Thursday, September 10, 2009

Median Incomes and Economic Obsolescence of Large Homes

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.

9 comments:

Andrew Stegmaier said...

Your general point about how a lack of demand can cause economic depreciation in an asset, like Detroit real estate, is a good one. Prices for an asset can indeed stay below replacement cost for quite a while, and that just means that very little new construction will happen.

The fact that house size has grown by 20% more than dollar income is not good evidence for this point though. Dollars are only as valuable as what the things they buy, and the fact that people live in bigger homes with the same nominal income might easily mean that the real value of their income was more. If television size is a proxy for television quality, the fact that average television size has gone up dramatically in the last few years relative to dollar income does not mean that economic demand for televisions is unsustainable. It means either television manufacturers have gotten better (they have), or consumer preferences have changed so that people want to spend a greater portion of their income on televisions. The case of house size/quality is no different.

The fallacy that income is the best measure of well-being is one of the major reasons why inequality is typically overestimated. See Will Wilkinson's paper here: http://www.cato.org/pub_display.php?pub_id=10351

CoachingByPeter said...

In order to close a deal, there are some plan that should be written down. Part of the strategy should include hiring a skilled realtor, creating a strategic plan, fair pricing and great presentation of the house.

Anonymous said...

More smaller homes should be built. Otherwise, the bottom half will simply be priced out of the market. Creative financing doesn't work.

You can't gentrify the entire housing market, unless the entire population consists of gentry. Zoning regs in many areas are simply unrealistic. The less well-to-do need an affordable place to live.

Rising energy prices will make this situation worse. The bottom half cannot afford to heat/light a McMansion, even if creative financing somehow allowed them to buy one.

Brad said...

The biggest problem with housing for the last 15 years that I have been an adult in the housing market has been on the banking end. It is next to impossible to get a mortgage for inexpensive properties, so builders have done what ever they can to justify price increases. The builders totally squiffed it since they are almost as greedy as bankers (who would lend $50k w/ $0 down for a car but won't lend $35k for a house appraised at $50k on the same terms).

The big problem on the builders when it came to larger homes was the failure to understand the need for more rooms vs more square footage. They asked which was cheaper for them to add and went with it. They should have been adding more bedrooms/private rooms as opposed adding another hundred and twenty square feet to the living room or adding adding less useful rooms like formal dining rooms.

This economic crisis is no where from being complete, and in fact I doubt we have seen the worst impact from it yet. Maybe, when it finally hits rock bottom we will finally see banks and builders acquiescing to the facts that median income and buying power are no where close to what it once were.

David Pearson said...

The total price of a house includes land value and structure value. What you mean when you say "replacement cost" is probably the implicit value of the structure combined with land at current prices. Obviously, land prices can fall further. So rock-bottom "replacement cost" for a house is the depreciated value of a structure with zero land value. Zero, of course, is pushing it, but anything meaningfully above it (like $600,000 an acre in California) has significant downside still ahead.

Katherine G. said...

Thought of this post when I read this NYTimes article about baby boomers having to prematurely downsize (and their kids getting cranky about it): http://www.nytimes.com/2009/09/10/garden/10nest.html?ref=style

It's thin on actual data but anecdotally supports what you are saying here. An interesting point that one of the commenters makes is that if relatively wealthy middle aged boomers start buying up what were previously considered "starter homes," all the 20 and 30 somethings that are aiming for those smaller properties might be out of luck.

George M said...

Rising energy prices will make this situation worse. The bottom half cannot afford to heat/light a McMansion, even if creative financing somehow allowed them to buy one.

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Edward said...

Millions have already lost their homes. Regrettably, all too many people seem to give up without a fight, pull the shades down and move away, leaving the home vacant behind them and a devastating mark of foreclosure on their long-term record.

Houses for Sale in Eagle Rock CA

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