Markets

Reality checking real estate

A macro analysis of home price performance and affordability.

I’ve been thinking a lot about real estate as an asset class lately. My brief look at 2012-Present Sacramento home prices in Relatively Speaking showed that homes have been losing value in purchasing power (/M2) terms since mid-2018 (despite all-time-high nominal prices).

That admittedly narrow snapshot of time for only one market did make one thing crystal clear:

In this current monetary environment, home prices alone don’t tell the full story.

That reality left me wondering whether two recently-dominant narratives about residential real estate (1) being a good long-term “investment” and (2) becoming increasingly “unaffordable” were supported by the economic data.

To test those narratives, I framed them as questions:

  1. How have home values performed in purchasing power terms?
  2. How has home affordability changed over time?

I’ve spent the past few weeks building data models to answer them and wanted to share what I found.

Hope you find it interesting!


TL;DR

  • Home Value Performance: On average, homes have done a poor job of preserving purchasing power over the long term. Local markets can deviate meaningfully and be far more amplified than the national trends. Meaning, short-to-mid-term performance in a specific market is highly dependent on cycle timing.
  • Affordability: On average, homes have become more affordable over the long term, but the average doesn’t account for rising income inequality. Meaning, homes are becoming more affordable for high-income households while at the same time becoming less affordable for low-to-middle-income households.

Investment or Cost of Shelter?

First, a note about applying this analysis to one’s personal home:

This analysis aims to take a deeper look at how residential real estate has performed in purchasing power (/M2) terms. This context is vital for better understanding what role(s) real estate is playing in one’s portfolio and life — be it investment, cost of shelter, or a blend of both.

Weighing the opportunity costs a capital allocation to real estate implies for one’s overall portfolio and quality of life is very much a personal choice. There are no wrong choices. Everyone’s expertise, needs, and desires are different. Homeownership can provide stability and the freedom to tune a space so that it best enhances and supports your life, family, and work. These benefits can’t be analyzed or charted.

The goal of this analysis is to paint a high-level, data-driven picture of the financial implications of homeownership to aid in making choices about real estate that better align with our intentions.

With that in mind, let’s dive in!


The Big Picture

This analysis is based on FRED Economic Data published by the St. Louis Fed, which covers 1981 through Dec 31, 2020 (next release is late May 2021).

To confirm 1981 is a fair point to index from (ie. not an outlier cycle top or bottom), here’s a chart of median US home prices going back to 1951:

Median Home Prices in the US 1851-2020
Data courtesy of DQYDJ

[As an aside, it’s worth noting home prices begin their exponential rise immediately following the end of the gold standard and floating of the US Dollar in 1971.]


Average Home Value Performance

National Average (US)

First, let’s see how average US home prices have performed nationwide in both nominal and purchasing power (/M2) terms. M2 is included for reference (in red). Note: the vertical axis is log scale to accommodate how dramatically M2 has risen over the time period.

Performance Index: Avg. House Prices (US, National)

Here’s just M2-adjusted home prices on a linear scale, to get a better look at what’s happening:

Observations

  • M2 Money Supply has increased 11.81x since 1981 (6.38% CAGR).
  • Nominal home prices have risen 4.51x (3.84% CAGR).
  • In purchasing power terms, homes have lost 62% (–2.39% CAGR).
  • In purchasing power terms, homes have consistently failed to keep pace with M2 growth (with the exception of the 2013-2017 housing bubble).
  • Home price growth tracks directionally with M2 growth, but at a lesser rate. The major exception being the devaluation between 2007 and 2012. Since 2012, price growth has directionally tracked with M2, but at a lesser rate.
  • Home values held stable 2012-2019, but have fallen meaningfully behind the COVID-19-induced M2 growth that began in 2020.

A few additional notes worth mentioning:

  1. The home performance values above don’t include property taxes, insurance, or maintenance. So the real performance of homes is even worse than what’s shown in the charts above.
  2. The home performance values are based on owning real estate without leverage (ie. all cash), which is uncommon. Most people hold real estate with 10-25% equity (ie. 4-10x leverage), which can amplify and accelerate the negative performance even further.
  3. Factoring in 1 and 2, you’ll effectively lose the entire capital investment’s purchasing power over the course of a standard 30-year mortgage.

Local Market Performance: Sacramento, CA

In the context of this analysis, it’s important to stress the national average does not accurately describe the dynamics of a specific, local market.

To illustrate the reality and get a sense of how a local market’s behavior compares to the national average, I took a closer look at my local market, Sacramento, CA. I also chose Sacramento because it’s a stable, tertiary market with a high concentration of government and health care jobs and is within commute distance of the SF Bay Area.

Here’s the Sacramento Area market data compared to the national average in nominal and purchasing power terms:

Performance Index: Avg Home Price Sacramento
Performance Index: M2 Adjusted Avg Home Price Sacramento

Observations

  • Sacramento’s cycles are much more amplified than the national average (ie. short-to-mid-term performance is highly dependent on cycle timing).
  • The macro trend of homes being a poor long-term store of value holds true at the local, Sacramento level.
  • Despite all-time-high prices, Sacramento homes have been losing purchasing power since mid-2018.
  • Sacramento tends to find a cycle bottom near the national average.
Home Price Index Multiple

To visualize market cycles more clearly, I use a multiple oscillator to get a sense of a cycle’s amplitude in proportion to the underlying national trend. A value of 1 means the average Sacramento home price is the same as the national average home price. A value below 1 means Sacramento is less than the national average. A value above 1 means Sacramento is more than the national average.

In the case of Sacramento, a multiple below 1 has historically indicated a cycle bottom, and a multiple above 1.25 has indicated a cycle is getting overextended (highlighted in blue and red respectively).

Sacramento Home Price Index Multiple

Observations

  • On average, Sacramento cycles are ~12 years from trough to trough. We are 9 years into the current cycle.
  • Sacramento’s current cycle has approached but held below the 1.25 overextended threshold, indicating the current cycle is mature in terms of price but has room to continue higher based on historical precedent.
  • The rate of increase of the current cycle slowed noticeably starting in 2014. One possible reason is home builders began supplying more smaller homes, which helped dampen price growth and improve affordability (source, source). Median home price per square foot would be an interesting topic for future analysis.

Conclusions: Home Value Performance

Based on the above, it’s clear that homes have performed poorly as a store of value over the long term. It’s also clear that it is possible to meaningfully outperform the national trends in the short-to-mid term IF purchasing during a local cycle low.

Said simply:

On average, it’s more accurate to view residential real estate as a “cost of shelter expense” instead of an “investment”.

Locally speaking, it is possible to increase purchasing power using residential real estate via cycle speculation but is not realistic for the average buyer.

Next, let’s combine the home value analysis above with income to see if homes are becoming more or less affordable over time.


Home Affordability

Affordability is measured by the ratio of home price to income:

Affordability = Home Price / Income

Having established above that home prices have been falling meaningfully in purchasing power terms, let’s take a look at how incomes have faired over the same timeframe.

Gross Domestic Income (GDI)

The chart below shows Gross Domestic Income (GDI) in both nominal and purchasing power (/M2) terms. M2 is included for reference (in red). The chart below is a linear scale, which gives a truer sense of just how parabolic M2 growth is versus the log scale home price chart at the beginning.

Gross Domestic Income Index

Here’s just M2-adjusted GDI, to get a better look at what’s happening:

Gross Domestic Income Index (M2 Adjusted)

Observations

  • From 1987-2000, income purchasing power grew ~24% (1.13/0.91) (1.56% CAGR).
  • Since 2000, income purchasing power has collapsed ~47% (0.53/1.13) (-3.71% CAGR).
  • In 2020 alone, income purchasing power has collapsed ~20% (0.73 to 0.58) as a result of the monetary response to COVID-19. This is somewhat expected, as it will take time for newly created monetary units to permeate the broader economy (as described in The Cantillon Effect).
The Big Question: Why did GDI begin falling in 2000?

In 2000, the Clinton administration pushed Congress to approve the US-China Trade Agreement and China’s accession to the World Trade Organization (WTO). In 2001, the Bush administration granted China “Permanent Normal Trade Relations” (PNTR), permanently granting China access to US markets.

These actions were presented as a “one-way” opportunity for US companies to export products into the Chinese market without exporting jobs. In practice, the exact opposite was true. These actions enabled China to provide US companies access to low-wage and low-cost production and paved the way for the massive offshoring trends that have dominated the past 20 years and played a major role in the collapse of US GDI.

Home Affordability Index

Now, let’s combine the M2 adjusted home price and income data from above to assess how the affordability of homes has evolved over time:

Home Affordability Index: National (US)

Observations

  • Since 1981, homes have become ~37% more affordable.
  • During 2001-2006, homes became ~25% less affordable (0.84/0.67).
  • Since 2012, homes have become 5% less affordable (0.63/0.60).

Local Market Affordability: Sacramento, CA

As was highlighted before, it’s important to stress the national average does not accurately describe the dynamics of a specific, local market.

Using Sacramento again, here’s the Sacramento Area Affordability Index compared to the national index:

Home Affordability Index: Sacramento

Observations

  • Sacramento affordability can swing widely.
  • Sacramento is currently moderately affordable when compared to historical levels.
Affordability Index Multiple

Similar to the Home Price Index Multiple above, it’s helpful to do the same for affordability. You’ll notice it’s almost identical in nature to the Home Price Index Multiple (adding evidence to the adage that markets top due to lack of buyers not an influx of sellers.).

A value of 1 means the average Sacramento home affordability is the same as the national average. A value below 1 means Sacramento is more affordable than the national average. A value above 1 means Sacramento is less affordable than the national average.

In the case of Sacramento, a multiple below 1 has historically indicated a cycle bottom, and a multiple above 1.25 has indicated a cycle is getting overextended (highlighted in blue and red respectively).

Home Affordability Index Multiple: Sacramento

Observations

  • On average, Sacramento cycles are ~12 years from trough to trough. We are 9 years into the current cycle.
  • Sacramento’s current cycle has approached but held below the 1.25 overextended threshold, indicating the current cycle is mature in terms of affordability but has room to continue higher based on historical precedent.

The Shadow in the Room: Income Inequality

Finally, it’s important to note one major caveat that has gone unaccounted for in this affordability analysis:

Just like National Average Home Prices don’t tell the local story, Gross Domestic Income doesn’t account for increasing income inequality.

According to the Pew Research Center, upper-income households are increasing their share of U.S. aggregate income, while middle- and lower-income household share is falling:

Pew Research Center Share of U.S. Aggregate Income
Data courtesy of Pew Research Center

Growing income inequality in the US is a major symptom of the historic money supply expansion which is boosting asset prices in the face of collapsing wages due to offshoring. This reflexive scenario further enriches those who can afford to hold and/or acquire assets, while pushing those same assets further out of reach for many. A deeply concerning reality that gets lost when using averages.

In terms of real estate, this leaves the smaller, high-income segment of society to trade record-low inventory of homes for sale amongst themselves.

Conclusions: Home Affordability

Based on the above, the question of affordability is really a tale of a “K-Shaped” America. Homes have become more affordable for those in the top income tiers, but the reality is homes are becoming less affordable for the majority of Americans.

Locally, affordability is near the upper bounds of “normal” but it doesn’t appear to be overextended (yet). It’s difficult to predict how impactful inequality will be in terms of this cycle’s ability to reach historically overextended levels or not.

In short, it’s complex because the economic challenges and forces affecting our society are complex.


Looking Forward

Though unhealthy for society at large, it seems this low-inventory-high-income market dynamic has room to push prices higher for the foreseeable future.

Months Supply is my go-to metric for assessing market cycle strength. Historically, less than 3 months supply indicates a seller’s market. More than 6 months supply indicates a buyers market and the likelihood the cycle is rolling over. With current inventory at historically low, sub-one-month levels in markets across the country (we currently have ~3 weeks supply in Sacramento), I’ll be curious to see if that rule of thumb holds true during these paradoxical and increasingly unequal times.

I always find it easier to identify cycle lows than highs. My general sense of the current cycle is this:

  • We’re very much in the “cost of shelter” zone, not the “investment” zone. We’re likely entering the final third of the cycle. Meaning prices are likely to continue rising but by no means guaranteed and could easily stagnate.
  • If you need a home: Buy what you need, prioritize prudence over boldness, and don’t expect nominal prices to fall (see Relatively Speaking for more on “hidden devaluations”).
  • If you already own a home: A home is a good short-term inflation hedge, so do everything you can to hold onto your “boat”. If you need to move, secure your next home before selling your current one. In this fast-paced, low-inventory environment, the risk of getting locked out of the market between selling and buying is very high and very costly.

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