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How to Calculate the Real Estate Market's Overvaluation

I recently had an email discussion with someone about the real estate market and trying to determine when it will be done falling. After thinking about it I realized that although we couldn’t predict when, we will be able to easily figure out how much the real estate market is overvalued when it’s done falling. That is, we will be able to figure out by how much people are overpaying for real estate properties today.

The easiest solution that most people will think of right away is to calculate how much properties drop in price. We can’t do that! It’s completely inaccurate. So how can we really calculate the premium on today’s price? Ignoring inflation for simplification, I’m going to suggest that we can only really calculate that premium by determining how much the monthly mortgage payments drop for the same size of property.

Why can’t we just say that if a property was say $500k, and drops to $400k, that the premium was then $100k, or 20%? Because of the effects of interest rates on real estate prices! As interest rates climb back up, prices have to fall, there’s nothing we can do about that. Therefore if real estate prices fall at exactly the same rate that interest rates climb (a good rule of thumb is that for each percent interest rates climb, real estate prices have to drop by 10% to keep the same monthly payment), then we can say that the market is fairly priced today.

Since I don’t believe that the real estate market is properly priced today, I also think that prices will drop faster than dictated by interest rates. I actually think the real estate market is highly inflated. For example, a general rule of thumb of real estate investing is that your yearly rental income should cover at least 10% of your total purchase price, including renovations, closing costs, etc. This is almost impossible today for the average residential properties. Getting positive cash flow is also almost impossible in today’s market. The market is overpriced, plain and simple.

But just by how much? The key to calculating this is by seeing how much the monthly mortgage payments will drop! Again, if interest rates increase, prices have to drop to keep the same monthly payments. Therefore, if the market is efficient, and the real estate market is correctly priced, we should see little to no difference in the monthly mortgage payments. That is to say prices will only fall in proportion to the interest rate hikes to keep the monthly mortgage payments the same. Cash flow would then also remain where it is.

However, if the real estate market is inefficient and real estate properties are overpriced, then the monthly mortgage payments will drop to bring properties back to profitable levels, to positive cash flow. Therefore prices will have to fall faster than dictated by interest rates alone. If the market is 10% overpriced (assuming no change in interest rates), then we should see monthly mortgage payments drop by 10%.

So for example, if interest rates increase by 3%, then prices have to drop by 30%, nothing new here. However if the market is overpriced by 10% then real estate prices will drop by not only 30% as dictated by interest rates, but by 30% + 10% (the market premium), which means real estate prices will drop by 40%.

As you can see, calculating the premium in today’s real estate market is basically determining how much monthly mortgage payments for a real estate property drop, not how much the purchase price drops.

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