Home > Update > December 2006

BEYOND the BUBBLE

What’s Next for Housing Prices

Housing prices have lagged in recent months after years of often-spectacular increases. Our panel of experts discusses what that means to the real estate industry and to homeowners and sellers.

In recent years we’ve kept hearing about a real estate “bubble.” What does that actually mean?

Stephen Malpezzi: There’s a really simple definition of a bubble: It’s when a market— the housing market in this case—gets out of line with fundamentals. The reason economists rant and rave at each other about this is that it’s very hard to definitively tell when you are in a bubble or not because you are never completely sure of what the fundamentals are.

Morris Davis: Let’s take a house. A house doesn’t just provide services to a homeowner today, but provides services for today, tomorrow and for the future. The reason an asset price could potentially have a bubble is if homeowners think that the future value of housing is growing faster than fundamentals would dictate. So, the reason housing might have bubbles is that homeowners might just guess wrong about what the future stream of the payoffs from housing is going to look like.

François Ortalo-Magné: This relates to “irrational exuberance” type of behavior, where people are paying high today because they expect the price
to be even higher tomorrow.

Marc Ley: Simply stated, the housing “bubble” is demand exceeding supply, causing prices to grow beyond a sustainable level. The next question is, when supply exceeds demand, what price level is sustainable? Every residential submarket has its own set of fundamentals that will determine sustainable price levels over time.

William Malkasian: From a street perspective, most states in the Midwest tend to be a little more conservative on the investment side. A bubble is often defined as a mental shift in the consumer’s mind from basically buying a home for shelter, to buying a home as an investment. That’s something that’s typically done more in a second home, or resort world. It also ties into lender philosophy and the laws of each state. Many bubbles are caused by the cyclical nature of someone saying, “I want to invest for a short period of time, flip it, and then re-sell it and make a profit.”

So, there’s no doubt the housing bubble has burst?

Malkasian: There is absolutely a slowing of the market. Inventory is up about 40 percent higher than it was a year ago. What’s affecting the slow down of the market is the glut of new construction. There’s a backlog of approximately 350,000 units nationwide, which people predict will take about 18 months to dissipate, to get a natural balance in price between inventory and supply and demand. Yes, it’s slowed down. Yes, the median price has come down. According to the National Association of REALTORS, it’s the greatest decline in median price of existing homes since 1968. But it’s not a panic market and that’s really important for people to understand. It’s not a recessionary decline. It’s a psychological decline. The buyer is saying: “I know it’s going to come down further. Rates are still stable, so therefore I’m going to wait.”

Ortalo-Magné: People used to say, “I better buy right away because prices may keep rising and then I’ll be kicked out of this market.” Now people are saying, “Hey, you know what? If I wait a bit, I may get it cheaper.” A very small change in fundamentals can result in a very big change in people’s attitudes.

Michael Conaghan: In most markets across the country, there are twice as many homes listed on the multiple listing service as the same time last year. However, I don’t think this alone explains what is going on. I think consumer confidence has been shaken by $3 per gallon gasoline, the Middle East and the media’s obsession with the housing bubble. Add to that, better interest rates on CDs, and buyers feel it is OK to sit on the sidelines for a while.

Davis: Just because we are having a slow down, does not mean the sky is falling. It might just mean that we’ve fully adjusted to the demand shock that we had. Here’s a story you can tell of the recent boom: Strong income growth plus a large decline in long-term lending rates made housing relatively more affordable, and people demanded more housing. As result, we had a big surge in residential investment and a big surge in housing prices. Think of that as a demand shock—a shift in a demand curve. Suppose we’ve taken that as far as we can. You’d expect a slow down in residential investment because maybe now we’ve built all the new homes that needed to be built as a result of the increased demand. The prices of existing homes have adjusted to where they needed to be so people were satisfied with owning the portfolio they had in place.

Malpezzi: I have one thing to add to that story. Different places had different rates of population and employment growth. What you find is that different metro areas, different markets, have different abilities to respond to a “demand shock.” In some places, when demand increases it is not very difficult for builders and developers to respond with more housing. Other places, due to physical geography or regulatory environment— or in places like San Francisco, a combination of the two—make it harder for the market to respond. So, the same demand shock can lead to a much bigger runup in price, as we’ve seen in places like San Francisco, many of the other California cities, Boston, New York and so on. A similar demand shock doesn’t have as big an impact on prices in places like Chicago, where it’s easier to build.

Do the rest of you agree with these interpretations of the cause of the decline in housing prices?

Ley: That’s a good supply-side commentary on what’s happened. On the demand side, another thing we see as a big influence is the equity buildup that homeowners have been able to extract in recent years by selling and paying more to move up. Now, the move-up chain has been broken. People’s expectations of what their homes are worth are not being met, so they aren’t selling.

Malkasian: And in many cases, they have a first and second mortgage, so you may end up with
a short sale because you don’t have enough
equity in the house to pay off the first and
second mortgage.

Ley: The appraisal business and home equity lending have done a lot to set expectations because homeowners took out maximum home-equity loans believing in a certain value of their house. Now they are upset when then get it reappraised or they try to market it for the appraised value and it’s not coming through. Others have used a variety of mortgage products at high leverage to purchase homes, expecting appreciation that won’t occur until the next cycle. If they need to sell now, these buyers and their lenders may be facing losses.

Malpezzi: Freddie Mac found that in the last period surveyed, something like 90 percent of refinancings have taken more equity out, even as interest rates are going up, suggesting that people have gotten much more aggressive about using their house as a “piggy bank.”

Ley: Yes, many homeowners have extracted significant equity in the form of larger first mortgages to pay for home improvements and lifestyle choices, and at the same time have actually reduced their monthly payments due to low mortgage rates. Other homeowners have large home-equity loans that were taken out when values were higher. Now that interest rates are higher and values are suspect, these homeowners are worried about their values and have stopped borrowing from the “piggy bank” if they can. Those really in trouble are using home equity loans to make their monthly mortgage payment, waiting for a recovery.

Malkasian: When you talk to people on the street, that’s becoming a sale issue. The equity line may have been established in a period of robust pricing two to three years ago. The value of a house in places like Las Vegas, Tucson, Miami or the coasts, has declined anywhere from 30 to 40 percent in value in one year. I suspect that has to be a pretty challenging issue for the bank that offered the equity loan.

Ley: What’s interesting about this housing slowdown it that it wasn’t preceded by a recession or huge layoffs. Based on recent economic data, we’re still in a pretty good economy. The one thing that was most surprising about last quarter’s earning calls of public homebuilders was the amount of write-offs that a lot of these firms took by walking away from land deals. Today, public homebuilders are encouraged not to carry land on their books. They spend a lot of money while they have a piece of property tied up, including either option money, good-faith deposits as well as the costs of pre-development and planning. Many have walked away from these investments, expecting things to get worse before they get better. In the West, when the market improves, they will be short on land again.

Ortalo-Magné: When you have a run up in price fueled at least in part by the fact that people are using capital gains on their homes to move up the property ladder, then you only need a slow down in the economy to get a downturn in housing, you don’t actually need a recession.

People were moving up the ladder in three years instead of the usual five or six years because they were using capital gains in their current home to finance bigger purchases. The slowdown in the economy means the rate of capital gains accumulation decreases. People need to wait longer for capital gains to be able to move up the ladder. As a result, I think we are going to see more of a correction at the top of the ladder (high-end homes) than the bottom. The bottom end of the ladder is sustained because we aren’t in a recession.

Ley: The other part is that builders are increasingly trying to capture the entry-level buyer, which also breaks the move-up chain. When there’s not a lot of supply, entry-level buyers historically buy an existing home and push up someone else, and the whole chain reacts going up the price-point ladder. With the advent of condos and lower price point products, you can get an entry-level buyer who is just buying a new unit and not creating any ripple affect. Also, we’ve seen some pretty dramatic price cutting by certain public builders. We don’t think this is warranted or sustainable in our market. Some builders are overreacting and becoming part of the problem by contributing to negative buyer psychology and the expectation of lower future prices.

Conaghan: The move-up buyer helped fuel the housing market from the mid ’90s to 2002, but with lower interest rates, first-time buyers flooded into the market. There will always be move-up buyers, but they may not be as big a factor as historically. You may find that buyer is now buying a second home instead of moving up.

Is anyone willing to predict what the housing situation will be like in six months?

Davis: I am willing to state right now, that houses nationally are 15 percent over-valued. So, I am willing to take a gamble and say that within six months, when the statistics come out, there will be a year-over-year real loss of 5 percent. We’ll see in six months just how far off I am. There are some places, like Miami, where it is hard to know what will happen, because the models predict such a dramatic downturn in house prices that it is hard to believe the models anymore. There are other markets that actually seem perhaps less overvalued then you might think. I think Boston is one of those markets or maybe New York, which doesn’t seem as out of whack, at least according to these asset-price models, say as San Bernardino or Sacramento.

Malpezzi: Models I have been estimating with Yongping Liang, one of our former PhD students, agree with Morris, especially the California cities. Our rule of thumb is to be afraid in any market that starts with the word “San”— San Jose, San Bernardino, San Diego… I agree with François that housing on the top end will be hardest hit.

Ley: I also agree the high end will have the greatest percentage decline, and impact will be market specific. Here in California we have a phenomenon along the coast where, because of import/export activity, there is significant international influence where people are coming in and paying cash. And we are talking mid- and high- range housing—the mid range is probably in the 1-2.5 million dollar range and the high end is 3+ million dollars. For those that have to sell, there are many buyers looking for a good deal, but the problem is that they may not be willing
to pay what the buyer wants or needs to get out
of the home.

Malkasian: In Madison, our condominium market downtown was very, very hot but has slowed down dramatically. If you look at the high-rise condominiums in our affluent areas, many were bought as second properties, held for a year to two years and then sold. In our little world, buying something at 395,000 and selling at 500,000 10 months later is pretty spectacular speculation. Many of those properties that I am describing at the top end of the market were bought from an investment perspective, not a shelter perspective. And I don’t know what that is like for the rest of the country, but for the Midwest that is unusual.

How do land prices relate to overall housing prices?

Davis: Think of a house as having two components: a structure and some land. So, if the structure is easy to produce and there is a demand for housing, then we can build more structures.
If land is hard to produce—and land means location, view, the crime rate, good schools, all the bundles of amenities associated with land—and there is a shock to the demand for land, then prices are going to increase.

I have some research that suggests that in the boom there was a big demand shock for housing that reflected itself nationwide in a surge everywhere in the price of land. The growth rate in land prices was fastest in cities you might not expect. The city that had the most rapid growth in the price of land was Minneapolis. In the boom, it appreciated more than 200 percent in real terms. Part of the reason land in Minneapolis was able to appreciate so rapidly was that it was cheap to begin with, but it’s not so cheap anymore.

Davis: Research I’ve done suggests a house in Milwaukee has most of its value wrapped up in the structure, while a house in San Francisco has most of its value is wrapped up in land. So it turns out that in these two cities the price of land increased at the same rate and the cost of building the structure roughly increased at the same rate, but because land was a much larger fraction of home value in San Francisco, house prices there increased more rapidly than in Milwaukee.

So, the old saw, that real estate boils down to “location, location, location” is still true?

Ley: Half the population of the U.S. currently lives within 50 miles of a coastline. Recent research by Richard Florida on this topic says that half of the growth over the next 10 years is expected to be in those same coastal areas. To me, future residential pricing is really a fundamental issue of supply and demand and we are going to continue to have a dichotomy: the supply-constrained coastal regions versus the interior of the country. Where people choose to live will continue to be driven by jobs and a coast versus interior story, but many non-coastal cities with good locations will have better than average price appreciation over time.

Malpezzi: Your point is a good one, and a little bit broader way to put it is that the amenities of locations matter. We think of rural areas, especially the Great Plains, as emptying out, but there are rural areas where you see strong demand pressure and housing market performance. Those tend to be places with decent air links to major cities and good natural amenities.

Let’s change our focus for a moment. The first wave of the Baby Boomers is starting to retire. How will that affect housing?

Malpezzi: The first question is whether the first wave of baby boomers is actually going to retire! That’s an open question, especially on the high end of the labor market. I think there will be quite a few boomers, some by necessity and some by choice, who will stretch out their working lives longer than we have seen in the past.

Malkasian: I think the second home market goes back to the original question about, “Do you see a slowdown?” This is not a traditional slowdown, and the largest percentage increase last year in Wisconsin was in second-home sales. The Baby Boomer generation is the richest generation this country has ever seen, and they have enough disposable income to buy a second home and possibly keep the family residence. The second growth factor in Wisconsin is single women. They have bought more homes than any other time historically, and a lot of it has to do with financing, and zero percentage down. It will be interesting to see if that comes back to bite us in the long run, if foreclosures are up.

Davis: I have a slightly different point, but it reinforces the impact the boomers might be having.
I have an ex-colleague at the Federal Reserve, Robert Martin, who is now on the President’s Council of Economic Advisors. He thinks the boomers may have driven much of what we’ve seen with asset prices. He says once the boomers stop trying to accumulate wealth and actually start trying to spend out their wealth we might see—in his words— a much more significant collapse in housing prices than we’ve observed. Now, he’s a bit extreme, but the case he points to is Japan. He says that if you look at the Japanese age structure, they basically had a baby boom that peaked around 1989 or 1990, which was right around when the Japanese land bubble popped. He’s not saying this is definite proof, but he’s saying that if the Japanese experience is reflective, the baby boom in the U.S. might not have only been responsible for the run up that we’ve observed, but may also be responsible for the decline in house prices that might come in the future.

Malpezzi: There is a question about whether the boomers will be as frugal as their parents have been, or whether they will be quicker to liquidate their wealth in the way that Morris’ friend is
suggesting.

Ortalo-Magné: Some research shows that people are accumulating just what they need to pay for health care in their old age. So you will dis-save as you age because the cost of health care will take it from you. A less depressing way to say it is you will be happy to spend on keeping your health at a higher level!

Last question. What’s the most common myth about residential real estate?

Malkasian: That it’s always going to appreciate.