Zillow: Housing Correction Could Mean Home Price Volatility

Recent housing affordability is a function of cheap borrowing costs, not fundamentally low home prices.

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A house for sale, price reduced.
A house for sale, price reduced.

After bottoming in October 2011, U.S. home values have appreciated for 16 straight months (and counting). It's a great recovery story. But given some signs of volatility in the market, is the recent, robust home-value appreciation too much of a good thing?

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Home values have been on a wild ride over the past decade: Up almost 52 percent cumulatively from February 2002 to February 2007, then plummeting more than 23 percent to the bottom in the fall of 2011, according to the U.S. Zillow Home Value Index. More recently, national home values were up almost 6 percent from year-ago levels in February, and many markets saw price appreciation of more than 15 percent annually.

These wild and largely short-term home value gains and losses can give buyers and sellers whiplash, and can lead them to think about housing as a short-term or speculative asset, trying to time transactions to coincide with market peaks and valleys. But buying primarily with the intention of selling a few years down the road and reaping a windfall profit is a recipe for disaster – ask those who bought in 2006 or 2007.

Housing is a long-term asset and, generally, a nondepreciating one (with the exception of the past five years). Buyers in it for the long haul shouldn't expect huge annual value appreciation, but can also expect some immunity from short-term volatility. Over the past 10 years, national home values have appreciated at an annual pace of more than 2 percent, on average, even after the double-digit depreciation experienced during the worst of the housing recession. In the pre-bubble period between 1985 and 2000, home values appreciated at almost 4 percent per year.

The idea of buying for the long term is more important when considering just how unusual this recent, very rapid value appreciation is in many markets, and how much housing affordability is a function of mortgage rates – not fundamentally low home prices.

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Between 1985 and 2000, the monthly mortgage payment on the median home in America (after a 20 percent down payment) represented about 20 percent of monthly median household incomes. As of the fourth quarter of 2012, this has fallen to roughly 13 percent. Based purely on monthly mortgage payments, housing is currently 37 percent more affordable than pre-bubble norms.

The Federal Reserve has adopted policies aimed at keeping mortgage rates incredibly low, but that won't last forever. And once mortgage rates climb to more normal levels between 6 percent and 8 percent, housing is going to seem quite expensive again, potentially introducing a new, troubling element to the housing recovery.

Home values have been climbing during the housing recovery, but wages have remained stagnant. Historically, Americans bought homes that cost roughly 2.6 times more than their annual household income. This ratio skyrocketed during the housing bubble, peaking with homes costing four times as much as annual incomes. Today, homeowners are spending three times as much as they make in a year on a typical home – a big correction, but still not back to pre-bubble norms. In fact, independent of the effect of low mortgage rates, homes actually cost 15 percent more today than their pre-bubble norms.

The housing correction has introduced several new facets to the housing economy, some of which may produce price volatility, not stability. For example, high levels of negative equity are likely producing inventory constraints in many markets, causing price spikes. Additionally, robust investor activity has helped transition homes from being owner-occupied to rentals.

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While we hope the draw down of investor activity will be offset by increasing numbers of mainstream buyers as the economy improves, we can't be sure that these countervailing trends will dovetail so nicely.

In other words, just as the real peril of global warming isn't necessarily rising temperatures but rather increasingly inconsistent and extreme weather, the real housing correction might not just be the five-year decline in home values from which we've recently emerged. Instead, it may entail a much longer period of price volatility, with current robust price appreciation just one small part.

Home value appreciation is expected to moderate, slowing from the current 5.8 percent pace of annual appreciation to 3.2 percent over the next 12 months, which should help the market regain its balance without overheating. But regardless of what happens, home buyers and sellers are encouraged to enter the process with their eyes wide open, prepared for however the market turns in coming years.

Stan Humphries is chief economist at Zillow, an online real estate marketplace that provides information on home buying, home selling, homeownership, mortgages, and rentals.

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  • Corrected 04/10/13: A previous version of this article misstated the home price bottom. It was the fall of 2011.