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Regression
to the mean does not imply a return to a normal rate of change, but
rather, a return to the long-term trend – what would be expected as an
end result years from now given historical averages.
So,
for example, if the average annual appreciation for real estate in a
particular area is seven percent, and a few years of twenty or thirty percent
appreciation occur, a regression to the mean implies a return to the
long-term trend that was in place before the rapid price increases.
Looking
at the last few decades of home price data in Phoenix and in the U.S. in the
chart below, the situation become a bit more clear.
While home prices on a national level have risen briskly in the last few
years, this part of Arizona seems to have set a few records in recent years.
A
long-term average of six or seven percent appreciation eems
reasonable from looking at the chart above, but after the increases of the
last few years, it’s natural to wonder what might lie ahead. If the
late-70s to mid-90s experience is any example, there are sure to be some
below average years of appreciation coming to Phoenix.
But,
how far below average?
It
depends on how quickly prices move back to the mean.
If
the average increase is seven percent, what would it look like to revert to
the mean after consecutive years of ten percent, 32 percent, and 26 percent
appreciation as was the case in Phoenix?
That
same question arose in a recent Money Magazine article where a reader asked for advice
regarding an upcoming rent vs. buy decision, one of many considerations in
their relocation to Phoenix. Here’s the advice that was offered:
The
first thing you need to ask yourself is how long you plan to live in Phoenix.
If you’ll stay less than two years (five in a city that’s growing
more slowly than this one), go ahead and rent because by the time you pay
closing costs and broker’s fees on a purchase and sale, you’ll
lose 5% to 10% of the home’s value.
If
you plan to stay longer, the math gets fuzzier. Unlike some cities, Phoenix
has an abundant supply of single-family rental housing. And home prices have
risen faster than rents lately, which has made
renting unusually attractive. Consider our simplified calculations: You
can rent a three-bedroom, two-bath house in a nice neighborhood for about
$14,600 a year, including renters insurance. The same home
might sell for $450,000. With your $70,000 down payment, if you took
out a 30-year fixed-rate mortgage, you’d be spending some $31,100
annually after tax deductions, including insurance, property taxes
and maintenance.
Measured
by cash flow, renting is cheaper, hands down. But home ownership is also an
investment decision. To make up the $16,500 annual difference in cash outlay,
your property would have to appreciate by about 3.7% a year. If you think
you’ll see growth of that much or more, buying might be the way to go.
But the market is tough to call. Phoenix’s prices are up 11.8% from a
year ago, according to the National Association of Realtors, but that rate
obviously can’t be sustained. And if Phoenix’s long-term growth
rate were to drop back to the U.S. historical average of 6.7% appreciation a
year, the adjustment could be painful.
Now,
the advisor does a pretty good job of explaining the situation up until the
point where long-term appreciation is involved. It seems that, as a nation,
we have difficulty in this regard, perhaps accustomed to having our
gratification instantly whenever possible.
According
to OFHEO data, since 1978, there has been little difference in the
“long-term growth rate” between the nation’s housing stock
and the housing stock in Phoenix – six percent and seven percent,
respectively. And even if there were a big difference, that last sentence in
the advice above, no matter how many times you read it – it just
doesn’t make any sense.
Given
what is going on in Phoenix right now, ‘ghost towns’ appearing here and there, many
homeowners would surely be pleased with the prospect of resuming the
long-term growth rate of near seven percent, but that is not likely to
happen.
What
the writer was probably trying to describe was the painful adjustment process
in reverting to long-term trends, or in regressing to the mean. Those
painful possibilities, both for the renter seeking advice and for the many
thousands of others pondering an Arizona real estate purchase, are shown
below.
The
chart shows two curves – actual home price data through the second quarter
of 2006 and the long-term trend projected from 2003, when many homebuyers
stopped caring about prices paid, using the historical average of 7 percent
appreciation.
A
couple of quick calculations help to demonstrate the possibilities. If it
takes six years for Phoenix home prices to make it back to the long-term
trend, that would leave a homebuyer down $10,000 on a $450,000 home purchased
today, in addition to repairs and other expenses. That doesn’t sound
too bad, but six years is a long time.
If
the process took eight or ten years, this would leave the homeowner in the
black by $72,000 and $130,000, respectively. Interestingly, taking the
$16,500 per year saved by renting, as noted above, and banking it at just
four percent yields $111,000 and $133,000 for the same periods.
Naturally,
the worst case would be the two-year and four-year price moves where
today’s $450,000 home would be worth $297,000 and $383,000, respectively.
Ouch!
But
the prospects for homeowners could potentially be worse than that shown above
– in addition to there being a tendency to revert to the mean, there is
also a tendency to overshoot during the process. This is what happens when an
entire nation sours on the idea of owning something – think common
stocks in 2002, and maybe real estate sometime in the years ahead.
On
the bright side, it’s always possible that things will be different
this time.
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