Is Home Equity Wiped Out for the Long Run?

In the years when real estate was booming, home equity values grew much faster than inflation, personal income, and rent metrics. Assuming that those values have to get back to where they would've been without that excessive growth, it might be a long time before home prices start increasing again.

The grand housing experiment of the early 21st Century has gone sour. Like something out of Aldous Huxley's Brave New World, mortgage lenders tried their hand at providing homeownership to everyone-even those who couldn't afford it. Initially, the results were promising; home prices and home equity climbed, and homeowners became wealthy. But now, it's all gone bad, and some experts are arguing that the damage done may last a lifetime.

An argument is brewing about home values. In the wake of the subprime mortgage crisis, housing prices have already dropped almost 20 percent. Some experts are saying that we could expect another 15 to 20 percent decline before things begin to turn up again. This dismal prediction is rooted in the relationship between housing values to inflation, income growth, and rents.

Housing values to inflation

Over the long term, housing prices normally track with inflation. A graph showing inflation-adjusted home values throughout the 20th century would have its variances, but would remain roughly flat. But extend that graph out a few years, and the flat line takes a quick and steep turn upward just after the turn of the century. That steep climb continues until 2006 before it starts to head south again.

Housing values to income

The pace of personal income growth has historically influenced how fast housing prices have grown. This makes sense; houses are paid for from income. If income doesn't grow, people can't afford more expensive homes-unless, of course, lenders loosen the financial requirements for mortgages, or change mortgage terms so that the payments no longer reflect the loan size. Sound familiar? That's exactly what happened during the housing boom, and it unleashed home values to grow at a faster pace than personal income.

Housing values to rent

It used to be that you could expect to buy a home for somewhere between 15 and 20 times what it would cost to rent that home for a year. But in the boom years, that multiple rose to more than 30, which was probably an indication of irrational buying behavior.

Some experts now believe that home values will naturally fall enough to re-establish those traditional relationships with inflation, personal income growth, and rents. If that argument is valid, the 20 percent value decline experienced thus far isn't nearly enough. Further, once home values drop back to where they should be, they'll revert to the slow-and-steady growth that was apparent throughout most of the 20th century. Gone are the days when home equity was a self-replenishing money tree. Net it all out, and it may be a long time before home values recover.