Written by Richard K. Green, Director, USC Lusk Center for Real Estate
One thing that has led me to believe that the housing market in Southern California is largely at bottom is the fact that many houses are selling at less than replacement cost. While such a discrepancy can exist for a long time in places with declining population, replacement cost is a pretty sound fundamental for determining the minimum sustainable house price in areas with growth.
The report on median incomes released yesterday, though, suggests to me a flaw with my line of reasoning. While the average new house has grown about 20 percent in size over the past ten years, median household incomes have actually fallen a bit. If house size is a proxy for house quality (and we have good statistical evidence to think that it is), then house quality has outstripped the ability of people to pay for it.
When comparing market prices to replacement cost, we really need to think about depreciated replacement cost. Depreciation comes in three flavors: physical, functional and economic. Physical depreciation happens because things wear out as they age--it is what Congress is thinking of when it allows depreciation deductions for investment property and plant and equipment.
Functional depreciation happens when a component of a capital asset does not perform its function well by current standards. Think of a furnace that uses lots of energy, and could be replaced by something more efficient. It is possible that it could work as a furnace for years, but it still would be best replaced by something more efficient.
Finally, there is economic depreciation, which happens when the demand for something (like Detroit real estate) disappears. It is possible that large houses have incurred economic depreciation because people lack sufficient income to afford them. If this is true, values can fall below original construction cost and stay there for some time.
Such considerations do not, of course, apply to reasonably well located, modest homes--I continue to believe that 1500 square foot houses in the San Fernando Valley and the central part of the San Gabriel Valley are reasonably priced now. But the market for larger houses may be troubled for some time yet to come.
One other implication: builders should construct smaller houses in the years to come. This vindicates a prediction I once made. Unfortunately, I made it in 1990.
Hi Dr. Green,
Very interesting and great to see the blog active. Quick thought on the McMansion line of thought. If builders are now building considerably smaller homes and plan to do so for some time, then shouldn't the supply of these larger homes shrink relative to the overall housing stock. Would this better align wealth demographics to the available supply? Maybe this will take awhile and that is the assumption in your conclusion about prices staying low for an extended period of time. Thanks for the insight!
-Alex Knott
Yes, the days of the McMansion are toast. In fact, the dropping of median house prices is not all that accurate to those who own a smaller size house. Those who own the 3,500 sq feet and up homes are seeing the most decline. It's back to reality, which is a good thing.
Don
USC
Class of 1978
Gotham, WI where you can buy a 1600 sq ft hosue for $150K!
When you speak of 'replacement' costs you don't mention land values. Building lots were bubble-priced during the boom and are now plummeting. On 'scrape' lots here in Denver the lot costs were as much as the labor and materials. A few years ago spec builders were in bidding wars over those lots. Lots in those same neighborhoods are now $150k to $200k less and very few are selling.
I don't understand how you can consider the average 1500 s/f home in the Valley reasonably priced?? Those homes are blue collar, average Joe homes. Yet they are priced int he $400k plus range. How is the average family going to afford that? Families making $60k to $100k can't afford that house. Sure with a 5% loan and eating Top Ramen they might make it. Prices in nearly all of SoCal are still well above where they should be. How can spending drive the economy if these families are spending everything they have on a mortgage. And what happens when interest rates return to historical norms? Then who will be able to afford those $500k homes?
Dr Green,
I am not sure I believe your assertion that houses are selling at replacement costs. If you look at Texas or the Midwest, housing costs for new construction are well below So. Cal. prices.
The price differential is not due to the quality of construction. The average house in LA would not survive one season in tornado alley.
It is not labor costs, as Southern CA has a vast pool of cheap immigrant labor. No, the real reason is a corrupt building code system, and lazy voters.
The building codes, despite being a law the public needs to comply with, are owned and licensed to the state by the building industry! They are not even public domain. You must buy a copy of the code in order to comply with it.
The code forbids and restricts thousands of useful products which fail only because they have not bought off the correct officials in the building industry or government offices.
These same codes require houses to be built with bizarre conditions which do not promote safety or well being. These restrictions are there to ensure guaranteed sales to politically preferred groups.
So in short, if there is wholesale reform of the building industry in California, houses are not selling at anything close to replacement cost. If reform does not occur, eventually we will be just like Detroit.
Oliverks
"Experts say this is a bad omen for residential real-estate prices and homeowners trying to sell or refinance, because the fire sales, many to cover soured subprime loans, put downward pressure on the value of nearby homes. All of this undermines federal efforts to stabilize the housing market and revive the broader economy.
While the banks are trying frantically to get loans off their books, they face the problem of large shadow inventories of housing being dumped on the market, which would depress prices further," said Anthony Sanders, real-estate finance professor at George Mason University in Fairfax, Va."
With high joblessness, it is only normal that subprime-mortgage holder would like to sell their properties since they are not sure of the employment status in the coming months.
Read More: http://www.housingnewslive.com
Replacement cost is irrelevant. The mistake you have made is to incorrectly account for a deflationary overhang of capacity -- and to assume that prices are set by the supply-side of the equation. They are not. We can go for decades without seeing demand resume. Who cares if useless, un-needed building capacity is overpriced? That capacity will atrophy and die. You reference the unsustainability of surplus capacity as evidence of bottoming. This is silly. It is evidence only of a greater precipice approaching -- one with greater unemployment and a long cycle of decreasing demand. You seem to not understand deflation.
Homes in San Fernando Valley are only at replacement cost if you make assumptions about the value of the land. For example if you have a 600k
home with 450K land and 150K Replacemnt cost, and then price drops, is it going below replacement cost, or is the value of the land decreasing ?
I would maintain that as long as the land part of the Price is far above that in most of the country, it is possible for the land value to decrease.
Housing is a consumption item and does not resemble an investment in any way shape or form. With that said it is obvious that you misclassified. Houses physically and economically depreciate.
Home builder should all shutter their door as we have a huge over supply in housing and that will not change for over a decade. Building new homes is a way to ensure that their senior management keeps their jobs. They cannot service their debt (generate CF) unless they keep building and selling homes. They are not serving their share holders interest and should liquidate immediately...ever last builder.
Lastly but importantly, replacement cost are plummeting and will continue to plummet which will bring down replacement costs. It will take time but it will happen.
Prices are set to fall 30% to 40% as incomes and rents do not justify prices.
Cheers!
JT
The only possible demand I see on the horizon for the 5 bedroom/5 bathroom genre of homes is as group living arrangements for aging baby boomers.
As an alternative to nursing homes, I can imagine retired "roommates" sharing expenses for maintaining these unmanageable monstrosities.
I've always thought that there was one segment of the housing market that was constantly overlooked - well to do singles that want a small freestanding house with a large bedroom, well appointed bathroom, and cut out the dining room and just make one large great room. With laptops, etc, you don't even need a computer room, just a main floor room for the washer and dryer. Don't even need much of a kitchen. Where are the builders for these houses? Why do we only sell nice houses if they have 4 bedrooms? What are we, spawnng fish?
I won't add to your burdens on this one; well, maybe a little...
Nice pep talk, and I appreciate the laugh...I mean, of course, the "...if house size is a proxy for house quality..." and it's immediately following statement that yes, by golly, it does seem to be.
Interesting blog; found thru patrick.net. Will try to follow.
Not to worry. Americans in general have goldfish-like memories. In about 20 years this will all happen again.