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House Prices Likely to Fall Further, But Not for Expected Reasons 

September 5, 2007

House prices are likely to fall further, but not for the reasons usually cited, according to a study  published by the Federal Reserve Bank of Cleveland. Two real estate professors at the UW-Madison School of Business are among the study’s co-authors.

House prices are likely to drop, according to an “Economic Commentary” published by the Federal Reserve Bank of Cleveland, "What's Really Happening with Housing Prices," The commentary notes that most of the public concern about housing markets is based on claims that house prices have increased at historically atypical rates and that house prices have outpaced incomes. The first claim is based on inaccurate historical data, says the study, while the second claim is linked to relaxed credit constraints.

Although some observers claim that house prices increased at historically atypical rates from 1998-2006, there is a precedent. Using a different source of data, the commentary’s authors – Morris Davis and François Ortalo-Magné from the University of Wisconsin-Madison School of Business and Peter Rupert of the Cleveland Reserve Bank – found a similar boom in house prices from 1970-1980.

The researchers also say that relaxed credit constraints could explain why house price appreciation has outpaced incomes. House prices can, and should be expected to, surge if credit constraints are unexpectedly relaxed for first-time homebuyers who are credit or down-payment constrained. As the demand for starter homes increases, the prices of those homes also increase. Owners of starter homes enjoy capital gains, enabling them to trade up to a more expensive house. The increased demand for more expensive homes pushes up the prices of those homes.

The commentary predicts:

• as private mortgage originators tighten credit standards, the availability of subprime variable-rate mortgage programs will sharply curtail.
• the demand for starter homes will then decline, causing their prices to fall.
• the result will be a reduction in the wealth of the current owners of starter homes, triggering a chain-reaction decline in the price of trade-up homes.