Clause 61: The Pushback Blog

Because ideas have consequences

Is Texas Housing Overpriced?

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Last week, Fitch Ratings pronounced that Texas has the most overpriced housing in the country, warning of  a possible correction. In its report, Fitch wrote:

Fundamentals do not appear supportive of current prices and the economy is vulnerable to the energy sector. Overall, Fitch views Texas prices as approximately 11 percent overvalued, with prices in Houston, Austin, and Dallas each growing by over 20 percent since 2011.
— quoted in the Austin American-Statesman, http://www.statesman.com/news/business/are-texas-home-prices-overvalued-as-report-claims/njZms/

The report went on to state that Texas had “vaulted past California and now has the housing markets deemed most overvalued.”

Texas is a big state, and conditions in Houston, Midland-Odessa and Wichita Falls can all move independently of one another. Nevertheless, the report makes blanket overall statements about Texas, so one has to interpret and consider it in these terms.

Compared to What?

Making a statement that real estate is overpriced begs the question: in comparison to what measure? There are two primary objective measures of value:

  • Market value: the amount of money someone will actually pay for the asset;
  • Net present value (NPV): the value of present and future cash flows that will be generated or required by the asset, discounted by the time value of money.

Net present value requires managing some uncertainty, because it involves forecasting future events:

  • Future cash flows in and out of the asset;
  • The appropriate discount rate.

Nevertheless, NPV is appropriate for an investor in rental real estate to use. You have an initial outlay and future outlays to maintain the property. You have future inflows from rents, modified by the risks of having the property unoccupied at any time.

For owner-occupied properties, NPV is not usually a consideration. It would require using imputed rent, and it would ignore non-financial advantages of home ownership.

Appraisal

During the process of purchasing a home to be financed through a mortgage, the lender will almost always require an appraisal. The appraisal is an attempt to estimate the market value of a home. An appraisal is an opinion, not a fact. Organizations such as the Appraisal Institute (http://www.appraisalinstitute.org/) endeavor to ensure the reliability and rigor of real estate appraisals. Nevertheless, they always introduce levels of subjectivity that are not present with the hard evidence of a market transaction:

  • What existing homes that have sold are comparable to the home under discussion?
  • How far in the past can you go to obtain a valid comparable sale?
  • How far away from the home under discussion can you go to obtain a valid comparable sale?
  • What are the components of value you can count or measure, such as bedrooms or finished square feet?
  • What are the components of value you cannot count or measure, and how do they influence value?

There is an interesting definition of appraisal in Investopedia:

An appraisal is an opinion or estimate regarding the value of a particular property as of a specific date. Appraisal reports are used by businesses, government agencies, individuals, investors and mortgage lenders when making important decisions regarding real estate transactions. The goal of an appraisal is to determine a property’s market value: the most probable price that the property will bring in a competitive and open market. Market price, the price at which a property actually sells, may not always represent the market value. For example, if a seller is under duress because of the threat of foreclosure, or if the property was sold in a private sale without being exposed to the open market, the property may sell below its market value.

The distinction between market price and market value is worth noting. However, where the appraisal differs from the market price, how do we know which is closer to market value?

The reason lenders want the property appraised is to provide a control, managing their risk. In the past, when the lender who originated the mortgage expected to service the mortgage, the lender wanted to know that the homeowner actually had at least the equity position in the property that the lender believed. If the loan is underwritten in the belief that the mortgagee will have a 10% equity position in the property, but in reality the mortgagee will only have a 5% equity position, the mortgagee has less skin in the game and the risks of having the mortgagee walk away from the property under adverse circumstances are greater than the lender knows.

The appraisal business was strained in the years leading up to 2007, as mortgages were increasingly originated by organizations who had no intention of servicing the loans. These originators had every incentive to do the deal and little skin in the game themselves once they had sold the mortgage. The real estate industry, mortgage industry and regulators are struggling to cope with these changes and find the right balance of getting business done and protecting the interests of the various parties.

In Search of Market Value

There can be circumstances in which a buyer either overpays for a house or gets a bargain. In these situations, market price will not reliably reflect market value. But how do we know, and how do we identify market value?

Consider a purchase situation where comparable homes are selling for $150/square foot. A cash buyer purchases a home with 3,000 finished square feet of living space for $600,000, or $200/square foot. Assume there are no specific compelling features that push up the value of this house in the overall market. The buyer just wants this house. We say things like:

  • “He paid too much for that house.”
  • “He better be ready to stay there a long time or he will never get his money back.”

Thus, rather like obscenity, overpaying is something we know when we see it. Finding objective support for the claim, however, can be problematic. Take the hypothetical purchase price down to $465,000, or $155/square foot. Did the buyer really overpay? Or was the house finished better? In better condition? Did it have some feature that was more compelling than comparable houses sold in the recent past? Would any of these characteristics be similarly appealing to other buyers?

Establishing a measure of market value other than market price is more art than science. We have to try, because mortgage financing would be unacceptably risky without some attempt to validate the transaction price. Nevertheless, any attempt to establish a valuation basis other than what someone will actually pay for the asset introduces a lot of subjectivity.

Asset Bubbles

The events of 2007-2008 have heightened our awareness of asset bubbles in real estate. Bubbles can have negative consequences when they burst, as the prices people are willing to pay for comparable assets drops precipitously in a very short time.

Seiji Steimetz describes bubbles from an economic point of view:

.. the definition of a bubble involves some characterization of the extent to which an asset is overvalued. Let us define the “fundamental value” of an asset as the present value of the stream of cash flows that its holder expects to receive. These cash flows include the series of dividends that the asset is expected to generate and the expected price of the asset when sold. In an efficient market, the price of an asset is equal to its fundamental value. For instance, if a stock is trading at a price below its fundamental value, savvy investors in the market will pounce on the profit opportunity by purchasing more shares of the stock. This will bid up the stock’s price until no further profits can be achieved—that is, until its price equals its fundamental value; the same mechanism works to correct stocks that are trading above their fundamental values. So, if an asset is persistently trading at a price higher than its fundamental value, we would say that its price exhibits a bubble and that the asset is overvalued by an amount equal to the bubble—the difference between the asset’s trading price and its fundamental value. This definition implies that if such bubbles persist, investors are irrational in their failure to profit from the “overpriced” asset.
— “Bubbles”, Library of Economics and Liberty, http://www.econlib.org/library/Enc/Bubbles.html

Right away, the first thing we notice is that Steimetz equates “fundamental value” with NPV. This is the orthodox economic position, but as noted previously, it profoundly limits the applicability to the owner-occupied home. Most people who purchase their residences do not attempt to calculate their imputed rent and determine the NPV of the home purchase. If they even notionally consider it, it is most often a justification for a buy/rent decision they have already made.

Steimetz concludes:

The jury is still out on whether or not bubbles can persist in modern asset markets. Debates continue among economists even on the existence of irrational or rational bubbles. And there is often confusion in trying to distinguish irrational bubbles from rational bubbles that might be generated by investors’ rational but flawed perceptions of market fundamentals. Most modern efforts focus on developing sophisticated statistical methods to detect bubbles, but none has enjoyed a consensus of support among economists.

Whether or not bubbles can persist, we have seen that they can occur. Perhaps the best identifier of a bubble is behavioral: are purchasers making decisions on the inherent properties of the asset, or are the prices being driven by prior increases in price, with the expectation of a “greater fool” to come along in the future and pay even more for the asset? The latter is properly identified as speculation, not investment.

The more speculation going on, particularly in the same direction, the higher the likelihood of a bubble. Thus, in the years 2002-2007, residential real estate was seen as a stairway to the stars, with no possibility of downside. Originators began to give more consideration to the expected price performance of the asset than the credit risk of the borrower. As we experienced, it all came crashing down.

Is There a Bubble in Texas?

With this framework, we can evaluate the claims made by Fitch as to the conditions in Texas using the facts on the ground.

Is Texas Dependent on Energy?

The Texas A&M Real Estate Center provides a monthly review of the Texas economy. In their review for November 2014, the mining and logging industry, which includes oil and gas extraction, still accounts for less than 3% of total Texas jobs. The report states:

Of the 11,768,300 nonagricultural jobs in October 2014, the highest percentage of employment by industry was in the government sector followed by the trade industry, education and health services, professional and business services, and leisure and hospitality. Since October 2013 the state’s professional and business services, financial activities, construction industry, transportation, warehousing and utilities industry, and mining and logging industry have expanded their shares of Texas employment at the expense of the government sector, trade, education and health services, leisure and hospitality, manufacturing, other services and information industries.
— Ali Anari and Mark G. Dotzour, “Monthly Review of the Texas Economy: November 2014”, http://recenter.tamu.edu/pdf/1862.pdf

Thus the claim that the Texas economy is vulnerable to the energy sector is not supported by available data.

What about Price Growth?

The Fitch report also cites the fact that prices in Austin, Houston and Dallas have gone up over 20% since 2011. This is a significant increase, but how to interpret it?

The TAMU Real Estate Center also maintains an affordability index for various Texas markets. The index is the ratio of the median family income divided into the income required to qualify for an 80 percent, fixed-rate mortgage to purchase the median-priced home. Here are recent historical trends in these markets:

MLS Area 2013 2012 2011 2010 2009 2008
Arlington 2.51 2.95 3.32 3.13 2.4 2.11
Austin 1.8 2.09 2.38 2.31 1.88 1.56
Bay Area 2.17 2.38 2.61 2.49 1.99 1.67
Beaumont 2.18 2.51 2.71 2.35 1.96 1.68
Collin County 2.26 2.64 3.04 2.92 2.41 2.08
Dallas 1.94 2.31 2.65 2.58 2.09 1.77
Denton 2.62 2.99 3.25 3.07 2.25 1.98
Fort Worth 2.71 3.27 3.75 3.53 2.74 2.35
Galveston 2.16 2.57 2.44 2.27 2.09 1.33
Garland 3.18 4 4.58 4.58 3.14 2.71
Houston 2.02 2.3 2.63 2.53 2 1.72
Irving 1.96 2.61 3.13 3.2 2.39 1.88
Northeast Tarrant County 2.41 2.79 3.24 3.14 1.98 1.69

Source: http://recenter.tamu.edu/data/hs/afford.asp

Thus, for example, a median income home buyer in Dallas in 2013 would need a mortgage 1.94 times her income to purchase the median priced home in Dallas. Higher numbers indicate lower affordability.

To get a sense of comparison, let’s look at California. The California Association of Realtors doesn’t do their affordability statistics the same way. Instead, they report on the percentage of households that can afford to purchase the median home. For 3Q14, their numbers are:

Single-family homes statewide 30%
Los Angeles metro 32%
San Francisco Bay area 21%

Source: http://www.car.org/marketdata/data/haitraditional/

While the different methodologies frustrate direct comparison, it is clear that the median income household in California cannot afford the median priced home.

Moreover, look at the Texas figures across the rows. The figures are not trending uniformly upward from right to left. While prices are rising, so are median incomes in the region. Yes, prices are going up, but affordability is not falling out of bed.

Consider the earlier discussion on speculation and asset bubbles. If prices had gone up 20% in 3 years and affordability indices had marched from 2.5 to 4+, that would at least support the idea of an asset bubble developing. But the data do not show this. Instead, we observe that incomes support the rising prices. The area is generating wealth and jobs, and people are bidding up home prices.

Conclusion

The Fitch report makes serious and startling claims about the Texas real estate market. I am unable to find data to support these claims. The data I can find support my observations on the ground that the Texas economy is diverse across industries and, while real estate prices are rising, they are not rising out of proportion to wealth production.

Articles

The actual Fitch report costs money to obtain. These publicly available sources have quotes and summaries:

 

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Written by srojak

December 29, 2014 at 12:58 pm

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