Because there are only a half dozen or so indexes out there … sorry, I’m being told that’s actually a half million. Oh well, too late! I’ve already created the index and feel compelled to announce it. Drumroll …
Easynomics Real Estate Price Stability Index (EREPSI)
First off, it’s clear that I picked the acronym first (it’s so catchy!) and worked my way backward to think of what it stands for. Anyway, let’s get to the why, what and how of the index.
Why did I create this index?
Simple. I see all kinds of housing indicators out there, but none of them seem to encapsulate in one number the thing that I’m personally looking for. I want to know how close we are to achieving a balanced state of equilibrium in the price of real estate. That is, are we close to a situation where there isn’t a bubble or a depression in any area of real estate. The best way I could think of capturing that was to look at three indicators that all relate to price stability. This is NOT a scientifically validated index with any special adjustments or complex calculations. I’m not using it to make investment decisions, and neither should you. It’s just an easy way for me to comment on housing in my weekly indicator roundup.
What makes up the index?
There are three components:
- New Homes Inventory Months of Supply (Source: U.S. Census Bureau) - When there are too many new homes still left unsold (inventory) on the market, it usually means that prices will be dropping because supply is greater than demand. The opposite is also generally true. A good way of measuring the inventory is to calculate how long it would take that inventory to sell at the current pace of sales. The normal level for this is around 6 months. NOTE: Data for this indicator lags considerably. In addition to the index that is based on all available actual data, I will also calculate an index using the Easy Trends projection for the latest month, which basically assumes the recent trend will continue. If there is no projection from Easy Trends, I will assume the trend of the last several months will continue in a straight-line fashion.
- Existing Homes Inventory Months of Supply (Source: National Association of Realtors) - Same concept as “New Homes” above but with homes that already have an owner. NOTE: Data for this indicator lags considerably. In addition to the index that is based on all available actual data, I will also calculate an index using the Easy Trends projection for the latest month, which basically assumes the recent trend will continue. If there is no projection from Easy Trends, I will assume the trend of the last several months will continue in a straight-line fashion.
- Price-to-Rent Ratio (Source: I use the S&P Case-Shiller 20-City Composite Seasonally Adjusted Home Price Index for the price of homes and the Bureau of Labor Statistics “Owners Equivalent Rent of Primary Residence” for the rent component – setting the ratio of the two on January 1998 as 1.0. NOTE: The S&P Case-Shiller 20-city index actually started in 2000, but because I felt 1998 was a more “normal” starting point, I estimated what it would have been by using the ratio of another housing price index from 1998 to 2000.) - Comparing the prices of homes to the equivalent price of renting a similar home is a good way to gauge whether there is generally more incentive to buy or to rent. Based on what I’ve seen, the housing market was roughly in equilibrium around Jan 1998, so I have set this index to 1.0 for that time. So if this number is higher, it means home prices are more likely to fall. The opposite is true if the ratio is below one. NOTE: Data for this indicator lags considerably. If we are waiting on a particular piece of data (price or rent) to complete the calculation, I will estimate that data using the trend from the previous three months of data.
How is the index calculated?
The index is the equally-weighted average of the deviation from normal for these three components. Although there are a ridiculously higher number of existing homes than there are new homes, the sale of each new home is much more important to the economy (GDP), so I didn’t feel that I should weigh one more than the other.
Example: For a given month, if the new homes months of supply is 7.5, and the existing homes months of supply is 5.5, while the price-to-rent ratio is 1.10, the calculation is as follows:
- Deviation for new homes months of supply is 1.5 months (because normal is 6 months). 1.5/6 = 25% (rounded) –> I convert this to negative because it’s in the direction that hurts home prices.
- Deviation for existing homes months of supply is 0.5 months (because normal is 6 months). 0.5/6 = 8.33% (rounded) –> I keep this number positive because it’s in the direction that favors existing home prices.
- Deviation of price-to-rent ratio is 0.10 (because normal is 1.0). That’s 0.10 divided by 1.0 = 10% — I convert this to negative because it’s in the direction that hurts home prices.
- Final calculation is the average of: -25 percent, +8.33 percent and -10 percent = -8.89 percent.
What is the current level of the index?