Housing Inventory Drives Price Movements

In the long run, housing prices are driven by fundamental variables such as income and population growth on the demand side, and land availability and construction costs on the supply side. These variables generally move in predictable long-term trends. The recent housing bubble suggests, however, that long-term trend variables are not the only factors that drive housing prices. If you're thinking about buying or selling a home within the next year or so, it would be nice to have a near-term price forecasting tool.

Take a look at the chart below, which compares the beginning-of-year inventory of single family homes in California to the change in median real price during that same year.

Inventory is stated as the number of months required to sell the current stock of for-sale housing, assuming that selling activity remains at current levels. I plotted it using an inverted scale in order to highlight the correlation with price changes.

The apparent strong relationship between the two series will be easier to understand if you consider what the inventory variable is really measuring. Months-of-inventory is a ratio, whose numerator is the number of houses currently for sale; in other words, the numerator is a measure of housing supply. The denominator is the current monthly rate of sales; in other words, it's a measure of housing demand. The combined ratio provides a snapshot of the balance between supply and demand. We shouldn't be surprised, therefore, to see a strong relationship between this ratio and subsequent near-term price movements.

Real estate practitioners often assert that the housing market is equally balanced between buyers and sellers when there is six months worth of inventory. The chart bears this out. In years when the beginning-of-year inventory was less than six months, the average increase in median real price was 11.6%. In years when the beginning-of-year inventory was greater than six months, the average increase was -1.7%.

This isn't a recipe for quick riches. For starters, housing bubbles are rare occurrences; it may be awhile before we see another year of 20% price increases. Remember also that buying or selling a home involves large transaction costs. When you account for those, a buy/sell strategy based on months-of-inventory is unlikely to yield substantial profits. Nonetheless, if you're planning to buy or sell a home within the next year, it seems wise to keep this basic supply/demand snapshot in mind.

The inventory of single-family homes in California was roughly 12 months at the beginning of 2008. The most recent figure was 6.7 months, as of August (although that’s not a seasonally adjusted figure). In light of what's happened in financial markets since then, my guess is that inventory has increased significantly. That suggests that home prices will be soft in the coming months. (Before you panic, remember that the average real price decline in high-inventory years was only 1.7%.)

By the way, you may be curious about the relationship between months-of-inventory and long term price changes. Months-of-inventory is sensitive to short-term factors such as interest rate fluctuations, recessions, and stock market turmoil. That’s why it correlates with near term price changes. For precisely the same reason, however, it is unlikely to predict long term returns.