A collapsing housing bubble?

Stewart, Suzanne ; Brannon, Ike

Anytime there is a consensus about the future, it is probably wise to bet against it. In the past couple of years, predictions about home prices have one from a sober questioning of future price growth to shrill apocalyptic predictions of an impending market collapse that will trigger a deep recession.

We cannot claim to have a crystal ball that works any better than the commentariat, but we believe a clear look at the available data suggests that the situation is far from dire. While average home prices in the United States have increased smartly in the past decade, that by itself is not sufficient to conclude anything about what future prices will do.

NATIONAL MARKET? The first problem with such prognostications is that it makes little sense to talk about "the" American housing market. Home appreciation rates vary widely across the nation and there is no such thing as a national housing market. While areas in Nevada, Arizona, Hawaii, and California, as well as the metropolitan areas of New York City, Boston, and Washington D.C., have seen housing prices skyrocket in recent years, those places comprise a small portion of the national housing stock (and even in those "hot" markets, the price jumps have not been universal). Elsewhere, home prices have grown at more moderate rates.

Table 1 shows the variation in home price appreciation over the past decade. It reveals that prices in New England and the Pacific regions have risen dramatically over the past decade, but house prices in other parts of the country have increased more modestly.

Also, the context in which the price growth is presented matters quite a bit. A 55 percent real increase in the average price of a house over the course of a decade can seem impressive at first glance, but when broken down to an annual average increase, it translates to just 4.5 percent. That is a healthy gain, but not the stuff of unsustainable bubbles. Compared to stocks, which have had a real average annual increase of 7 percent for the past 70 years, investing in a house is relatively pedestrian.

CHANGING HOUSES The annual rate of growth in house prices seems even less alarming when one discovers that the indexes used to measure home prices likely overstate the actual price appreciation. Homeowners constantly add, fix, improve, and expand their homes, and over an extended period of time a house can morph into an utterly different entity. Harvard's Joint Center for Housing Studies estimates that homeowners spent $233 billion on home improvement projects in 2005 alone.

The House Price Index in Table 1, constructed by the Office of Federal Housing Enterprise Oversight (OFHEO), tracks the same homes and their prices only as they are bought and sold over time. Improvements such as remodeling a kitchen, adding a room, or re-landscaping are not captured by the index. As a result, what often looks like a large jump in a home's price actually has a concrete (or granite, marble, tile) reason behind it.

But it is not just existing homes that are being upgraded. New homes today are not what they were 40 years ago, as home construction has responded to the changing American lifestyle. Strides have been made in the building materials and techniques used in home construction. New homes today are generally built with more square footage and include more features than the homes of yesterday. New homes are more energy efficient and, in some respects, safer than their predecessors. There are also a myriad of options available in homebuilding today that did not exist even a decade ago. The American appetite for home improvement is just as much a driving force in the housing market as anything else out there. Just ask Ty on Extreme Home Makeover.

When considering the ratio of owner's equivalent rent to home prices--the standard housing market bubble meter-using the correct measuring stick for home prices puts the market in perspective. The ratio of owner's equivalent rent to home prices compares the rental price a homeowner could get for renting his home to the actual price of homes. A reading well below or above 100 indicates a market that is out of equilibrium: if the reading is below 100, renting is a bargain; if it is above 100, buying is the better deal.

So what does this ratio look like currently? As shown in Figure 1, it depends on which index is used to represent home prices. If the OFHEO index is used, it appears as if houses are overpriced. If the constant-quality new home price index is used, housing has actually been more affordable than renting for a considerable period until very recently, and is now at a "break-even" point. There are still places where the index shows that housing prices are dear relative to rents, such as the San Francisco Bay area, but they are the exception.

[FIGURE 1 OMITTED]

'EXOTIC' MORTGAGES If construction is responding to the changing American lifestyle, it makes sense that the mortgage market would also respond and offer new products that appeal to consumers. The long-term, fixed-rate mortgage is still a staple in home financing, but today there is a wider variety of mortgage options available that allows more people than ever to enter the market.

For instance, the oft-derided interest-only mortgage allows families with sufficient earning power to enter a market earlier than they would otherwise. (Interest-only loans made up 28.5 percent of all mortgages in the first half of 2005, according to the mortgage data company Loan Performance.) A generation ago, someone beginning a new career would find buying a house on a typical starting salary to be quite difficult, and would most likely be forced to rent for a number of years. Today, that same person can take out an interest-only loan and buy a house much sooner than before, with increasing mortgage payments being met by the prospect of higher future income.

Similarly, the high transaction costs of buying a house can make it impractical for people with peripatetic careers to buy a house; high closing costs can make it difficult for people who anticipate needing to move in a few short years to afford buying a house. While the relatively uncompetitive real estate services market keeps closing costs high, the ultra-competitive mortgage market makes it easier for this cohort to enter the housing market. Undoubtedly, there are families who use such mortgages to buy houses that are beyond their reach, but that fact alone should not be reason to deter such loans.

NOT JUST A HOME Houses are unique in that they are investment goods as well as consumption goods. There is good reason for people to be willing to pay more for both aspects. With no specter of inflation in our future and a world of relatively low returns, investing more in a house makes perfect sense. A stagnant stock market does not send off the siren song to investors that it did a decade ago. Who is to say that in such an environment a family spending another $100,000 on a nicer house is not making a wise decision? And as Americans become wealthier, it only makes sense that we want to spend more on the consumption aspect of our homes.

The fact that expenditures on homes in the United States outpace incomes is a sign of nothing but the fact that a house is, in effect, a form of luxury good. As people begin to accumulate wealth, they start aspiring to own a house. As they get wealthier, they want a nicer house.

The "speculative froth" in the housing market definitely exists to a degree, and can be seen in the significant proportion of condominiums bought by investors in major markets. But the froth is relatively minor in the ocean of home buyers. We see little reason to think that it is enough to swamp the other forces supporting home prices in this country.

Suzanne Stewart and Ike Brannon work in the U.S. Congress.

TABLE 1
Real Home Price Appreciation

1995-2005

AREA DECADE ANNUAL

United States 77.25% 4.53%
New England 83.66% 6.27%
Mid-Atlantic 61.54% 4.91%
South Atlantic 61.25% 4.89%
East North Central 31.61% 2.78%
West North Central 42.29% 3.59%
East South Central 21.90% 2.00%
West South Central 22.02% 2.01%
Mountain 51.32% 4.23%
Pacific 99.33% 7.14%

SOURCE: OFHEO