The March Existing Home Sales report released today by the National Association of Realtors shows big price increases. No bubble here, but the party is about over.
In March, 6.9 million homes changed hands at a median price of $195,000. To the delight of my real estate broker friends, that’s +4.9% more transactions at an +11.9% higher price, than one year ago, which means real estate commissions increased by +17.4% in the past 12 months.
The biggest increases were in the West, +5.9% in March and +19.9% year over year ago. The Northeast, although +11.4% over last year, were down -3.2% in March. Guess the Wall Street bonuses aren’t looking so good.
I am always more interested in existing home prioces than new home prices for three reasons. There are a lot more old houses than new ones, which makes the numbers more reliable. Existing home sales are less distorted by variations in lending terms in the fickle construction loan market. Finally, the total expected return on existing homes is a very important driver for the level of interest rates.
The key term above is expected. The expected capital gains yield (the expected increase in the price of a home the next year divided by its current price) plays the same role for investors managing wealth as does the expected capital gains yield on their stock portfolio.
What matters, of course, is comparisons of expected total returns on real estate, stocks, bonds, and the other assets people can own. These include estimates of their respective current yields; the service yield of the house (roughly the value of living in the house divided by today’s price), the dividend yield of the stock, and the current interest yield of the bond. All sorts of other things matter too, including transactions costs (for fellow geeks, like my friend Paul Davis, transaction costs create a kind of arbitrage threshold for transactions, identical to the role played by Boltzmann’s constant in the numerator of the exponent in Boltzmann distribution, which measures alternatively the probability of two particles crashing into each other or to a chemist the speed of a chemical reaction), tax rates on each asset, and liquidity.
Of these, expected price increases and changes in tax rates are the stars in the show. Not because they (analytically) matter more; because they happen more.
This is the analytical root of the link between expected inflation and interest rates, and explains why we should NOT measure that link using CPI inflation rates, as I wrote about the other day.
So why are interest rates so low today in the face of such huge home price increases? Mainly because the increases of last year don’t imply they will go up gain next year. The big increases were caused by falling interest rates when owners capitalized future rental income streams at lower rates. Their behavior next year will depend on rates then too.
There are many people who think rates will rise a lot next year. They will be proven wrong. They get excited when they see a big CPI number, like the one we saw last week, and they sell the stock market. I think we will see very soft inflation numbers next year, which will keep long bond yields roughly where they are now. Stable bond yields should allow housing prices to come in for a gentle landing, maybe up 3-5% next year with slower increases after that, but still with huge variations across the country driven by income fundamentals.
The private equity market gives us another piece of evidence that the big price run-up is over. I have been seeing a big increase in the number of businesses for sale in the construction and building materials sectors. I saw a residential construction business for sale today, for example, with $10 million in profits last year on $30 million in revenues. That 30% pretax profit margin is too high for a construction business, reflecting the builder shortage in today’s hot market.
JR
