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March 25, 2005
Housing bubble?
Recently the wife and I took a big step: we bought a house. It is a beauty. However, this has made me more acutely aware of a recurring subject these days: the possibility that were are in the midst of a housing bubble, the aftermath of which could involve the most terrible sort of vibes in the form of falling prices. For instance, today's NY Times has an article about speculative home buying. This is just one of many articles I have read recently on this increasingly popular investment choice. The crux of the article, as with many others in its basic vein, is that many people are buying second and third homes as an investment vehicle. They anticipate that most of the return on their investment will come from capital gains (as opposed to rents), and this might just be the right kind of setup for a bubble.
Let's begin with a little bit of recent and not so recent history. First, consider the following graph, lifted from the NY Times site:
What we can see from this graph is that, after a long era of falling prices, housing prices have experienced modest but steady gains throughout the post-WWII era. As the graphic indicates, the post-war increases in prices roughly followed inflation. Note one immediately obvious problem with the current "eternal sunshine" view: housing prices have in the recent past (note modest but pronounced spikes in the 70s and 80s) risen more quickly than trend only to fall back to the trend. Thus one simplistic view (housing prices always rise, they will continue to rise, and it will just go faster and faster) has little historical evidence to support it.
While this is a pretty stunning national figure, it obscures the fact that the boom has not been the least bit uniform across the nation. Here are some figures I ran across during an informal internet search (these undoubtedly aren't perfect, but they generally do match well with many others that I have seen). The point to absorb here is that the spectacular rise in overall prices has really been driven by particular markets within the U.S. Overall, Florida does appear to be a really hot market. Generally speaking, big urban markets (ie for places with yuppie appeal) have also done pretty well. On the other hand, the residents of South Bend, Indiana can be forgiven for saying "what boom?".
The other interesting dimension of this is that the US is not the only place where this is happening. It is actually occurring with even more force in most other wealthy, industrialized countries. In it's annual review ("The World in 2005"), the Economist magazine predicts a global housing price crash in 2005. In the article, they note the following percent increases in housing prices from 1997 to 2004:
Australia (110%)
France (68%)
Germany (-3%)
Ireland (181%)
Italy (62%)
Japan (-2%)
Netherlands (74%)
Spain (125%)
UK (132%)
US (57%)
So, what are we to make of this? Is it a bubble, or part of a more permanent trend? I can't answer that question (no one can with any certainty) but I can broadly outline some of the themes that guide my thinking on the subject.
1. There is no easy yardstick by which to gauge whether the rise in housing prices is reasonable. With equities, there is usually some sort of well defined return (eg dividends) beyond capital gains by which to consider the underlying fundamental value of the equity. For instance, in some sort of rough sense the value of a stock should reflect the discounted stream of expected future dividends. The closest analogy with housing would have to be rents. There is an implicit rent even on owner-occupied homes (the financial stream foregone by not renting the house out to someone else). The value of a house should then in some sense reflect an underlying discounted stream of rents. By that yardstick, we would seem to be in the midst of a massive bubble: in most markets where housing prices have been rising quickly (here and abroad) they have been doing so much, much faster than rents. Homes in these markets would thus seem to be massively over-valued. Even here in the Durham-Chapel Hill area, where prices have been rising at a comparatively modest rate, I have to admit that they appear to have been doing so much faster than rents.
2. At the same time, the experience of our local market shows how tough the rental analogy can be. It seems to me by casual observation that far more residential construction in the past decade focused on houses, rather than apartments per se. The rental stock here has thus aged allot more rapidly in the past decade than the housing stock (because of slower building of new apartment buildings), and some of the slow growth in rents might reflect that. Apartments have other disadvatnages. You are more exposed to the consequences of the behavior of others in apartments (as someone who has lived through a terrible fire caused by a careless smoker, I know what I am talking about). But this explains differences in levels, not trends (unless Americans and others are becoming more risk averse in this sense).
3. Some have argued that given the limited amount of land, coupled with the desirability of certain markets (eg NYC, San Francisco, etc.), their is a certain inevitability to rising housing prices. But there are at least two problems with this argument. The first is that we already have stunning specific examples of its limitations (eg the Tokyo metro market in the past 10 years). The second is that, were this true, rents would also have been rising.
4. Nonetheless, there is a recent paper (“Why Have Housing Prices Gone Up?” by Edward Glaeser and Raven Saks, of Harvard University, and Joseph Gyourko, of the University of Pennsylvania (forthcoming in the American Economic Review)) that argues, basically, that a big part of the story of rising housing prices has been an insider-outsider problem: those who own homes have successfully discouraged significant amounts of new development, introducing a new avenue for rising prices, increases in the price of permission to build. This is an intriguing line of thinking, because it introduces a real supply-side fundamental that might actually be driving prices up (as opposed to the demand side factors, cheap money and lousy returns on alternative investments, that are usually mentioned). Can this sustain the types (magnitudes) of increases we have seen in recent years after these demand side factors are no longer in play? I tend to doubt it.
Posted by dag at March 25, 2005 10:42 AM