Bay Area Home Prices Back in Fair Territory

Bay Area home prices have fallen more than 40% from their peak. Judging from the heavy demand for bank-owned homes, many investors seem to think that prices have bottomed out. There may in fact be good deals available in the foreclosure market, but recent price trends are not encouraging for the broader market. What do the fundamentals have to say about the issue?

One way to assess the value of an asset is to compare it to the cash flows that it generates. Homes generate rents, so many analysts focus on the ratio of home prices to rents.

(In the past, I've compared home prices to incomes. I've also pointed out that rising incomes lead to rising rents, so the two series typically move in tandem with each other. Comparing prices to incomes is therefore equivalent to comparing prices to rents. Indices of historical rents are easier to find, which is why so many people use them.)

The Case Shiller indices are widely used measures of home prices. Their main strength is that they are based on repeat sales of the same homes, and thus are not distorted by unusually heavy activity in low-end neighborhoods. Unfortunately, these indices don't cover the period before 1987, so I combined them with price indices from OFHEO in order to cover the pre-1987 period. That shouldn't invalidate the present analysis, because we're mainly interested in the post-1987 period anyway. (The two indices were in close agreement until around 2003.)

As for rents, the most readily available measures are the Owner's Equivalent Rent of Primary Residence indices, which are provided by the Bureau of Labor Statistics.

Take a look at the chart, below, which shows Bay Area home prices, rents, and median household incomes for the period since 1983 (when the BLS rent series began).

The solid blue line shows the Case Shiller home price index (with the pre-1987 period represented by the OFHEO index). The dashed blue line shows the BLS rent index. The purple diamonds show an index of median household income, assembled from data provided by the Census Bureau. (The absolute levels of the price and rent indices are meaningless, so I re-based every index to have a value of 1.0 in 1999.)

It's risky to make sweeping assertions on the basis of aggregate statistics, especially when the statistics are compiled from multiple, unrelated sources. But based on this snapshot, I'd say that Bay Area home prices are back in fair territory.

Note: I don't have long-term historical price or rent data for the City of San Francisco, so it's harder to do the same kind of valuation analysis for the City. I'll tackle this in a future blog entry.

Update: The most recent figures from Case Shiller are for December. I should have mentioned that I brought them forward to the end of February using numbers from Dataquick. That approximation is probably no more brutal than any of the other approximations that go into this kind of analysis. (Case Shiller will release its figures for January on Tuesday, March 31st.)