Sammy Looks at the Role of Expected Price Appreciation in Housing Prices

Sammy sends this one…

Role of Expected Price Appreciation in Housing Prices

U.S. home prices are declining, putting considerable strain on the economy. Much of the blame is focused on “reckless” financial institutions. But what has been the role of the public (or free market) in driving housing assets up to, in retrospect, unsustainable levels?

Up to now the price of a house has been made up of two components:

1) Shelter Value (tax adjusted mortgage (ownership) payment vs. comparable rental payment)

2) Investment Value (price appreciation)

Here is a model that illustrates the effect of these two components on House price.

Note: There are many Rent vs. Buy models out there. I chose this one because 1) It’s from the New York Times and 2) It’s so easy, visual, and fun.

O.K. Real World inputs. I currently rent a condo with a market value of $400,000 for $1250 per month (Portland OR). I used 0% rent increase as my assumption. Feel free to use your own.

Plugging these figures (shelter value) along the top, and adjusting expected appreciation (investment value) with toggle on the left yields the following results:

1) At 10% expected price appreciation buying is better than renting after 1 year

2) At 5% expected price appreciation buying is never better than renting

3) You don’t even want to know what happens below 5%, (but toggle the arrow anyway)

4) Reverse mojo, assuming 0% price appreciation (pure shelter value) a fair price for the condo is $165K (“Buying better than renting after 10 years”)

Buyers, sellers, investors use some form of this calculation in their decision making process. It was “Appreciation Crowd Mania” that drove home prices up. The screwy lending, relying on historical loss data, just followed. Now the crowd mania, as is want to do, is reversing.

This one was by Sammy.

Cactus here… I agree with Sammy. I have no doubt that home buyers and lenders both drove up prices together. I will say this….

1. Presumably, the lenders – financial institutions – were more financially savvy than most buyers
2. When the bail-out comes, I expect the lenders to do better than the buyers from it