Home prices have continued their upward climb, as evidenced by the latest report from S&P/Case-Shiller. However, the most recent data show a sequential deceleration in aggregate price increases. While there are several variables that influence the price trajectory of housing, the recent spike in borrowing rates—in anticipation of tapering by the US Federal Reserve—appears to be a primary driver. In this paper, we discuss the key variables, in addition to housing price indices, that contribute to create a more complete assessment of the fundamentals for a further price recovery.

1. Investment Research
Update on the Improving Foundations of
US House Prices (September 2013)
Ronald Temple, CFA, Managing Director, Portfolio Manager/Analyst
Home prices have continued their upward climb, as evidenced by the latest report from S&P/Case-Shiller. However,
the most recent data show a sequential deceleration in aggregate price increases. While there are several variables
that influence the price trajectory of housing, the recent spike in borrowing rates—in anticipation of tapering by the
US Federal Reserve—appears to be a primary driver. In this paper, we discuss the key variables, in addition to housing
price indices, that contribute to create a more complete assessment of the fundamentals for a further price recovery.

2. 2
The most recent house price reports from S&P/Case-Shiller in
September (based on data from May through July 2013) were in
line with our previous expectations. Prices in all cities in the S&P/
Case-Shiller 20-City Composite Home Price Index (the 20-City
Index) have increased from their levels 1, 3, 6, and 12 months ago.
The 20-City Index was up 21.2% from the low in March 2012 and
up 12.4% from a year ago. The report also showed a third sequential
deceleration of price increases in aggregate. This reflects the diverging
patterns we have seen across the cities in the index. Exhibit 1 shows
the extent of the decline in house prices during the bust (the change
from the high reached up until December 2008) and then shows what
percentage of the decline has been recouped. The highlights we would
point to include:
• Dallas and Denver are outliers on two counts: 1) Prices did not
decline as much in the downturn (i.e., the period from mid-2006
to early 2009) and 2) they have now reached new highs. To be fair,
in the housing bubble, neither Dallas nor Denver participated fully
on the upside so their relative resilience should not be a surprise.
As an example, prices in Dallas rose at an annualized pace of only
3% from the beginning of 2000 to the bubble peak in mid-2007.
This contrasts with an average annualized increase of 14% for Las
Vegas until its peak in the fall of 2006 and the 20-City Index which
increased approximately 12% annualized through August 2006. The
magnitude might not sound great, but the cumulative increase for
Dallas from 2000 to 2007 was 26% versus Las Vegas where prices
increased 134%.
• Losing cities continue to suffer: We have highlighted in the past
that some cities in “sand states” that saw the sharpest declines in
(%)
150
Proportion Recovered
Max–Min Decline
100
50
0
Dallas
Boston
San Francisco
Denver
Seattle
Portland
Atlanta
Charlotte
San Diego
Detroit
Washington, DC
Minneapolis
-100
Miami
New York
Tampa
Phoenix
-50
Chicago
Composite-20
Los Angeles
Cleveland
Through the last quarter much of the investor debate revolved around
the impact and timing for tapering of large scale asset purchases by the
Fed. While the central bank ultimately decided to maintain the same
level of monetary stimulus and asset purchases in its September meeting, the markets raised the cost of financing substantially for home
buyers in advance of the meeting. However, the impact of tapering on
housing demand has been a bit difficult for many to understand as the
varying timing lags in the range of housing data are not well known.
In this update, we will provide perspective on the most recent data
and how to interpret incoming information as higher mortgage rates
gradually impact housing demand and prices.
Exhibit 1
Housing Price Declines and Recovery from Low
Las Vegas
Home prices continued to surge through the second quarter of 2013
according to the most recent reports. At the same time, mortgage rates
have increased by about 130 basis points since the lows reached in
May 2013 when the market began to believe the US Federal Reserve
(the Fed) would begin tapering monetary stimulus in the near future.
An increase of this magnitude translates into an increase in the cost of
buying a home of approximately 17%. Given the combined effect of
higher financing costs, the 21% increase in national home prices since
the end of 2011/early 2012, and seasonal patterns, we expect monthon-month price increases to decelerate substantially in the fourth
quarter.1 Importantly, a decrease in sequential price increases will
greatly reduce the number of mortgage borrowers moving back into
positive equity. To the extent home prices stop increasing altogether on
a sequential basis—a reasonable prospect—we could also see consumer
confidence weakened as homeowners would become less optimistic
regarding the balance sheet recovery they have enjoyed of late.
As of 24 September 2013
Source: Standard & Poor’s
Exhibit 2
30-Year Mortgage Rates
(%)
9
8
7
6
5
4
3
Jul 96
Jul 99
Jul 02
Jul 05
Jul 08
Jul 11
Sep 13
As of 17 September 2013
Source: Bloomberg
home prices had also rebounded most strongly. In this note, we
look at the data in a different way. True, the prices have increased a
large amount from the recent lows, but when approached in terms
of how much of the previous decline has been recouped we get a
slightly less encouraging view. In Exhibit 1, one can see that six of
the twenty cities have regained at least half of the ground they lost
in the downturn. Notably, San Francisco was among the cities with
the largest decline but it is also among the strongest recoveries. On
the other extreme, four cities have regained less than 25% of the
decline. Three of these four cities were among the hardest hit with
declines ranging from 48% to 62% from peak to cycle trough.
The key data points that we are watching beyond the 20-City Index
include (in order of importance):
1. Mortgage borrowing rates, as illustrated in Exhibit 2: A 100 basis
point increase in mortgage rates from 3.5% equates to a monthly
payment increase of approximately 13%. The rise from the recent

3. 3
low of 3.45% in early May to almost 4.75% by mid-September
implies a 17% increase in the cost of financing the same home.
2. Mortgage Bankers Association Mortgage Loan Applications for
Purchase Index (the Loan Applications Index), as shown in Exhibit
3: This index measures the volume of applications to buy a home
(new or existing). By excluding refinancing volume, we can get
a clearer picture of future closings on home purchases. We have
been consistently disappointed with the lack of improvement in
this index. Even when mortgage rates were at record lows in early
May, the index climbed only to a level well below the activity seen
one year earlier when rates were at 5%. Perhaps the lesson is that
mortgage rates are less important to borrowing activity than are
other factors such as the ability to accumulate a down payment and
employment growth. Regardless of the driver, we will continue
watching this index as a divergence from our expectations could
mean that economic growth substantially trumps borrowing rates.
If that is the case, we can be more optimistic that the eventual
tapering of monetary stimulus might not impair activity as much as
we currently suspect.
3. New single-family home sales: Closely monitoring this series is a
priority, as it is the most current tangible measure of actual activity.
New home sales are recorded at the time of contract signing rather
than actual purchase closing. As a result, the report tends to reflect
activity with a lag of only one month. The most recent report was
materially disappointing relative to consensus expectations. In our
view, this report reflects the spike in mortgage borrowing rates since
May (see Exhibit 4).
4. National Association of Home Builders (NAHB) Housing Market
Index (the NAHB Index): The NAHB Index is next in our queue
of key data series to monitor, as it captures a combination of actual
activity and sentiment. As such, we see it as offering positives and
negatives. The positive to this index is that it should reflect demand
for new construction better than other indices as it incorporates
traffic of potential home buyers, as shown by the underlying index
components in Exhibit 5. On the negative side, while we would
expect home builders to be very aware of mortgage rates, they likely
would have a difficult time discerning which potential customers
might be squeezed out of the market by higher financing costs.
Hence we consider this index slightly less predictive of future activity in aggregate (beyond new home construction) than the new
home sales data.
5. Existing single-family home sales: Existing home sales are the least
predictive in our sample of key metrics, as these data generally
reflect a lag of two to three months from the date of a purchase
agreement. This delay results from recording the transactions only
at the actual closing of the purchase, which typically takes a few
months given the time required to obtain a mortgage and arrange
document signings. Nevertheless, we believe it is instructive to
monitor this series even with its drawback of delayed data (see
Exhibit 6).
When we weigh the combined evidence of the previously described
indicators, we conclude that sequential price momentum will decelerate meaningfully through year end. However, the data also leave
reason to suggest that we may be too pessimistic. The two key data
points that would support a more constructive view on housing,
Exhibit 3
Mortgage Bankers Association Mortgage Loan Applications
for Purchase Index
(Index, March 1990=100)
500
400
300
200
100
Jul 93
July 96
Jul 99
Jul 02
Jul 05
Jul 08
Jul 11
Aug 13
Jan 08
Jan 11
Jul 13
Jan 11
Aug 13
As of 6 September 2013
Source: Mortgage Bankers Association, Haver Analytics
Exhibit 4
New Single-Family Home Sales
(Units, thousands)
1600
1250
900
550
200
Jan 93
Jan 96
Jan 99
Jan 02
Jan 05
As of July 2013
Source: US Census Bureau, Haver Analytics
Exhibit 5
Components of the NAHB Housing Market Index
Index
100
75
50
25
0
Jan 93
Jan 96
Jan 99
Jan 02
Jan 05
Jan 08
Sales of New Single-Family Homes Next 6 Months
Sales of New Single-Family Homes
Traffic of Prospective Buyers of New Homes
As of 15 August 2013
Source: NAHB, Haver Analytics

4. 4
that limits how much rates can increase without leading to a reaction from the Fed.
Exhibit 6
Existing Single-Family Home Sales
• Growth in personal income and employment: House price increases
since the cycle lows have been driven by a range of factors including, but not limited to, investor activity, employment growth,
income growth, and record affordability. In the long run, however,
we believe the governing factors for house prices are personal
income growth and financing rates. While this might seem obvious,
sustained patterns of price increases well above or below income
growth in particular tend to lead to large subsequent moves either
down or up in home prices.
(Units, thousands)
7000
6000
5000
4000
3000
Jan 93 Jan 96
Jan 99
Jan 02
Jan 05
Jan 08
Jan 11 Jul 13
As of July 2013
Source: National Association of Realtors, Haver Analytics
even against a backdrop of higher borrowing rates, are the Loan
Applications Index (Exhibit 3) and the NAHB Index (Exhibit 5).
The Loan Applications Index seems to imply that activity has not
increased substantially as a result of lower rates, but on a positive
note perhaps might not decrease as much when rates normalize.
The NAHB Index implies that even with a substantial interest rate
increase, actual traffic of prospective buyers to new home sites has continued to improve, albeit flattening slightly in the last observation. We
hope these are the right leading indicators, but on a closer look other
variables will help determine the magnitude of price deceleration,
which we describe next.
• Mortgage rates and a reduction in the Fed’s asset purchase programs
(i.e., tapering): In light of the Fed’s decision to delay tapering, we
might have a retracement in mortgage rates to slightly lower levels.
We recognize that the current rates are not sustainable on a multiyear basis, but we do believe there is a self-governing feedback loop
Conclusion
In summary, we remain constructive on the still young US house
price recovery. We continue to expect substantial divergences across
regions and cities based on local economic conditions and foreclosure
processes, as discussed in our prior updates.2 We also acknowledge that
a range of factors could derail improving consumer confidence. Such
risks include the potential for US military engagement in Syria, the risk
of a debacle around the debt ceiling, or an overly aggressive approach
to tapering by the Fed that could cause an incremental spike in borrowing rates. In spite of these risk factors, we believe the price recovery is
strong enough to endure the headwinds of higher rates, although prices
are likely to rise at a slower pace than our recent experience.

5. 5
Appendix
S&P/Case Shiller 20-City Home Price Index (January 2000 = 100)
City
San Francisco
Low Since
December 2008
Date of Low
High Since Inception
(January 1987)
Date of High
Current
Change from Low
(%)
Change from High
(%)
117.7
Mar 09
218.4
May 06
176.9
50.3
-19.0
Detroit
64.5
Apr 11
127.1
Dec 05
90.8
40.8
-28.5
Phoenix
100.2
Sep 11
227.4
Jun 06
139.4
39.1
-38.7
Atlanta
82.5
Mar 12
136.5
Jul 07
111.5
35.1
-18.3
Las Vegas
89.9
Mar 12
234.8
Aug 06
120.6
34.2
-48.6
San Diego
144.4
Apr 09
250.3
Nov 05
188.3
30.4
-24.8
Los Angeles
159.2
May 09
273.9
Sep 06
206.3
29.6
-24.7
Minneapolis
105.8
Mar 11
171.1
Sep 06
134.9
27.6
-21.2
Seattle
129.0
Feb 12
192.3
Jul 07
159.5
23.7
-17.1
Miami
137.0
Apr 11
280.9
Dec 06
169.1
23.4
-39.8
Washington, DC
165.9
Mar 09
251.1
May 06
203.0
22.3
-19.2
Chicago
102.8
Mar 12
168.6
Sep 06
125.7
22.3
-25.5
Tampa
123.9
Feb 12
238.1
Jul 06
151.2
22.0
-36.5
Portland
129.0
Mar 12
186.5
Jul 07
157.3
21.9
-15.7
Denver
120.2
Feb 09
145.6
Jul 13
145.6
21.1
0.0
Dallas
112.3
Feb 09
131.5
Jul 13
131.5
17.1
0.0
-8.6
Charlotte
108.4
Jan 12
135.9
Aug 07
124.2
14.6
Boston
145.8
Mar 09
182.5
Sep 05
167.0
14.5
-8.5
Cleveland
94.2
Feb 12
123.5
Jul 06
106.3
12.8
-13.9
New York
157.4
Mar-12
215.8
Jun-06
171.0
8.6
-20.8
Composite-20
134.1
Mar 12
206.5
Jul 06
162.5
21.2
-21.3
As of 24 September 2013
Data include transactions from May to July 2013.
Source: Standard & Poor’s
Notes
1 Note year-on-year prices will continue to show strong increases in all likelihood as prices have increased over 8% in the last seven months alone. Source: Standard & Poor’s, as of 24
September 2013.
2 Papers available at: http://www.lazardnet.com/investment-research/
Important Information
Published on 4 October 2013.
Past performance is not a reliable indicator of future results.
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