Learn How To Start Investing In Real Estate
Learn How To Start Investing In Real Estate

Undervalued Home Prices & Slow Gains Undermine Threat Of Bubble

Written by Than Merrill

With the effects of the previous recession still weighing heavily on the minds of many homeowners, it is not hard to understand why the housing sector has yet to fully recover. However, while there may be a sense of hesitation in the air, there is reason for encouragement. Not only are significant indicators heading in a positive direction, but the threat of a subsequent housing bubble has been all but eliminated. According to Trulia’s Bubble Watch, U.S. home prices were undervalued by approximately 3% in the second quarter of 2014, which is far from bubble territory.

Trulia’s Bubble Watch reveals whether or not home prices are overvalued in comparison to their fundamental value. In doing so, Trulia compares today’s prices with those of the past, incomes and rents. The relationship serves as an indicator as to whether or not there is concern of an imminent bubble, as the more prices are overvalued to relative fundamentals, the larger the threat of a bubble. Subsequently, overpricing makes the entire housing sector susceptible to a price crash.

While prices have increased dramatically over the previous two years, it is important to understand that the rate in which they increase is not necessarily indicative of a possible bubble. A bubble may occur when prices look high relative to fundamentals.

In order to quantify the exact position of the housing sector, Trulia accounts for several indicators: price-to-income ratio, price-to-rent ratio, prices relative to their long-term trends. Here is what the comprehensive analysis of these values revealed:

Taking into consideration all of the relevant data, Trulia has come to the conclusion that home prices are undervalued by 3% on a national level, which is not indicative of a bubble. Conversely, during last decade’s housing bubble, home prices were overvalued by as much as 39% in the first quarter of 2006. Again, the more overvalued prices are compared to their relative fundamentals, the higher risk of a bubble. At 3% undervalued, the housing sector looks safe for now.

At their current rate, national home prices should return to normal levels, that is to say neither over- or undervalued, by the end of this year and into 2015. Particularly encouraging, however, is the slow down in price gains that is accompanying the current undervaluation. Accordingly, an acceleration in price gains would put the market at more of a risk of a bubble. Fortunately, that is not the case.

Even the most overvalued markets are not exhibiting numbers that resemble the last bubble. The 10 most overvalued markets in California are much less overvalued than they were at the height of the previous bubble. As a comparison, Orange County, today’s most overvalued market, is only 17% overvalued. While this may seem like a lot, Orange County was overvalued by approximately 71% in 2006. Among the most overvalued markets today, only Austin looks more overvalued now (13%) than in 2006 (8%). Austin’s valuation is likely due to its absence from the worst of the last bubble. Austin, and Texas in general, avoided the worst of the recession for the most part.

For a better understanding, the following list highlights the top 10 metros where home prices are most overvalued:

  • Orange County, CA (+17%)
  • Honolulu, HI (+15%)
  • Los Angeles, CA (+15%)
  • Riverside-San Bernardino, CA (+13%)
  • Austin, TX (+13%)
  • San Jose, CA (+11%)
  • Oakland, CA (+10%)
  • Ventura County, CA (+9%)
  • San Diego, CA (+7%)
  • San Francisco, CA (+6%)

Only in Akron and Cleveland are prices undervalued by more than 20%. Furthermore, in those two markets, home prices are rising below the national average of 8.0%. In several of the most undervalued markets, including Detroit and Chicago, prices are now rising year-over-year in the double digits. However, those markets are unlikely to stay on the most-undervalued list for many more quarters. The top 10 metros where home prices are most undervalued are as follows:

  • Akron, OH (-21%)
  • Cleveland, OH (-21%)
  • Detroit, MI (-19%)
  • Dayton, OH (-16%)
  • Worcester, MA (-15%)
  • Memphis, TN (-14%)
  • Toledo, OH (-14%)
  • Chicago, IL (-14%)
  • Lakeland-Winter Haven, FL (-14%)
  • Providence, RI-MA (-14%)

Out of the 100 largest metros that were accounted for, 76 appear to be undervalued. However, the number of overvalued markets has increased from 19 last quarter to 24 at the end of the second quarter this year. Most of the 24 overvalued markets are overvalued just a bit, with 17 overvalued by less than 10% and 7 overvalued by more than 10%. While the number of overvalued markets is rising, there remains little reason to worry about a new, widespread bubble forming.