How Far Will Housing Prices Fall?

Amid all of the economic nuttiness of the past few weeks, there is one thing that's for certain: all of this isn't likely to end until housing prices fall back to their natural levels.

So how far are prices likely to keep falling? It's anyone's guess really. But there are some key indicators that economists point out — and, of course, then disagree about — that probably provide some hints.

Historically, home prices have increased roughly in line with real income growth. That was until about 2001.

(Update: added below is a comment from reader Dan Schlung for you math whizes. He crunches his own numbers and figures out it will be 2.19 years before he sees prime home prices in his native Chicago.)

As any first time home buyer can attest, that's when housing prices began far outstripping people's incomes as interest rates stayed low and capital flowed out of stocks and into housing.

For decades, median home prices and median incomes have always shared a close relationship. From the mid-1970s to 2001, the historical ratio of housing value vs. household income was consistently around 3.0.

What this essentially means is that median home prices were (on average) around three times the median household income for the last 30 years. Before housing prices started to ease in 2006, that number was approaching five times peoples' income.

According to this chart, home prices must fall a third or more in some locations to get back to a normal price/income level.

One thing that may make this housing downturn potentially unique: the national median single family home price fell in nominal terms in 2007 for the first time in four decades, leaving as many as tens of millions of homeowners with houses worth less than there mortgages.

Meanwhile, inventory and foreclosures continue to rise in most parts of the country, meaning it'll be a long while before prices stabilize.

Reader Dan Schlung of Chicago had this to say about our Planet Money post today:

If this is true, it paints a very bleak picture for our housing market. Though the chart only goes to 2006, one can extrapolate from the S&P Case-Shiller Home Price Indicies (which currently are updated through July 2006) approximately where the current Ratio is for each major metro, and can also determine when/what their peak home value was. If this is valid here in Chicago, we've still got a good 2 years of correction in front of us, given the current rate of decline, although as of recent months the Case-Shiller index has seemd to have leveled off somewhat, so who knows. Anyway, assuming the worst (which isn't hard to do nowadays), my personal situation looks like this, which is not exactly reaffirming: - S&P Home Price Index:Peak (Chicago, 2006) 167 - S&P Home Price Index:Current (Chicago, July 2008) 149 - Current Value as a % of Peak 89.2% - Existing Reduction in Value (Correction) 10.8% - Med. Income to House Value Ratio (Chicago, 2006) 4.9 - Estimated July 2008 Ratio, based on S&P Index fluctuations 4.37 - House Value July 2008 (per S&P Index fluctuations)- $160,598.80 - Med. Income to House Value Ratio (Chicago, 2001) 3.6 - Home Value Correction Ratio (Assuming 2006 Baseline) 73.5% - Remaining Correction 15.8% - House Value 2006 $180,000.00 - Fully Corrected Value (2001 Med. Inc. to House Value Ratio) $132,244.90 - Years to Achieve Correct Value (At Mean rate of decline Peak - July 2008) : 2.19 Yikes.

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