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September 7, 2010
The Bears and the State of Housing
By DAVID LEONHARDT
Of all the uncertainties in our halting economic recovery, the housing market may be the most confusing of all.
At times, real estate seems to be in the early stages of a severe double dip. Home sales plunged in July, and some analysts are now predicting that the market will struggle for years, if not decades.
Others argue that the worst is over. As Karl Case, the eminent real estate economist (and the Case in the Case-Shiller price index), recently wrote, “Buying a house now can make a lot of sense.”
I can’t claim to clear up all the uncertainty. But I do want to suggest a framework for figuring out whether you lean bearish or less bearish: do you believe that housing is a luxury good and that societies spend more on it as they get richer? Or do you think it’s more like food, clothing and other staples that account for an ever smaller share of consumer spending over time?
If you believe housing resembles a luxury good, then you’ll end up thinking house prices will rise nearly as fast as incomes in the long run and that houses today aren’t terribly overvalued. If housing is a staple, though, prices will rise more slowly — with general inflation, as food tends to.
The difference between these two views ends up being huge, and it’s become the subject of an intriguing debate.
After digging into it, I come down closer to the luxury good side, which is to say the less bearish one. To me, housing does not rank with unemployment, the trade deficit, the budget deficit or consumer debt as one of the economy’s biggest problems. But you may disagree.
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No one doubts that prices rose roughly with incomes from 1970 to 2000. The issue is whether that period was an exception. Housing bears like Barry Ritholtz, an investment researcher and popular blogger, say it was. The government was adding new tax breaks for homeownership, and interest rates were falling. These trends won’t repeat themselves, the bears say.
As evidence, they can point to a historical data series collected by Mr. Case’s longtime collaborator, Robert Shiller. It suggests that house prices rose no faster than inflation for much of the last century.
The pattern makes some intuitive sense, too. As people become richer, they spend a shrinking share of their income on the basics. Think of it this way: someone who gets a big raise doesn’t usually spend it on groceries. You can see how shelter seems as if it might also qualify as a staple and, like food, would account for a shrinking share of consumer spending over time. In that case, house prices should rise at about the same rate as general inflation and well below incomes.
Here’s the scary thing, at least for homeowners: if this view is correct, house prices may still be overvalued by something like 30 percent. That’s roughly the gap between average household income growth and inflation over the last generation.
It’s also the overvaluation suggested by Mr. Shiller’s historical index. Today, it is around 130, which is way down from the 2006 bubble peak of 203. But it’s still far above the 1890 to 1970 average of 94.
In effect, the bears are arguing that housing was in a multidecade bubble and has now entered a multidecade slump.
The second, less bearish group of economists doesn’t buy this. This group includes Mr. Case, Mark Zandi of Moody’s Analytics and Tom Lawler, a Virginia economist who forecast the end of the housing boom before many others did. They say they believe that house prices rise nearly as fast, if not quite as fast, as incomes, and that real estate is no longer in a bubble.
This side can also make a case based on history. Mr. Case points out that all pre-1970 housing statistics are suspect. By necessity, Mr. Shiller’s oft-cited historical index is a patchwork that relies on several sources, like Labor Department surveys. These sources happen to paint a more negative picture of past house prices than some other data.
For example, the Census Bureau has been asking people since 1940 how much they think their houses are worth, as Mr. Lawler noted in one of his newsletters. The answers suggest that house values rose faster than general inflation — and about as fast as incomes — not just from 1970 to 2000, but from 1940 to 1970, as well.
Likewise, Mr. Case has dug up sales records for houses in the Boston area that were built in the late 19th century and are still around. The records show prices rising 2.5 percentage points a year faster than inflation, which is just about what income has done.
Perhaps most persuasive is a statistic that Mr. Shiller sent me when I asked him about this debate. It shows that the share of consumer spending — and, by extension, of income — devoted to housing has not fallen over time. It has hovered around 14 or 15 percent for the last 60 years. The share of spending devoted to food, by contrast, has dropped to 13 percent, from 25 percent.
These numbers make a pretty strong argument that the post-1970 period is not one long aberration. As societies get richer, they do spend more and more on housing.
Some of this spending, Mr. Shiller notes, comes in the form of bigger, more expensive houses. These houses don’t do anything to lift the value of a smaller, older house — which is what matters to individual homeowners. But McMansions are not the only factor.
To see this, you can look at the share of consumer spending devoted to things inside houses, like furniture. As with houses, they have become fancier. But they haven’t become so much fancier that they make up anywhere near as large a share of consumer spending today as in the past. That’s a strong clue that the upgrading of houses themselves isn’t enough to explain the increased spending on housing.
What is? The value of the underlying land. Those Boston-area houses that Mr. Case studied did not change much over time. Yet their value did.
For a house whose location has any value — in a major city or a nearby suburb, where a builder can’t simply put up a similar house down the street — the land is a big part of the equation. Over time, Mr. Zandi says, the value of that land should grow almost as fast as the local area’s economic output or, in other words, with incomes.
The best advice for homeowners and would-be buyers may be to think of a house not as an investment, first and foremost, but as a place to live. If there is a good chance you will move in the next three years or so, you should probably rent. The hassles of buying and the one-time costs are just too big. Plus, house prices are not low in most places today.
The ratio of median house price to income is about 3.4, compared with a prebubble average of about 3.2. Given the economy’s weak condition and the still high number of foreclosures, prices may well fall more in the next year or two. They look especially high in places where rents are comparatively cheap, like San Diego and San Francisco. And maybe income growth will remain weak for years, holding down home-price growth.
But if you can imagine staying much longer than a few years, you should take some comfort in the fact that the bubble seems mostly deflated. Sometime soon, prices should begin rising again. They may not quite keep up with incomes, but they will probably outpace the price of food and clothing.
Now, if only it were possible to be as sanguine about the economy’s other problems.
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