Investing in Overvalued and Undervalued U.S. Metro Housing Markets Ahead of A Recession

September 10, 2022

Introduction and Housing Market Overvaluation as of Q2 2022:

On September 8, 2022 RealtyQuant published an article titled Most Overvalued and Undervalued Housing Markets in the U.S. as of Q2 2022 listing the top 10 most overvalued and undervalued housing market metropolitan statistical areas (MSAs) in the U.S. as of Q2 2022, out of a study of 395 MSAs total. Over- and undervaluation is based on deviation from historical fundamentals such as income, population and housing supply.

The top 10 most overvalued MSAs are all in the U.S. West and South regions, namely the states of Idaho, Texas, Arizona, Washington, Florida and Utah. The MSAs containing Boise, Phoenix, and Tampa are some of the most overvalued.

The top 10 most undervalued MSAs are largely in the U.S. Northeast and Midwest regions, namely the states of New York, Pennsylvania, Maryland, Illinois, North Dakota, as well as the state of Louisiana in the U.S. South region.

As mentioned in the article, as of Q2 2022 approximately 60% of all MSAs studied were overvalued greater than 10%, 28% of all MSAs fairly valued 0% to 10%, and 12% of all MSAs undervalued. A total of 25 MSAs were greater than 40% overvalued.

Similar studies performed by RealtyQuant at the U.S. state and county levels, reveal states and counties in the U.S. West and South regions to be most overvalued, while states and counties in the U.S. Northeast and Midwest regions to be most undervalued. RealtyQuant's full market valuations data can be found here.

Recession Studies for Downside Risk following Mild versus Severe Recession:

An article named Housing Market Valuations in U.S. Metro Areas: A Back Study for Downside Risk after Two Recessions, details a back study for the downside risk of MSAs at varying degrees of overvaluation following both the 1990 recession and the Global Financial Crisis.

Pew Research Center describes the 1990 recession as "relatively mild" with a stronger economic recovery compared to Global Financial Crisis. The latter is described as "one of the deepest downturns of the U.S. economy since World War II" having "the longest economic recovery dating back to the mid-19th century". Their full article can be found here.

Based on the above, this article uses 1990 recession as a "mild" recession scenario, and the Global Financial Crisis as a "severe" recession scenario.

Back study showed high correlation between MSAs percentage overvaluation at Peak and their subsequent price decline peak-to-bottom. It also suggested "long" duration of declines in the 4 to 6 years average range, for overvalued markets following even a mild recession such as 1990, and shorter duration of declines in undervalued and fairly valued markets.

Market Overvaluation in U.S. Metropolitan Areas at Peak vs. Subsequent Price Performance for Mild vs. Severe Recession:

The below table may well contain the most informative and comprehensive real estate price performance analysis ahead of a recession, you will find. It buckets 395 U.S. metropolitan statistical areas into ranges of overvaluation, starting at less than -10% undervalued and ending with > 80% overvalued, in 10% increments.

It then illustrates the average peak-to-bottom decline and average decline duration for each overvaluation bucket, as well as their +1 years to +10 years ahead price changes, for both a mild recession scenario such as 1990, and a severe recession scenario such as the Global Financial Crisis.

Average peak-to-bottom declines are almost perfectly ordered with ranges of overvaluation. As noted in the article Housing Market Valuations in U.S. Metro Areas: A Back Study for Downside Risk after Two Recessions: "The most Overvalued range declined an average 52% peak-to-bottom following the Global Financial Crisis and 14% following 1990 recession. The most undervalued range declined an average 4% following the Global Financial Crisis and experienced no decline following 1990 recession. The rest overvaluation ranges are well ordered as well."

A mild recession scenario such as 1990, had whooping 6.5 years average decline duration for its most overvalued range of greater than 50% overvaluation. Average decline itself for the most overvalued range was just 14%. It appears that the strong economic recovery post 1990 recession including growing real estate fundamentals of personal income, served to resolve most of the overvaluation, leaving a modest residual price decline only. Significant overvaluation though took longer to resolve even with the strong economic recovery. Similarly, other overvalued ranges in the 20% to 50% ranges took 4.2 to 5.4 years on average for what were modest 7% to 17% average declines.

In comparison, a severe recession scenario such as the Global Financial Crisis, that exhibited weak economic recovery including declines in personal income, resulted in high average price declines for its most overvalued ranges. On a high level, declines were of the magnitude of the overvaluation itself, as personal incomes didn't serve to "compensate" or help resolve the overvaluation. Per the table, such declines took 5.1 to 5.8 years on average for the greater than 10% overvalued ranges.

Undervalued and fairly valued MSAs had average declines of under 2% for the mild recession of 1990 and under 11% for the severe Global Financial Crisis recession. They also had shorter decline duration of less than 1 year for the mild recession, and 2 to 4.4 years for the severe recession. Average price declines in the less than -10% undervalued buckets were extremely mild for both a mild and severe recession, standing at no decline and 4% respectively.

By how Long did Peak in Overvaluation precede Price Peak:

In MSAs that were overvalued, peak in overvaluation percentage preceded peak in prices by around 3 quarters ahead of each the 1990 and Global Financial Crisis recessions. A decline in overvaluation percentages for greater than 10% overvalued MSAs may be a leading indicator for price declines ahead of both a mild and severe recession. This can be seen in the below table.

Lead in valuation peak ahead of price peak was higher for fairly and undervalued MSAs compared to overvalued ones.

Where to Expect most Favorable Price Appreciation ahead of a Recession:

Below table looks at 1-year ahead price performances for different overvaluation ranges, starting 1 year and 2 years ahead of price peak, before each of 1990 recession and the Global Financial Crisis.

For the two years ahead of 1990 recession, more overvalued MSAs performed high level in line with there less overvalued counterparts in terms of 1 year ahead price performance. Much of the overvaluation ahead of 1990 was achieved in earlier years, with little excessive growth happening in the 2 years ahead of the recession.

For the two years ahead of the Global Financial Crisis, overvalued MSAs outperformed fairly valued and undervalued MSAs in terms of 1 year ahead price performance, by a wide margin. There was excessive growth happening in the 2 years ahead of the recession, with price performances well ordered relative to percentage overvaluation. High level, the more overvalued an MSA was in the two years ahead of the Global Financial Crisis, the stronger it performed in the short run.

Let's take a look at price performances across overvaluation ranges, starting at Peak before each recession, on a 1 year ahead to 10 year ahead time horizon in 1-year time increments. These are given in the Market Overvaluation in U.S. Metropolitan Areas at Peak vs. Subsequent Price Performance for Mild vs. Severe Recession table above.

More undervalued MSAs ranges outperformed consistently their more overvalued counterparts. Further, they did so on each of the 1-year ahead through 10-year ahead time horizons, under both the mild 1990 Recession and severe Global Financial Crisis. Price performances across the different overvaluation ranges, on the 1-year through 10-year time horizons, appear almost perfectly ordered.

On a 10-year ahead time horizon, the most undervalued MSAs range of less than -10% valuation, appreciated 54% following the mild 1990 recession, and 25% following the severe Global Financial Crisis. In comparison, the most overvalued MSAs range appreciated 16% following 1990 recession on a 10-year ahead time horizon, and declined 25% following the Global Financial Crisis.

Below table lists the average 10-year ahead price performance across starting dates of 1 through 5 years before Peak, for each of 1990 and Global Financial Crisis recessions, as well as for each overvaluation range.

More undervalued MSAs ranges outperformed their more overvalued counterparts on average on a 10-year ahead time horizon, if one invested up to 5 years ahead of both a mild a severe recession.

Summary:

We looked at average peak-to-bottom decline and average decline duration for various overvaluation ranges, as well as their +1 years to +10 years ahead price changes, for both a mild recession scenario such as 1990, and a severe recession scenario such as the Global Financial Crisis. Here are some summary points:

• Average peak-to-bottom declines are almost perfectly ordered with ranges of overvaluation after both the mild 1990 and severe Global Financial Crisis recessions.

• Strong economic recovery post a recession including growing real estate fundamentals such as personal income, may serve to resolve the overvaluation partly, leaving a residual price decline only. Significant overvaluation may take a long time to resolve even under strong economic recovery and a modest price decline.

• A severe recession, that exhibits weak economic recovery including declines in personal income, may result in price declines of the magnitude of the overvaluation itself, as personal incomes don't serve to resolve the overvaluation.

• Undervalued and fairly valued MSAs exhibited small price declines and shorter decline duration following both the mild 1990 recession and severe Global Financial Crisis.

• A decline in overvaluation percentages for overvalued MSAs may be a leading indicator for price declines ahead of both a mild and severe recession. The former peaked around 3 quarters ahead of prices peaking.

• In the years before a recession, overvalued MSAs may outperform fairly valued and undervalued MSAs on a 1-year ahead price performance, by a significant margin if excessive price growth is observed, such as ahead of the Global Financial Crisis.

• Following price peak, more undervalued MSAs outperformed consistently their more overvalued counterparts, on each of a 1-year ahead through 10-year ahead time horizons, under both the mild 1990 Recession and severe Global Financial Crisis.

• Starting up to 5 years ahead of both the mild 1990 Recession and severe Global Financial Crisis, more undervalued MSAs ranges outperformed their more overvalued counterparts on average on a 10-year ahead time horizon.

Based on the above analysis, current overvalued MSAs, predominantly located in the U.S. West and South regions, for example the MSAs containing Boise, Phoenix, and Tampa, are likely to underperform on a 10-year ahead time horizon, relative to their more undervalued counterparts, predominantly located in the U.S. Northeast and Midwest regions. Such underperformance seems likely under both a mild and severe recession scenarios, as well as if recession occurs at a future time point, rather than immediate, within the next several years.

The most undervalued MSAs range of less than -10% seems likely to experience the strongest price appreciation over a 10-year ahead time horizon.

Data Sources:

Federal Housing Finance Agency, Bureau of Economic Analysis

About the Author:

Stefan Tsvetkov is the founder of RealtyQuant, a company that brings data-driven and quantitative techniques to the real estate industry. On a mission to add industry value through education, investment, technology, and analytics.

Financial engineer turned multifamily investor, analytics speaker, and live webinar host. He holds a Master's degree in Financial Engineering from Columbia University, and during his finance career managed ~ $90 billion derivatives portfolio jointly with colleagues.

Featured on multiple Podcast and Webinar events including Elevate, Best Ever Real Estate Show, Investing in the U.S. etc. Organizer of Finance Meets Real Estate live webinar series.

About RealtyQuant:

RealtyQuant brings data-driven and quantitative techniques to the real estate industry. On a mission to add industry value through education, investment, technology, and analytics.

Link to Data:

RealtyQuant Market Valuations as of Q1 2022 Contact for Data and Business Inquiries: contact@realtyquant.com +1-917-378-3154