I have a theory that areas that are the most over-priced will “correct” more quickly than other areas.
Below is a post I had published about 3 weeks ago in an U.S. housing stocks blog called “Seeking Alpha.”
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The Reverse Ripple Theory of Metropolitan Home Price Corrections
You drop a rock in water. The ripple is largest at the center and becomes weaker as it spreads out.
In the Reverse Ripple Theory of Metropolitan Home Price Corrections (you got a better name?), home prices in the outlying areas with a lot of new construction will tend to fall most and first (the splash), as it moves toward the center of the metro area, the ripple weakens and the fall in home prices is progressively less and later.
The “less” part is probably conventional wisdom among real estate geeks. The “later” part is probably not.
Will the Periphery Bottom Out First?
Buried in Appendix C of Global Insight/NationalCity’s September 2007 issue of “Home Prices in America,” I noticed an intriguing little table barely mentioned in the text, called “Past Price Corrections.” The table is now included in recent issues, as well.
The appendix showed 79 metro area home price corrections completed since 1985. Its great stuff for real estate geeks.
Don’t miss the last two notes in Appendix C.
- The more severe the overvaluation, the greater the subsequent declines tended to be: correlation = +0.25
- The more severe the overvaluation, the shorter the duration tended to be: correlation = -0.31
That last note surprised me. The more a market is overvalued, the faster home prices tended to correct! That seemed counter-intuitive to me. Why would a more overvalued market correct sooner than a less overvalued market?
Anyway, let’s run with it. What if that effect occurred within a single overvalued metropolitan area as well within the history of U.S. home price corrections?
What if home prices in the most overvalued areas of metro Phoenix Arizona, my home, fell most and bottomed out first?
Most Overvalued Areas
So, where were the most overvalued areas in metro Phoenix during the recent boom?
The conventional wisdom is that areas on the periphery with lots of new homes were more overvalued, at the peak, than other areas.
The periphery became more overvalued, in my opinion, because there was a bit of a pricing oligarchy in the new home areas. The homebuilders were the oligarchy.
As the market tightened during the boom, homebuilders had the market power to increase prices in their areas more quickly than was possible in older areas where each home seller made an independent pricing decision.
When a homebuilder increased its list prices by say, $10,000, he increased the value of all the resale homes in the subdivision at the same time.
If, however, Joe Homeseller in the same subdivision increased his list price $10,000 - and the builder did not - it would have essentially no affect on the market.
In my view, prices in new home areas increased more than in other metro Phoenix areas with similarly tight markets because of the market power of the homebuilders to raise prices.
Since the peak, we have certainly seen median home prices on the periphery fall faster than in the interior of metro Phoenix.
The future will show us if these peripheral sub-markets will also tend to be the first areas to see median home prices bottom out and whether the interior sub-markets of metro Phoenix will tend to have less severe but slower home price corrections.
Hey, it’s just a theory.
The charts below compare 85086 in far north Phoenix, which includes Anthem, a newish master planned community of Del Webb (Pulte Homes), and 85051 in Phoenix, an area of homes built in the 1960s and 1970s. Charts show monthly medians for resale (not new), single family detached homes.
Obviously, the periphery (85086) started to fall first. The question is will it fall further and bottom out first?
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Here is the original article.
Later the theory was referred to in an article in the San Jose Mercury News.
3 responses so far ↓
1 Brian McMorris // Apr 27, 2008 at 12:04 pm
Hah….John, you just made my point about prices in Scottsdale. It went up the most in 2003-07, but has yet to come down the most. If you believe in long term ratios based on human utility (no matter the object), reversion to the mean must occur. In another take on the (very) old saying: “The (higher) they are the (farther) they fall.
2 Brian McMorris // Apr 27, 2008 at 1:03 pm
Not to hog the comments, but I want to say I like your “oligarchy” theory. That makes a lot of sense and would account to the lag in older neighborhoods. Other factors would be that it is easier to speculate on lower priced houses (easier to qualify for a mortgage), and as you have said before, more established areas have houses with older mortgages, or no mortgages, which allows owners to sit on the investment. The newer and lower priced neighborhoods are more likely to have lots of “underwater” mortgages at this point, which drives those houses into bank liquidation.
3 Rich W // Apr 28, 2008 at 2:38 pm
I think there is something to your observations of the severity (and perhaps the timing) of different regions. But I think the cause is really a much more simple supply-and-demand question. In general, people don’t want to live far out from the city center (read job). But when prices are rising and there is a shortage of available properties, people are forced to move outward. Demand for out-lying properties, previously low-priced because of there undesirable location, shoots up.
As the market turns and availability of centrally-located properties increases (remember the availability will lead the price drops by a little), demand reverses.
But the point I really wanted to make is I’m not sure the article you cite really supports your theory. Unless I’m misunderstanding the wording, doesn’t appendix C say there is a NEGATIVE correlation between overvaluation and short-duration? Hence a positive correlation between overvaluation and long-duration?
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