Real home prices still need to drop to return to the historical trend level

With regard to Princeton Economist Paul Krugman's August 4th post, "Stations of the bubble":

The Case-Shiller graph shows real estate prices going from 100 to 130 between 1/2000 and 4/2008. Shiller has a highly respected data set of home prices going all the way back to 1890. He finds that although there are plenty of bubbles, busts, and flat periods, the average real (inflation adjusted) return (price appreciation) is just 0.4% per year (See Shiller's book "Irrational Exuberance", 2nd edition, Chapter 2).

If home prices had kept following that average trend they would only have risen to 103.38 rather than the 130 they had risen to over that 8 year and 4 month period. For prices to deflate to the average trend level they would thus have to drop from 130 to 103.38, a 26% drop. This is a good piece of good evidence pointing to a further drop in home prices of about one-quarter over the next few years.

Why over the next few years? Because Yale Professor Shiller's home price data also shows that home prices deflate slowly. Owners take a long time to admit that they are going to have to lose a lot of money if they are going to be able to sell their homes. They hold out. It also takes a long time to absorb excess building.

While a 1/4 drop may not seem that bad, you have to keep in mind that it's a 1/4 drop on a lot of money. Consider buying a $200,000 home now versus waiting 3 years. If you bought now and the price did drop by 1/4 you would lose $50,000 from the home price depreciation, but also, if you bought the home for cash, you would not have the $200,000 to invest in, say, a well diversified stock portfolio. The historical average return on such a portfolio is about 10.5% compounded annually. So over 3 years that $200,000 you spent on the house would have produced $69,847 in return, so your total loss from buying instead of waiting would be $69,847 + $50,000 = $119,847. Now, you would save on rent over 3 years, so that should be subtracted out. Suppose you would have rented an $800/month apartment. Over 3 years, with foregone return on a stock portfolio, that's $33,718; but subtracting it from the $119,847 still leaves you better off from renting by $86,129, a huge amount of money for most individuals or families.

What if a well diversified portfolio of stock doesn't have it's average historical return? There is risk to stock investing, but I think it's reasonable over the long run (in a well diversified portfolio), and low relative to the very high historical average return. I, like Wharton investments expert Jeremy Shiller, and many other top experts, think that a well diversified stock portfolio is a great way to invest most, or in some cases all, of your long run savings. Nonetheless, owning your own home with no mortgage is normally a great idea; it adds a lot of security, and in today's America that's really important, but it looks like it would be better to wait at least a year or two right now and keep saving, because it looks like home prices will drop substantially.

What if you don't buy for cash? What if you take out a mortgage? Then you only forego about 6% in mortgage interest (with good credit), not the 10.5% in average historical stock price return. Plus, you get the mortgage interest tax deduction.

In response to that, first, for most families the mortgage interest tax deduction is close to outweighed by having to pay property taxes, although this depends a lot on your particular tax situation. In addition, when you own you have to pay for maintenance and homeowners insurance, and these are substantial. There's also risk to a mortgage too, especially a large one (Remember the crucial personal finance advice of Harvard Professor Elizabeth Warren, never let your total Must-Haves (fixed expenses) exceed 50% of your take-home income.) If something goes wrong (job loss of a spouse, high medical bills, etc.), and that's a lot more likely in today's America than in the America of a generation ago, you risk foreclosure, or having to sell the home quickly at a fire sale price.

For most individuals and families, when you run the numbers it will still favor waiting, especially if the alternative is a significantly smaller and/or less opulent apartment or rented house. The bachelor living in a $600 apartment will probably be far wealthier three years from now if he stays there, and invests all of the money he's saving over buying in a well diversified stock portfolio, than if he purchases a $300,000 house.