CLAREMONT, Calif., April 3, 2006 (AScribe Newswire) — Fears of a real estate bubble are overblown, and homes remain undervalued in many markets, according to new research from a pair of Pomona College professors who developed a fresh methodology for gauging bubble trouble. By comparing the cash flow generated by owning a home to the cost of renting a comparable house, economics professors Gary Smith and Margaret H. Smith found bubble conditions in only one of the 10 metropolitan U.S. housing markets evaluated.
In a paper presented March 31 at the Brookings Institution in Washington, D.C., the husband-and-wife team concluded that buying a home generally remains an attractive long-term investment – even if buyers are conservative in their assumptions about how much home prices will rise in the future.
“Most of the country is certainly not in a bubble if you define a bubble as prices far above fundamentals,” said Gary Smith, who is the Fletcher Jones Professor of Economics at Pomona College. “The average person in the U.S. is still better off buying than renting.”
San Mateo County in the San Francisco Bay area was the only region studied where homes were overvalued and that was by 54 percent. Elsewhere in California, Orange County prices were about right, while homes in Los Angeles and San Bernardino counties still were somewhat undervalued, 11 percent and 20 percent, respectively. Beyond California, homes also were undervalued in Boston (12 percent under) and Chicago (17 percent under). Undervaluation was dramatic in Dallas (40 percent), Atlanta (53 percent), Indianapolis (65 percent) and pre-Hurricane Katrina New Orleans (46 percent).
The Smiths’ methodology consisted of evaluating housing as a long-term investment, similar to stocks and bonds. In each market they studied, the Smiths matched up similar homes, comparing the cost of buying versus renting, using Multiple Listing Service data from summer 2005. They projected homeowners’ net savings on rent over time, discounted by a required after-tax rate of return of 6 percent, because the money sunk into the home purchase could presumable be invested elsewhere, for example, in stocks and bonds. Their analysis factored in expenses such as one-time closing costs, taxes, maintenance and insurance. On the other side of the ledger, they also factored in tax benefits from ownership and the fact that rents will rise over time, while payments on a fixed-rate mortgage will not.
They assumed a 20 percent down payment, with a 30-year mortgage at a 5.7 percent fixed rate. Under the Smiths’ model, in many cases, the home purchase initially generates negative cash flow, as the expenses of owning exceed the rental value and tax benefits. But over time cash flow becomes positive. And in some of the more dramatically undervalued markets, such as Indianapolis, owning a home generated an immediate positive cash flow.
So why all the talk about a housing bubble? The Smiths note in their paper that as housing prices have risen dramatically in recent years, some researchers have concluded that homes are now priced well beyond their fundamental values. But the Pomona College professors question the implicit assumption that market prices previously matched fundamental values but now have exceeded them. “Perhaps housing prices were too low in the past and recent prices have brought market prices more in line with fundamentals,” they write.
Beyond that, the Smiths question the methodology by which some researchers have concluded that the housing market is “bubbly.” The report notes that “housing-bubble discussions generally rely on indirect barometers such as rapidly increasing prices, unrealistic expectations of future price increases, and rising ratios of housing price indexes to household income indexes. These indirect measures cannot answer the key question of whether housing prices are justified by the anticipated cash flow.”
Gary Smith says their model also can be adapted to calculate the likelihood of housing being a good investment under different scenarios, such as an adjustable rate mortgage instead of a fixed. However, the Smiths’ model assumes buyers will hold on to the house for the long haul, not selling in a couple of years.
He advises against trying to predict which direction home prices are headed, telling the cautionary tale of a Claremont, Calif., professor who in 2003 decided against buying because he had read in the newspaper that home prices were 20 percent too high. It turns out home prices rose dramatically in the area. Prices instead continued to rise dramatically. “You’ve got to run your own numbers,” Smith said.
Gary Smith is the author of more than 50 articles and several economics textbooks He earned his B.A. in mathematics at Harvey Mudd College and his Ph.D. in economics at Yale University. Margaret H. Smith, an assistant professor of economics at Pomona College, earned her B.A. at Yale University and her Ph.D. at Harvard University (both in economics). She also is a Certified Financial Planner and has been published in journals such as the Journal of Financial Planning, Applied Financial Economics and Industrial Relations.