You Might Be Buying Your House at the Top of the Market

Houses are really expensive, and getting more so. Prices jumped 1.2% in April from March, and are now up about 50% from the end of 2019, according to one prominent index.

For prospective buyers, it’s a crisis. For owners, it’s a windfall: Rising housing prices are a key reason the typical family’s real (i.e., after inflation) wealth has surged in recent years.

But for everyone, it should also be a warning sign. Homes are as overvalued as they were near the peak of the 2000s bubble, according to a variety of metrics, including a Federal Reserve model.

This doesn’t mean a collapse or crisis, like in 2008, is in the offing, for reasons I’ll get to. Nor is it a reason not to buy a home. As I explained back in 2020, pandemic trends such as remote work have enhanced the noncash return on homeownership.

But homes are also assets, and overvaluation is a predictor of stagnant, even negative, real returns in coming years, a headwind to anyone counting on real estate as a source of wealth.

Like any asset, a house’s value depends on several factors, and all have made valuations more stretched. First, price: The S&P CoreLogic Case-Shiller U.S. national home price index, which controls for changes in the mix of homes, is up 51% since the end of 2019.

The second factor is the stream of income generated by an asset. The income on your house is the value derived from living there, which can be proxied by how much a similar place costs to rent. According to the Labor Department, this owner-equivalent rent is up 24% since 2019.

That’s a lot, but far less than the rise in home prices and much, much less than the 114% increase in the monthly payment on a newly purchased and financed home, according to the National Association of Realtors. Owning and renting are close substitutes, so this widening gap is a red flag.

The third factor is the interest rate at which an asset is financed and its future income discounted. Higher valuations can be justified by lower rates, but since 2019, the benchmark 10-year Treasury yield has risen from below 2% to above 4%.

A model in the Fed’s semiannual financial stability report incorporates all these elements and shows that homes are now 25% overvalued, just below the 28% peak in 2007, using the Labor Department’s measure of rent, and 19% overvalued using private measures of market rents.

The Fed isn’t alone. John Burns Research and Consulting concludes that based on supply, demand and affordability, every part of the country is overvalued relative to its history, from 24% in northern California to 37% in southern Florida.

As with stocks, valuation isn’t much use for timing when to buy or sell a house. Overvalued houses can get more overvalued, as they did over the past decade in Canada, Australia and Britain, according to BCA Research. Home prices in all three countries have finally fallen, but by a fraction of how much they went up.

In the short run, supply and demand easily swamp valuation. Burns Research estimates underlying U.S. demand for homes exceeds supply by 2.1 million units, whereas in 2009, supply exceeded demand by 1.9 million. Founder John Burns said it usually takes a recession or financial crisis to push prices down, so if that isn’t your forecast, you should expect prices to stay high.

Still, some explanations for high prices are less convincing on inspection. Homeowners who have locked in low mortgage rates don’t want to move, depressing inventory and supposedly underpinning prices. But people who don’t move also subtract from demand, so the net effect on prices may not be great. In any case, all homeowners eventually move or die, and lock-in will fade.

The supply shortage is based on growing household formation thanks to millennials reaching peak home buying years and immigration. But households can buy or rent, so more households doesn’t necessarily mean prices should rise more than rents. Anyway, household formation is a moving target that changes with education, work, marriage and birthrates, geographic mobility and home affordability itself.

While valuation can’t time the market, it can temper expectations. Burns Research calculates that 74% of metropolitan markets are “high risk” for investors right now.

“From a landlord’s perspective, this is not a good time to be buying homes because the rental yields are very low,” Burns said. Indeed, he said publicly traded real-estate investment trusts have pulled back (though private equity is buying up apartments).

Just as high stock prices can be justified by strong earnings, house prices make sense if rent growth is above average in coming years, and indeed rents have begun to pick up. Still, a 2008 study by Fed economist Joshua Gallin concluded that when prices and rents get out of whack, they reconverge more via weak prices than higher rents. A return to prepandemic interest rates would support valuations, but that seems doubtful given stubborn inflation and big government deficits.

So some decline in prices is clearly a risk, especially regionally. But don’t expect prices to plunge as they did from 2006 to 2011. That reflected the lax underwriting and high leverage of the bubble era. When buyers defaulted, the resulting foreclosures drove down prices, which caused more borrowers to default. Bad loans lacking federal guarantees caused poorly capitalized lenders to fail or seek bailouts, shrinking the supply of mortgage credit.

Since then, income and appraisal standards have become far more stringent, credit scores are higher, especially at the bottom end, and foreclosure prevention is more effective, said Laurie Goodman, a housing finance scholar at the Urban Institute. Over 90% of mortgage-backed securities are now federally backed. “You will not have the big price declines because you’ve taken out the contagion effect that caused them,” she said.

So don’t expect to be wiped out financially by buying a house now. Don’t expect to get rich, either.

Write to Greg Ip at [email protected]