Twenty

How to Outguess Home Prices

In the 1980s the Boston housing market had gotten ridiculously expensive. Or so many believed, including Wellesley economist Karl Case. Case wondered whether there was an objective way to establish that homes were expensive. After all, a free market had set Boston’s home prices. Buyers were paying them, and sellers were getting them. Case got the idea of comparing sales prices of the same homes over time. This would track the home market better than the usual practice of taking an average of recent sale prices. The problem with a simple average is that there are times when cheaper homes sell in greater numbers than more expensive ones, and vice versa. That distorts the average price. Case’s approach compared apples to apples.

He collaborated with Robert Shiller and Allan Weiss in developing the idea. The Standard & Poor’s Case-Shiller Home Price Indices, as they’re now called, cover the entire US and twenty metropolitan areas. They express home prices relative to the first quarter of 2000, a reasonably average time for valuations. The index for the first quarter of 2000 is defined to be 100, and it’s not adjusted for inflation.

I’ll make that reasonable adjustment for you. I took the Case-Shiller national index and scaled it to the changing value of the dollar, using the Bureau of Labor Statistics’ Consumer Price Index. This was done so as to leave the 2000 value at 100. Here is the chart of US home values.

The first thing you’ll notice is that there was a big peak in 2006, followed by a sharp correction. This is the bubble that many homeowners (and former homeowners) are still reeling from.

The second thing you’ll observe is that the long-term return of the home market is approximately… zilch. Had you bought an average house in an average American community in 1987, held it for twenty-five years, and sold it in 2012, you’d be selling at just about the same price you paid, after allowing for the shrinking dollar. With broker commission and taxes, you’d lose money.

Sure, some property has appreciated in real terms. You could have bought some desert land in Nevada and found that, decades later, it’s in middle of the Las Vegas Strip. That would post an impressive return, but only because the land was virtually worthless to begin with.

Residential real estate is different. In order to afford mortgage payments, homebuyers usually have to buy into a mature community with jobs (and schools, shopping, transportation, etc.). The land has already appreciated from zero to hero. The most the buyer can realistically hope for is that the property will maintain its value and be a hedge against inflation. A home isn’t a growth stock. It’s more like a car, and you don’t want to get ripped off by paying too much.

A third observation from the chart is that the home market strayed up from the mean more than down from it. The highest valuation was a 61 percent premium on the benchmark. The lowest was a 13 percent discount. People need places to live, even when times are hard. That tends to prevent homes from becoming too undervalued. In the Case-Shiller time frame, there were a few very bad years to buy a home—2004 to 2008—but no not-to-be-missed buying opportunities when homes were absurdly cheap. Homebuyers should forget about making a good investment. The goal should be to not make an incredibly bad one.

Why do people think real estate is a good investment? I’ll give you three reasons. One is that we’ve been told it’s a good investment by construction and real estate interests that spend lavishly on ads. Another is that most people forget about inflation. A third is the hot hand. In the early 2000s everyone watched home prices spurt upward. They told themselves that the hot streak would continue a few more years. Many feared being locked out of the home market forever unless they took the plunge.

Memories are short. In early 2013 the Case-Shiller Index posted double-digit year-to-year gains for battered markets like Phoenix and Las Vegas. Case himself worried that reports of those gains might start a new frenzy.

Immense misery could be avoided, were there a way to tell when prices are too high to justify buying a home. The Case-Shiller Index supplies that, for those willing to pay attention. Clearly, you should buy a first home when prices are average, not high. One approach is to set an arbitrary limit, as in “never buy when the inflation-adjusted Case-Shiller Index is over 140.” That’s not the worst idea in the world. But a one-size-fits-all number won’t work for every buyer. Everyone has different motivations for buying a home. Some are willing to make a bad “investment” to buy at a convenient time in their lives or to get a unique home they love.

A more flexible system is to figure how much you stand to lose should the market revert to the mean, and ask yourself whether the home is worth that to you.

In other words, figure the home’s baseline value, defined as what it would be worth in a “normal” market with an inflation-adjusted Case-Shiller Index of 100. You should use the index for your metropolitan area when possible. Subtract that baseline value from the price you’re thinking of paying. The difference is an estimate of how much equity you stand to lose if and when the market returns to normal levels.

Though hypothetical, this loss demands to be taken seriously. Real estate bubbles don’t last long, and homes spend most of the time at close-to-normal valuations. Those who buy high and stay in a home a long time will find that inflation masks their loss. But the penalty is real and ought to figure in your decision making.

Example #1. You’re thinking of buying a house, and the Case-Shiller Index for your city is 123. The Consumer Price Index (CPI) is 228. In the first quarter of 2000, it was 169.8. Therefore, consumer prices are 228/169.8, or 1.34, times higher than they were in 2000.

Divide the Case-Shiller Index (123) by 1.34 to get 91.6. That is the inflation-adjusted Case-Shiller. Because it’s less than 100, it’s telling you that homes are cheaper, in real terms, than they were in the average year of 2000. You needn’t worry that the general market is overpriced. It’s a good time to buy.

Example #2. The Case-Shiller Index is 177, and the CPI is the same as above. The inflation-adjusted Case-Shiller would be 131.8. Prices are about 32 percent higher than they would be in a normal market.

You’re thinking of paying $800,000 for a home. Should prices revert to the mean, your home will be worth about 100/131.8 of what you paid, or $607,000. That’s almost a $200,000 drop. Are you willing to forfeit $200,000 to buy that specific home at this moment? If so, go for it. Otherwise, you should think about delaying a purchase until the market cools down.

Here’s a streamlined version of the math. CS is the Case-Shiller Index for your area, and CPI is the Consumer Price Index. This tells how much you stand to lose.

The above advice is most relevant for those buying their first home. Most homebuyers will own several houses or apartments in their lifetime. They sell one to buy another. There is much less risk when you’re both buying and selling real estate at the same time. Trade-up buyers should plug just the difference in price between their new and old homes into the above formula (in place of “Home Price”). Those downsizing have little to worry about.

Analytics has uncovered a number of surprises in the real estate market. Consider the day of the week that a home is listed (goes online). It’s an arbitrary choice, and many sellers never give it a thought. Others try to choose strategically. Some agents believe it’s best to list just before a weekend. That way the home gets maximum attention its first weekend, when it is freshest to the market. Buyers like to think they’re getting the first crack at a property, and a home listed on Monday may already be a little “stale” by the next weekend.

In 2012 the brokerage firm Redfin reported that Friday was indeed the best day to list. Friday listings sold for an average of 99.1 percent of the original asking price. In comparison, homes listed on the “worst” day, Sunday, sold for 98.4 percent. As it’s hard to believe that Sunday listers have more unrealistic asking prices, this suggests that a seller could net as much as 0.7 percent more just by listing on a Friday. On a $600,000 home, that would come to over $4,000. That’s far more than a few extra days’ mortgage and holding costs. In fact, Redfin also found that Friday listings sold the fastest.

Trade-up buyers might consider listing their homes on Friday and prioritizing looking at homes listed on Sunday, which may have less buyer competition.

Recap: How to Outguess Home Prices

• There are times when homes are seriously overpriced. The would-be homebuyer should avoid buying then.

• Look up the current Case-Shiller Index (CS) for your metropolitan area and the Consumer Price Index (CPI). Calculate this:

If the result is positive, the market is overvalued. The formula tells how much a first-time homebuyer could lose if (when) home prices revert to the mean.