***This post was originally published in PWA’s Newsletter: The Pretirement Press in Q4 2009 and it’s publish date has been edited here to reflect the approximate initial publish date***

By now we all know we were in the midst of a housing bubble earlier this decade, which peaked in 2006-2007 in most areas. While it’s easy to say in hindsight, one of the clearest depictions of just how dislocated prices were compared to the fundamental value of a home is a comparison of housing prices to rental prices. A house’s value can always be tied back to the cash flows that an owner of that house could earn if she rented the house to a tenant. In other words, a good way of determining if a house is too expensive compared to renting is to determine if you can cover the costs of ownership (mortgage interest, insurance, property taxes, association fees if applicable, maintenance, potential vacancy, management, etc.) with the rental income. If you’re planning to buy a rental property, contact your advisor who can help you project the long-term return on your investment taking all of these factors into account.

The U.S. government tracks average rental prices across the country in an index which is a component into inflation measurements. Industry organizations track median house prices over time and so it’s easy to compare how each trends in relation to the other. Not surprisingly, as the chart below shows, the house price index and the rental price index track each other quite closely in most cases. What can also be seen is the huge spike in the home price index with no accompanying spike in rental prices from 2000 to about 2006-2007. As is usually the case in a bubble, prices have returned to a level that coincides with their fundamental value (measured by rental prices). So, does this mean the market has bottomed? Not necessarily, because there’s nothing to say that prices can’t fall to an extreme on the other side of the rental price index just like they peaked above it, but it does look like market is reasonably priced when compared to historical rents.

Additionally, there have been strong signs of life in the housing market in recent months with existing home sales gaining ground in four consecutive months (Aug-Nov). Not only have sales been increasing month over month, November’s sales are up 44% over November of 2008, showing the people are definitely out there buying. The number of homes for sale has also come down in the past four months, from just over 4 million, to just over 3.5 million. If the pace of sales from November could continue and no additional houses were put on the market, the current inventory of homes for sale would be depleted in 6.5 months. That compares to about 4-5 months of supply in a steady housing market, and a peak of 10-11 months around this time last year during the worst of the downturn.

What about prices? There are two different nationally recognized sources for home prices, the National Association of Realtors (NAR) and the Case-Shiller (CS) Index. CS always runs a month behind NAR, so we only have CS data through October where both sources show about an 7-8% drop in median home price year-over-year, but CS shows no change in month-over-month price vs. a decrease of about 2% from NAR. NAR’s November report shows virtually no change in price compared to October. Both reports show a trough in prices in April of 2009, at a level approximately 5% lower than today. It’s a mish-mosh of data, but it appears there has been some stabilization in prices, and when compared with the increase in sales data, it looks as though a recovery is in progress.

Before concluding that the housing crisis is over however, we have to look at the extraordinary circumstances that are currently affecting buyers as well as the impact of potentially increasing foreclosures. First, the First-Time Homebuyer Tax Credit of $8,000 was set to expire in November which could have

influenced buyers who were planning to buy soon to accelerate their purchase into the last few months. Congress has since extended (to April) and expanded (to include some existing homeowners) the credit, but at some point it will have to end. The extended credit could cause a lull in sales in December/January before spiking again to beat the April deadline.

Second, the housing market is still being stimulated by the Federal Reserve as they purchase mortgage backed securities on the open market to keep mortgage rates low. With prices down significantly and historically low interest rates at the same time, home affordability is extremely good. NAR calculates

a housing affordability index based on median income vs. the principal and interest owed monthly on the average mortgage for a home with the median home price. This index has soared as prices and rates have come down, but incomes have remained fairly steady in the past few years. The Fed has indicated that it plans to end its mortgage purchase program in March 2010 which could allow rates to start increasing. Combined with the credit ending in April 2010, this could put pressure on the housing market for a second wave down in prices.

Also potentially impacting prices going forward is the rate of foreclosures. Again, a bit of improvement in recent months as new foreclosure filings have decreased. This is in part due to the moratorium on foreclosures in some states as well as the ramp down in subprime, adjustable rate mortgage (ARM) resets. But, while we’re almost out of the woods on subprime, there is a new wave of ARM resets coming, in the form of option-ARMs. These are adjustable rate mortgages that allow the borrower to choose his monthly payment, sometimes even less than the interest amount, which can result in increasing rather than decreasing mortgage balances. As those rates reset from extremely low teaser rates, more homeowners could find themselves unable to make their payments, just like the subprime situation that peaked in 2008.

Another factor that could restart another wave of foreclosures is the increasing number of homes that have negative equity. As prices continue to fall, more owners find themselves upside-down on their mortgage, owing more than the house is worth. The Wall Street Journal recently published an article with some staggering statistics in it on this point.

· 23 % of homes that have a mortgage are worth less than the mortgage balance

· 50% of under-water homes are more than 20% under-water

· 40% of mortgages started in 2006 are underwater

· 10% of mortgages started this year are already underwater (so much for bargain hunting!)

The lack of equity in many homes contributes to the growing number of foreclosures which in turn puts more pressure on neighboring home values. So, while we have definitely seen recent signs of life in the housing market in terms of sales and prices, there is good reason to suspect another tick up in foreclosures, mortgage rates likely increasing after March, and the homebuyer tax credit expiration slowing down the pace of sales again. For those reasons, it’s too early to feel like the housing market and housing prices have bottomed on a national level. Temporary stability, yes. Recovery, not quite yet.