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| Fortunes Are Not Made on Shaky Intelligence – Part 2 |
| Written by Jonathan Smoke | |
| 11.08.2007 | |
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Discuss this article on the forums. (0 posts) In yesterday’s post I started discussing the errors I saw in a recent Fortune article on real estate. I ended yesterday’s post questioning the “price-to-rent” ratio calculations and cited a couple academic papers that support the proper way to calculate home price ratios.  Even upon further reflection today, I’m still not sure if Fortune’s crude ratio reveals anything meaningful. Think about it this way: If we look at households as different segments, we find distinct differences in preferences towards housing. Preferences do vary by market, but in general some segments are more likely to rent and some are more likely to own. There are segments that are on the cusp of rent vs. own because of income/affordability, age, and tenure in an area, but in general segments do not readily switch back and forth between owning and renting.To those owning, what really matters is the cost of ownership and not nominal housing prices. So the only time an invisible hand would nudge an owner to rent would be when the cost of ownership is so out of whack with rents that he or she could benefit by selling and switching to renting because such gross inequities would make up for any quality of home/life differences. As rational owners make these moves, presumably this demand for rental housing would increase while ownership would fall. Then the market forces would be back in alignment with rents rising and prices falling. But to make this decision, our rational owners would be comparing costs of owning vs. costs of renting. At what point would the total cost of a house matter? Never. What mattered were the comparable costs. This Fortune article doesn’t factor in comparable costs. The best paper I have seen on this topic is “Bubble, Bubble, Where’s the Housing Bubble?” by Margaret Hwang Smith and Gary Smith of Pomona College. The authors created a better and more thorough way of analyzing home prices relative to fundamental values. They ultimately conclude that housing prices in markets can be “justified by plausible, if perhaps somewhat optimistic, assumptions about the future growth or rent and prices.”
So I suppose that if the public is naïve enough to buy into Fortune’s faulty analysis the public could all have suddenly very pessimistic views about future prices, and thus home prices should fall despite what every other metric is telling them about the strength of the local economies. Who does this benefit beyond those selling magazines or shorted housing futures? The Fortune article looks for price falls in almost every one of the 54 markets studied. While I do see significant price risk in areas that saw great appreciation in the early part of this decade and in areas suffering economically (likely a result in changing and now more realistic view of future prices), the rest should be at worst static. Tomorrow I’ll delve more deeply into how I reached this conclusion. 
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