Issue: July 2005
By Carl Steidtmann, chief economist and director, Consumer Business, Deloitte Research

Everywhere you turn these days the buzz is about soaring real estate prices. If you are lucky enough to be a homeowner in one of the hot markets like South Florida or New York City, owning real estate is almost as good as winning the lottery. The increase in household wealth is seen by many analysts, who can’t stand the thought that someone somewhere might be doing well in this economy, as a sign of some future catastrophe to come. All the hype about a housing bubble is an excellent illustration of Benjamin Disraeli’s lament that there were ‘liars, damned liars and statisticians.’ While many of the housing price indexes that are published by both government and industry trade groups show prices spiraling higher, you really need to be a statistician to understand what they are saying.

When you strip away all of the white noise around a housing bubble, what you find is a robust market for housing that is undergoing several profound changes all of which manifest themselves in higher home price indexes, none of which adds up to a housing price bubble.

The Housing Bubble Illustrated

Exhibit A in the case for a housing bubble is the home price index put out by The Office of Federal Housing Enterprise Oversight (OFHEO). Published quarterly, this index shows housing prices soaring in 2004 and into 2005 as well. The rise in home prices is not quite as dramatic as the 1970s price increase, but then overall inflation in the late 1970s was much higher than it is now.

According to the Office of Federal Housing Enterprise Oversight their Home Price Index (HPI) is:

a weighted repeat sales index, meaning that it measures average price changes in repeat sales or refinancings on the same properties. This information is obtained by reviewing repeat mortgage transactions on single-family properties whose mortgages have been purchased or securitized by Fannie Mae or Freddie Mac since January 1975.

So if a brownstone in Harlem, New York sold for $25,000 in 1995 and the same property sold for $500,000 today that would represent an astounding level of price inflation over a 10 year period and certainly a sign of a housing bubble. The problem with this simple math is that it leaves out the qualitative changes that have taken place over the past 10 years both in the building itself and the neighborhood it is in.

Or take a condominium project in West Palm Beach Florida. Say a developer bought a rundown condominium project in 2003 for $250,000 a unit, knocks it down and replaces it with a new project where units are selling for $1,000,000 a piece today. While the OFHEO index does not cover multi-family dwellings, if it did, it would record this transaction as a big run up in home prices. But again, it fails to take into account the dramatic change in the quality of the dwelling that has taken place.

The Cohort Effect of the Baby Boom Generation

Everywhere the Boomers have gone, economic, political and social disruption has followed, and housing is no different. When the boomers were born, maternity wards were overwhelmed. When they went to school, there was a boom in school building that was not enough to keep a lot of public schools from going to a double session day. When the Boomers hit puberty we had a sexual revolution. At college age, they took to the streets in protest on a global level. Upon entering the workforce they produced record unemployment. When they first started buying houses in the late-1970s, housing prices soared. Even as we look ahead to their retirement, they will create a crisis in both private and public pensions. It should not be surprising that they are roiling the housing market.

As the children of the Boomers leave home, the housing needs of the Boomers are changing. They are moving back into the inner city to places like Harlem and at the same time buying second homes at record numbers. Both changes in housing demand are producing an upward movement in home price indexes. But do these changes really represent an increase in home prices that can be described as a bubble?

A financial bubble is first and foremost a monetary phenomenon. If you look at money growth in the US in the late-1920s or in the late-1990s you will see a sharp acceleration in the growth of the monetary aggregates. The same was true in Japan in the late-1980s during the Nikkei bubble. In the late-1990s, the Fed greatly expanded the amount of money in the banking system in part out of fear of Y2K related financial market disruptions. While those fears fortunately never came to pass, the money the Fed pumped into the banking system found its way to Wall Street where it sent internet related stocks soaring.

Since the breaking of the internet bubble in 2001-2002, liquidity has expanded at a much more moderate pace with current growth in the monetary base running at just above 4%, a fraction of the 1999 bubble inducing levels. 

The psychology of market participants in a bubble is also different from normal times. As a bubble reaches its peak the market participants are in search of the greater fool. Buyers buy only in the expectation that there is a greater fool out there who will pay a higher price. Eventually the greater fool is found and the price falls. As the market searches for the greater fool, the rising price brings out extra and sometimes unexpected sources of supply. It is this combination of increased supply and narrowing demand that results in the breaking of a market bubble and a fairly rapid descent in price. While there is some anecdotal evidence of market speculation, most participants are buying houses because they still represent a very good long term value. 

The Process of Gentrification

Thirty years ago there were brownstones in the Harlem section of Manhattan that the city government had condemned but could not give away. Slowly, urban pioneers moved in and began fixing up these classic old buildings. Crime fell. The drug pushers and the prostitutes were pushed out. More people moved in and a tipping point was hit. New businesses moved to the neighborhood. Retail and service related businesses began to flourish. Even a former President has set up offices now in Harlem. What was once a slum is now a gentrified neighborhood. The quality of the housing and the quality of the neighborhood have both improved dramatically. In so doing, the price of housing has soared.

On the surface all of this may look like a housing price bubble but the reality of what has happened is much different. What the rise in home prices is reflecting is a dramatic improvement in the quality of both the housing and the neighborhood. Given that different reality it should not come as a surprise that the biggest increases in home prices are taking place in places like Harlem New York and other east coast cities where the process of gentrification is dramatically improving the quality of both the housing stock and the old neighborhoods.

Boomers are not just moving back into inner cities, they are also buying second homes in record numbers.  Many of those second homes are being purchased in anticipation of future retirement. While much of this activity has been characterized as housing speculation, what it really represents is a shift in the nature of demand for housing. 

The front end of the Boomer generation turns 60 next year. The vast majority still have their 50’s ahead of them. The peak period for first time second home purchase is in ones early 50s. This demographic shift still has a long way to run as the back end of the Boomer generation will not turn 60 until 2024. Given this shift in housing demand, it should not be surprising that home prices are rising rapidly in traditional second home retirement markets like Florida and Arizona.

Breaking a Bubble

Financial bubbles come to a crashing end when the sky high prices lure a wave of supply onto the market that crushes demand.  Were housing a bubble, the high price of existing housing should be fostering a boom in home building. While new housing starts have risen steadily over the past couple of years, when adjusted for population, new home building is no where near the heights of building activity set back in the 1970s. 

One of the reasons for the modest rise in new home building activity is that the home construction business has changed dramatically over the past twenty years. Industry consolidation has left the business in the hands of large, well managed, professional home building firms. Fewer homes are now built on speculation then in the 1970s or 1980s as today’s builders work hard to match housing supply to demand. As a result, the boom and bust days of the industry are gone as housing construction has become much less cyclical.

Tax Changes

Gentrification is not the only change that is affecting the measurement of home prices. Tax changes over the past decade have dramatically improved the relative value of owning your home as opposed to renting it. Home ownership is still the best source of tax avoidance for the middle class. With both interest payments and property taxes deductible, the after tax cost of home ownership is reduced by anywhere from 15% to 35% of the home payment. The tax treatment of capital gains coming from the sale of a home has also been made more favorable. Once taxed as capital gains if not reinvested, gains
from a home sale are now tax free up to $500,000. 

Affordability

And finally, as interest rates have come down, the affordability of home ownership has gone up. Asset prices are high, but the actual cash flow cost of housing is near record lows due to low interest rates. The share of an average American household income going to finance a new median priced house today is lower then it was at any time in the past two decades. Interest rates are going to have to rise more than a little to increase the cash flow cost of housing back to the levels seen in previous decades.

Conclusions

H.L Mencken once said that the definition of a Puritan was someone who hated the notion that somewhere someone might be having a good time. The same can be said of the economic Puritans of today who cloak their disdain for continuing prosperity in a search for some element of the current economy that is not perfect. Last year it was the lack of job growth. This year it is housing prices. Next year it will be something else.

The housing market has been one of the bulwarks of growth in the current recovery. The rise in home values has added dramatically to household wealth and given consumers a source of additional cash flow that has contributed to a robust consumer spending environment.

Eventually mortgage rates will rise and the housing market will cool. But don’t expect the calamity that many of the housing bubble heads are hoping for. Declines in housing prices do not bring down an economy. Housing prices can decline but such a decline usually is a reflection of a weak local economy. Home prices fell in Houston in the early 1980s when the oil industry collapsed, in Boston when the high tech industry stumbled in the late 1980s and in Los Angeles in the 1990s following a decline in the aerospace industry. In each case the decline had nothing to do with a previous housing bubble and everything to do with the local economy.

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