August 6, 2019

Excerpted from a letter to clients sent August 1, 2019. Anyone can sign up for our quarterly updates here.
Measuring housing expensiveness

We all know that buying a home in San Diego costs a lot more than in most cities. But that's always been the case, and probably always will be, because San Diego is such a desirable place to live. More interesting is the question of how expensive San Diego is compared to its own history. This can tell us whether prices are out of whack even after adjusting for the desirability factor.

A good way to measure housing expensiveness is to compare home prices to local rents and incomes. Rents tell us how much it costs to live in San Diego as a non-owner, while incomes show how much money San Diegans have to spend on housing.[1] By comparing home prices to rents and incomes, we can get an idea of their cheapness or expensiveness relative to the economic factors that typically drive them. (This is also known as their "valuation").

Here's a chart of San Diego housing valuation since the late 1970s:


The main takeaway is that, while there have been significant forays into expensiveness and cheapness, there has been a strong tendency to revert to normal, reasonable (for San Diego) valuations. This makes sense: if prices become unhinged from rents and incomes, we should expect them to move back into line eventually.

Valuations can be a big help in evaluating the housing market's potential risk and reward. And they are showing that today's San Diego housing market is quite expensive -- not nearly at bubble-peak levels, but more so than at any time outside the bubble.

Can low interest rates (or something else) keep the game going?

Such high home prices are certainly a cause for caution. And yet, there is an interesting twist this time around: interest rates are unusually low, which has kept monthly payments reasonable despite rising prices.

Here's a chart that compares the typical San Diego monthly payment to local rents and incomes. It paints a very different picture than the chart above, which only considers home prices. Thanks to low interest rates, monthly payments are actually more affordable (compared to rents and incomes) than they typically have been over the past several decades. Put another way: the expensiveness of buying a home is more than offset by the cheapness of the borrowed money.


Can low rates keep home valuations propped up at their currently high levels? It's possible, but there are a couple reasons to be skeptical. The biggest one is that the idea depends on rates staying unusually low. There is great debate as to whether that will happen, and no one knows for sure. But in general, we think that while unusual situations can persist, it's not prudent to depend on that happening.

Even if rates do remain this low, it's questionable whether they can keep home prices high forever. It turns out that, while low rates may well play a part in today's elevated valuations, they have had very little influence on home prices in the past. (To keep this letter from getting too long, we'll leave it at that -- but if you'd like to read some evidence and theorizing about why this is, please see this Voice of San Diego article Rich wrote a while back.) Again, it's possible this has changed, but we are wary of depending on it.

Other factors could influence valuations as well. For instance, San Diego is an unusually housing-constrained city -- while this should show up in rents too, it could push prices up compared to incomes. Changes to the number of out-of-town investors, to the character of our housing supply, or to income inequality could also exert pressure on the ratio of home prices to both rents and incomes. Given that San Diego housing is, compared to global stock and bond markets, a very small, illiquid, and supply-constrained market, there is a higher possibility that it actually is "different this time."

It seems like such changes should be slow-moving and relatively subtle, though. And in any case, they are speculative. The odds have not historically favored the bet that it's different this time. The best approach is probably to allow for the possibility that valuations have permanently shifted to some degree, but not to depend on it.

Does it make sense to buy a home right now?

Summing it up so far:

  • While San Diego housing valuations have historically been all over the map, they've had a strong tendency to eventually return towards the middle range of their historical levels.
  • Currently, San Diego housing is quite expensive compared to history (though well short of bubble peak levels).
  • But unusually low rates are keeping monthly payments at reasonable levels, and should those low rates persist, it's possible they could prop up valuations indefinitely.
  • It's also possible that due to unique economic factors, valuations could settle at a different equilibrium level than they have historically. But this would likely be subtle and somewhat risky to bank on.

So where does that leave a potential buyer? It depends on the situation, and whether one is more concerned with future changes in monthly payments or prices.

If one is buying a home to keep for the long haul, and financing the purchase with a fixed mortgage, then the main priority is probably to lock in a reasonable long-term monthly payment. In this case, it may well make sense to buy. As the second chart above shows, monthly payments are lower than the historical average even despite high purchase prices.

If on the other hand a buyer isn't planning to keep the property for long, then it makes sense to be more concerned with what prices will be when the time comes to sell. The first chart shows the risks in that scenario. While it's possible that valuations could remain elevated, current price levels suggest more downside than upside. However, this will become less of an issue as time marches on and incomes and rents have a chance to catch up with prices. (To put some very rough numbers on it: 5 years feels risky; 10 years a lot less so).

Every situation is different, but the rough rule of thumb is:

  • If monthly payments are the primary concern, it may make sense to buy.
  • If future price changes are the primary concern, it may be best to hold off until valuations are a bit more reasonable.

The good news here is that there isn't a lot of pressure to do either one. There have been times where it was crazy to buy in San Diego, and times where it was crazy not to. This is neither of those times. Either choice is reasonable, depending on circumstances, so you can do what best fits your own circumstances and lifestyle.

The same applies to real estate owners. Given the context of low rates, valuations aren't high enough that anyone should feel compelled to sell on that basis alone. But for owners who are considering selling for other reasons (cash needs, downsizing, moving out of state, selling a rental property, etc.), they can sell now and take comfort that they are doing so at a time of unusually high valuations.

1 - For more on the relationship between incomes, rents, and home prices, see Rich's Voice of San Diego article on measuring housing valuations. As discussed in that article, the price/income and price/rent ratios have been very similar throughout history, so we've combined them here for simplicity.)