An asset has no value absent three things: what people are willing to pay for it, what people can pay for it, and it's fundamental value (i.e. an NPV of all present and future dividends and costs)
With housing "ability to pay" is the only factor that matters - it either drives the rent price or the sales price. Rent is a fairly liquid market, so it is a good indicator of long term "ability to pay."
Here is how you can calculate the fundamental value of housing:
Start with income * percent allocated to housing = housing budget
Take housing budget, factor it by interest rates, percent loan and term and you have the maximum loan you can support.
Maximum loan + down payment = house price.
(in excel, use this formula to get maximum loan =pv(rate,years,yearly housing budget) )
- percent allocated to housing is complicated as it varies from person to person, but there are hard caps on what people will spend on housing - it is physically impossible to spend more than 100%, lenders usually won't allow you above 40%.
- down payment is complicated as well, since you have to assume the down payment was either saved or borrowed
- housing budget has two parts: investment + lost payments. Rent is 100% lost payments, mortgages start out mostly lost payments then switch over time to mostly investment. This helps explain why mortgages should be more expensive than rent for the same size place.
- since inflation increases salaries it should pass through to houses, so over the long term absent any increases in salary or other changes, housing prices will track inflation.
- amount you can afford doesn't respond to changes in supply and demand.
- what responds to supply and demand is the size of the space you can afford (so in NYC you pay more for square foot, and in places where there is lots of available land you get as much space as you can afford to build)
The only long term drivers of house prices are 1) inflation 2) increased wages and 3) increased demand without corresponding increases in supply.
Short term fluctuations can be caused by:
- Required down payments (or the converse, amount you can finance)
- Interest Rates
- Expectations and other noise
For many places in the US, housing prices have already equilibriated. But in Seattle (where I now live) they have not yet. Based on median income (I assume $63,856, and growth of 4% per year), long term average interest rates (7% for the past 15 or so years), and current house prices (~440 median price) - don't be surprised to see another 10 to 30% drop in Seattle prices -- no appreciation for 5 to 10 years -- or worse.
PS I know, I've been gone for a really long time. This deserves some explanation, but I'm not going to provide it right now.