Despite the uncertain state of the economy, erosion of jobs and terrorist threats against the United States, home prices continue to defy the laws of economic gravity.  Residential housing has almost single-handedly kept the economy growing, thus minimizing the economic downturn.  However, with the recent price appreciation, many are questioning if the U.S. real estate market could strike a harmful blow to the economy, as previous turns have struck Japan and Hong Kong.

According to the Milken Institute, U.S. residential real estate is valued at over $23 trillion, making it one of the most valued asset categories in the U.S. and surpassing the $11 trillion market value of all New York Stock Exchange (NYSE) listed stocks combined. 

Some industry experts have suggested that the retail housing market is currently in a bubble (defined as price appreciation through irrational concentrations of capital that is unsustainable, and unjustifiable) while others believe that current prices are justified. 

The only fact the two sides do agree on is that the real estate market cannot continue to prop up the economy indefinitely.  The prevailing consensus is that the market growth rate will slow, but the velocity of this change will be market and area specific.

Real Estate – A Top Performer

According to the Census Bureau, a whopping 68.3% of U.S. residents own their home as compared to 64% in Europe.  Clearly, conditions in the U.S. are ripe for this type of growth. The sale of new and existing homes continues to grow due to historically low interest rates, aggressive mortgage lending, the desire to shelter income from taxes, and the choice to divert money from the stock market in to real estate. The private real estate market in the U.S. has returned 11.4% average annual returns over the last five years while the S&P 500 returned –1.6% during the same time period.

With the significant real estate returns realized over the last 10 years, real estate is now more strongly linked to the capital markets than ever before.  This provides better liquidity for this fragmented market, but also more volatility.

Is The U.S. Market in a Bubble?

Richard F. Muth, professor of economics at Emory University, believes that the U.S. is not currently in a real estate bubble and that there are many good reasons why prices have increased. Muth explains: “first, as population grows faster than the housing stock, the laws of supply and demand take hold.  The higher the demand and the lower the supply, the more the price is driven upwards.  Second, the decline of interest rates is making home ownership more attractive than ever.”  Another important factor Muth points out is that homes are bigger than ever before.  “There is an increase of housing per square foot of property.  People are building bigger homes on smaller lots than in the past and spending more to do so.”

Jeffrey A. Rosensweig, professor of finance for Emory University’s Goizueta Business School, observes:  "speculative excess, fashionably called ’irrational exuberance’, led to a stock market bubble in the U.S.  This bubble burst in spring and Summer 2000, similar to Japan’s burst stock market bubble of one decade earlier.  Japan then had a crash in its real estate prices.  This has led many to believe that real estate bubbles link with stock bubbles, and more wealth will be lost when these bubbles burst as well.”

But unlike Japan, Rosensweig does not believe that there is a generalized real estate bubble in the U.S.  “There are some pockets where prices rose quickly, particularly the fashionable areas of some cities and select resort properties.  In these spots, price declines of perhaps 20% are likely, or at least properties will sit on the market much longer,” says Rosensweig.  “Luckily, overall U.S. real estate prices did not soar to the levels seen in Japan’s bubble.” 

Indeed, Japan became notorious for unwarranted real-estate prices in the late 1980s.  At its peak, the Japanese were paying over 10 times their annual salaries to buy residential property, compared to the U.S. where residents pay approximately 3 to 4 times their annual income.  Today in Japan, home prices have dropped as much as 65% percent from their height. 

But Rosensweig contends, history will not repeat itself. The U.S. is “backed by more sound fundamentals:  boosted by higher fertility rates and immigration, the U.S. will gain population, whereas Japan [which discourages immigration] will suffer population loss.  All told, history sometimes repeats, but U.S. real estate will not implode."

Real Estate – The Backup Generator of the U.S. Economy

The strength in real estate has provided a positive cushion to the current U.S. economic condition.  Homeowners are tapping into their home equity and borrowing money at a record pace.  They are funding home improvements, consumer durables, and reducing other high interest debts.  This mechanism has been a tremendous driver to help prop-up the economy.  Additionally, strong demand in home sales has driven up new home production, redesign projects, and new additions – all contributing to GDP. 

Despite long stretches of unemployment and depleted savings, many people have stayed afloat during this difficult economic time by drawing cash from their appreciating homes, while others are skirting foreclosure by making mortgage payments utilizing home equity loans.  “This strategy works well when home prices are increasing but is lethal in a time of falling property values or rising interest rates,” says Kathy Hollenberg, a financial planning manager for Assante Holdings.  “Without this cash cushion, the economy certainly would be in a worse-off condition.”

According to the Federal Reserve, the sum of capital gains on home sales, cash taken out from mortgage refinancing and home equity loans totaled over $700 billion in 2002.  Even Federal Reserve Chairman Alan Greenspan suggests that the money saved by homeowners refinancing boosted disposable income, thereby minimizing the effect of stock market declines. 

Favorable interest rates and very low inflation are enabling buyers to purchase bigger and more expensive homes and take on larger mortgages for the same, if not lower monthly payments. According to David Lereah, the chief economist for the National Association of Realtors, mortgage payments as a percentage of income has fallen, making higher-priced homes more affordable.

The Federal Reserve reports that overall household borrowing has risen 46% over the past five years to $7.2 trillion.  Many observers worry about the ability of borrowers to keep up with their payments during a prolonged economic downturn.  Not surprisingly, the latest figures show a noticeable rise in conventional home loan delinquencies – from 3.74% in 2000 to 4.5% in 2002.

Indeed the old mantra of real estate-- location, location, location --may be the ultimate determinant of how consumers will fair in the current real estate market.

Atlanta – Buyers Market

Rosensweig says the Atlanta area is currently a buyers market.  This is due to the sheer number of homes being offered for sale. “The Atlanta market did not appreciate as much as select real estate in some other desirable cities. Thus, it is not vulnerable to a major "burst bubble" or collapse,” he notes.  “However, properties are moving slowly, and those needing to sell quickly often must accept prices well below their listing prices.”  Atlanta welcomed a lot of new home construction in the 90s.  With the poor business climate, Atlanta’s growth has not progressed as strongly as anticipated.  As a result, there is a good supply of housing on the market.  The median house price in Atlanta is $146,400, up 4.1% from last year, according to the Wall Street Journal.

Los Angeles – Sellers Market

Justin Milrad, a recent Goizueta Business School MBA graduate who lives in Los Angeles, is currently surveying the market to buy a house.  “LA has seen an average price appreciation of 10-12% for the past 4 years. Homes price range from $100,000 up to $20 million.  The market right now is so hot that it’s not uncommon to see multiple offers and sometimes even over the asking price. Entry-level homes are still selling very quickly due to the large number of buyers who want to live in Los Angeles. The higher end price range of $1 million and up has been hit harder, especially in the upper end of $5 to $20 million.”  Los Angeles continues to be a top living destination and more people are moving to LA than emigrating out.  This results in a diminished supply of housing for the stated demand, pushing prices upward.  The median home price of a house in LA County is $309,400, a rise of 19% from last year, according to the LA Times.

Spotting a Downturn

The nation’s median home values have risen 6% on average every year since the National Association of Realtors began keeping records in 1968.  However, the cities most vulnerable to real estate corrections are those with the highest rates of appreciation, which tend to be coastal markets.

Roy Black, associate professor of finance at Goizueta suggests, “All markets are vulnerable, and it is difficult to find a sector of the market that has not been affected. A red flag of a weak market and potential declining prices is an increase in vacancy rates. Prices tend to hold temporarily, but when landlords drop rents and make larger concessions to tenants to fill the buildings, prices start to drop.”

Another indicator involves a commonality that ties each of the previous booms and busts together: when prices are going up they reach a level where consumers place an irrational intrinsic amount of value in meaningless indicators.  Instead of valuing property by location, construction, square footages, etc., buyers in pre-bust markets start irrationally buying any type of property believing it will go up, similar to the 1999/2000 days of the pre-Internet stock market bust.  Jagdish Sheth, a professor of marketing at Goizueta, notes “the perception of value changes with the demand and supply function. When demand gets high and causes a temporary shortage, the perception of value goes up. On the other hand, when supply increases faster than demand, the perception of value goes down.  In short, perception amplifies the emerging phenomenon.  This creates a speculative upward or downward cycle.  The best example of a downward spiral is a ’run on the bank’ when there is perception that the bank will fail.”  Perception of value (or lack of) is a dangerous driver of an economy and could cause a dramatic correction in certain sectors of the real estate market.

One word of caution

While a downward shift in the real estate values may not cause the economic devastation seen in Japan, U.S. consumers may be more vulnerable than they realize.  With more Americans borrowing against the value of their homes, a turbulent job market and continued downsizing could pose a longer-term threat. 

“A significant price drop in real estate would likely force us into a double dip recession,” cautions Rosensweig.  “The average consumer has a lot more wealth in their home than in the stock market.  Consumption weathered the storm of the stock market bubble bursting, but could not weather the "perfect storm" of that combined with the massive loss of wealth and fear a major decline in real estate (especially housing) prices would cause. Consumption has been the only spending stream supporting our economy, such that it rose to 70% of our GDP, thus if the negative wealth effect of a burst real estate bubble makes consumption recede, the economy will do likewise.”

(July 2003)