnB, etc). In 'easy money' environments like the one created in the early 2000's and sustained since then, carrying costs have been kept low. If they go up, as they did briefly during the financial crisis, house prices will drop. The pattern seems to be to keep the money easy, so it's hard to say house prices are too high, even though their traditional relationship with income is out of whack.
hwever, local market conditions dictate the volatility around that trend line. SF, for example, is space-constrained, demand-driven, and limited by zoning and other regulations, so house prices will be high relative to historical trends.
appraisers use 3 methods to triangulate the current valuation of a house: (1) cost approach (how much it costs to buy the bare land and build on it), (2) sales comparison (finding recent sales for homes similar to the one you're valuing), and (3) income approach (typically the discounted cash flow of rental income). how these three approaches are combined to come to a final value is more art than science.
basically, just like economic bubbles, you can only know for sure after-the-fact if something was overvalued. you don't have enough statistical data to know if something is currently overvalued rather than within the normal volatility of the asset price.
(i used to manage the leading cost approach product)
both cost to build (both materials and labor) and sales price will be a little higher, typically.
Some things are cyclic and out span most people's memory/life.
Luckily, humanity learns from its mistakes, and people write down what happened in history, so we don't need to worry about where we are going.
For an interesting discussion about when and when this isn't the case the book Inadequate Equilibria by Eliezer Yudkowsky is pretty good.
Historically from time to time you do get these anomalies and bubbles where things get out of wack. The tulip bubble is a classic example, and BTC last year looked a lot like that too. I think the way to connect those prices back to value is that the price eventually (and not even that long from a historical perspective) got back in sync -- tulip bulbs eventually crashed and BTC has lost 50+% of it's value in the last year.
So I guess it's not to say price always == value for everything at every moment in time, but exceptions don't come around that often. Again, the Yudkowsky book explores when they do.
Related is this comment by Warren Buffett:
"I could improve your ultimate financial welfare by giving you a ticket with only 20 slots in it so that you had 20 punches—representing all the investments that you got to make in a lifetime. And once you’d punched through the card, you couldn’t make any more investments at all.
"Under those rules, you’d really think carefully about what you did and you’d be forced to load up on what you’d really thought about. So you’d do so much better."
This is an interesting segway into auction theory and Dutch vs English auctions in particular, if you are interested: https://mikebrandlyauctioneer.wordpress.com/2012/07/29/engli...
I only realised the pun in the product name when I first saw someone make this homophonic substitution error.
Either you got a great deal, or you got robbed.
I think housing in my area is overvalued because what I can afford to buy would be a step down in terms of comfort from what I can rent. I looked at some houses and checked tax records for sales history and notice a lot of houses were selling as if they grew in value 8% compounded annually. This made me think I would be buying high. I might be wrong but it feels to me that houses are overpriced. I could be wrong of course. Maybe prices increase at their current rate for 10 years. But it seems to me that the increases can’t be sustained given the situation in the country (USA).