The methodology and rationale for using market valuation metrics as predictors of real estate downside risk was described in the article Real Estate Market Valuations: Predicting Downside Risk, A Back Study.
Take an overvalued market as determined by the above framework. The magnitude of overvaluation correlates to the magnitude of a downturn following a peak in market cycle, once such gets reached, and assuming a price correction scenario follows. The latter was indeed the case post the Global Financial Crisis, as will be shown below. Further there is no prediction as to timing of such peak in market cycle.
There are perhaps three scenarios for the overvaluation to resolve, just one of them being a price correction scenario.
Percentage of U.S. Counties that Price Corrected During the Global Financial Crisis
A price correction scenario is hereby defined, as one where at least 50% of the overvaluation is resolved following a downturn in prices.
At the peak prior to the Global Financial Crisis, ~38% of U.S. Counties were overvalued i.e. > 10% market valuation. 93% of overvalued U.S. counties experienced a price correction as defined above, i.e. > half of their overvaluation was resolved following a price downturn.
Out of fairly valued U.S. counties having 0-10% market valuation, 98% experienced a price correction as well, as defined above.
Out of the 34% of U.S. counties that where undervalued at the time, 94% experienced a price correction as well, as defined above. For undervalued counties, since their is no overvaluation, a correction is hereby defined as a price change that is at least half the average income drop nationwide post the Global Financial Crisis, of 4%.
Scenarios post Real Estate Overvaluation
As discussed, the Global Financial Crisis was largely a price correction scenario for overvaluations at its preceding market peak. It is though not necessary for overvaluation to resolve via price correction.
Here are three possible scenarios for overvaluation to resolve:
Price Correction - most of the overvaluation is resolved through a price decline, often over a shorter period of time, with income change being smaller in comparison.
Reduced Price Growth - prices do not decline, though experienced reduced growth, over a longer period, as income catches up resolving the overvaluation.
Income Super-growth - prices do not decline nor experience reduced growth. Income experiences a super-growth resolving the overvaluation.
Below a graphical illustration of the three scenarios:
The Global Financial Crisis was largely a price correction scenario for the U.S. real estate market.
There are three scenarios for real estate overvaluation to resolve: price correction, reduced price growth, and income super-growth.
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 massive 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 InvestUp, Best Ever Real Estate Show, Discovering Multifamily etc. Organizer of Finance Meets Real Estate live webinar series.