IS THE HOUSING BUBBLE ABOUT TO BURST?

IN THIS ISSUE:

1. Are Home Prices In A Bubble?

2. Home Prices Versus Inflation.

3. Americans Have Huge Home Equity.

4. Home Prices & Consumer Debt.

Introduction

The gloom-and-doom crowd would have you believe we are already in a new recession, and that home prices are going to tank very shortly. But for how many years have they been saying that? In some cases, a decade or longer! The truth is, we’ve had several negative economic reports recently, largely due to concerns about the war, but the economy is still growing, albeit slowly. And there is no hard evidence that home prices are about to plunge.

For the record, I am not an eternal optimist. I can be negative and/or bearish with the best of them, as long-time clients will attest. But our capitalist, free-market has consistently surprised on the upside for the last 50 years, and it won’t surprise me if the next few years aren’t nearly as bad as the pessimists would have us believe.

In this issue, we’ll look at some interesting facts and statistics on home prices. Absent another major terrorist attack in the US, or some other big negative surprise, home prices should remain relatively firm and will continue to trend higher in the coming years. My thanks to Gene Epstein, economic columnist for Barron’s, for some of the statistics quoted below. While not an economist, per se, Epstein is one of my favorite writers.

The Pessimists’ Argument

There is no question that the continued boom in the housing market is a big reason why the economy came out of the recession in 2002, when GDP rose 2.4% based on the final report. The median home price nationwide was $188,800 in February, up 5.1% from $179,600 in February 2002. In 2001, when we were in the mild recession, median home prices still rose by 5.7% nationwide.

The pessimists argue that the housing market is the “last bubble” to burst, but their arguments aren’t particularly convincing. They assure that the economy is headed back into recession, if it’s not already, and that the huge and growing market of home buyers is going to dry up any day now. Depending on who you read, home prices are predicted to drop a minimum of 10% and very possibly 20% or more. Again, ask yourself how long they’ve been saying this.

Is Housing Really In A “Bubble”?

To begin this analysis, we need to decide if the housing market is actually in a bubble, or not. The term “bubble” typically describes a market that is in a speculative frenzy. The fact is, the vast majority of home buyers in recent years were not real estate speculators looking to “flip” them for a quick profit. No, the buyers were predominantly families looking to buy and hold, including millions of families that could never before qualify for a home mortgage.

I hate to rain on the pessimists’ parade – actually, that’s not true, I love to rain on their always negative parade, when appropriate – but the appreciation of home values is very well based. Let’s look at some real stats.

For purposes of this discussion, we will focus on home prices from 1968 to the present. Keep in mind that over the last 35 years, we have seen economic booms, recessions and everything in between. Over that 35-year period, the median home price has risen from $24,700 in 1968 to $188,800 as of February 2003. That’s a huge increase, or is it?

To get a proper perspective, we have to look at home prices in “constant dollars” – adjusted for inflation. From 1968 to 1980, the real median price (adjusted for inflation) for homes rose 2.9% per year on average. Surprisingly, there was then a 14-year plateau from 1980 to 1994 when the “constant-dollar price” (inflation-adjusted) was virtually the same as in 1980, with only short-lived dips in between. In other words, the inflation-adjusted price of the average home in 1994 was almost the same as in 1980. To put it differently, the rise in the price of the average home between 1980 and 1994 was roughly equal to the rate of inflation during that period of time.

The real boom in housing prices, again inflation-adjusted, occurred from 1994 to 2002 when the real price of homes increased 3.4% per year on average in constant dollars.

So, have the past eight years been a bubble - or merely a catch-up period - to compensate for the flat trend of the prior 14 years? If we look at inflation-adjusted home prices for the entire 35-year period, 1968 to 2002, we see that prices have increased only 1.2% per year on average when adjusted for inflation. This argues that there is no “bubble” in home prices.

Let’s Put The Numbers Into Context

Let’s look at the big picture. At year-end 2002, the total value of existing homes came to a record $13.64 trillion. $13.64 TRILLION. To hear the gloom-and-doomers, you would think that almost all this amount is in home mortgages, especially given the refinancing boom that has gone on for the last couple of years. Not so. As of the end of 2002, mortgage debt totaled only $6.04 trillion, less than half that extraordinary sum. The difference - $7.59 trillion-was owned free and clear.

A 10% drop in home prices would take $1.36 trillion from the $13.64 trillion in total value, with net equity affected disproportionately. A 10% drop in home prices would reduce the current $7.59 trillion in home equity to $6.23 trillion – an 18% drop. Yet that would only put homeowners’ net equity back to about where it stood in 1999.

The so-called “negative wealth effect”- the amount by which each dollar's worth of loss in wealth slashes consumer spending - has been generally estimated at 1% to 2%. Assuming 2%, the loss of $1.36 trillion in wealth would slice $27.2 billion from consumer spending, or merely 0.3% of the $8 trillion consumers spend every year. That doesn’t suggest that a 10% drop in home prices would throw us into a recession.

Are Homeowners Ready To Bail Out?

The pessimists suggest that if home prices were to fall, homeowners would be quick to sell. I don’t know where they get this idea. First, as pointed out above, over half of the total home value ($7.6 trillion out of $13.6 trillion total) is in equity, free and clear. Given that, most homeowners would sit tight if prices were to fall.

More importantly, let’s look at homeowners’ patterns in the two worst recessions we’ve had over the last 35 years – 1973/75 and 1981/82. Check out these median home price figures for new single-family homes from the Department of Commerce:

1973 $32,500 1974 $35,900 1975 $39,300

1980 $64,600 1981 $68,900 1982 $69,300

Sure, some homeowners decided to, or were forced to, sell during those recessions, but the supply/demand forces pushed prices higher nevertheless. In fact, in the last 35 years, home prices have risen every year but two – 1970 and 1990 - when the median home prices fell by only 0.9%. I wish my track record was that good!

Harvard Study On Home Demographics

I reported on the following study in the July 2002 issue of my Forecasts & Trends (paper) newsletter.

QUOTE: “Harvard University’s Joint Center for Housing Studies released a new report entitled ‘State of the Nation’s Housing.’ This report projects that the number of US households will increase 22.6% to 129 million over the next 20 years. That translates into apprx. 1.19 million new households a year, which is only slightly lower than the 1.26 million a year average in the decade of the 1990s.

While some economists have been predicting a significant slowdown in household creation, due to Baby Boomers retiring, the Harvard study disagrees due to two major points. First, Baby Boomers continue to move up to higher priced homes, as well as buying second and third homes. Second, the number of immigrants buying homes has surged over the last five years. The Harvard study expects both these trends to continue in the years ahead.

The report also focuses on the growing scarcity of land available for home and apartment construction around the US. Due to constraints and restrictions, builders are having a hard time finding enough available land to keep pace with the number of homes and apartments that need to be built in order to keep up with demand. This should support prices in general.

All of this, the study argues, will serve to keep home prices high and rising, generally speaking. Obviously, economic conditions will have a great bearing on home demand. If we have an extended recession(s), or a deflationary period, or if mortgage rates go up significantly, then the study’s projections will prove to be overstated. Yet the most likely scenario is that even if home prices were to take a dip in the short-run, they are very likely to be higher in the next 10-20 years, and perhaps substantially higher.” END QUOTE.

Conclusions

Housing starts fell 11% in February, the largest monthly drop in several years. Sales of new and existing homes were down in February also. This led to a new chorus by the gloom-and-doom crowd that the housing bubble is finally beginning to burst.

Never mind that just about every other economic report for February was also down, largely due to “war worries.” Never mind that sales of new and existing homes broke all records in 2002. Never mind that the median home price rose 5.1% in the 12 months ended February. And never mind the demographics showing demand for homes will be on the rise for the next 10-20 years.

The bottom line is this: Can home prices go down? ABSOLUTELY. But what is the likelihood of a significant decline in home prices? Not very likely, if history is any indicator. Remember that home prices actually went up in the 1973/75 and 1980/82 recessions.

The most interesting thing I learned in preparing this issue was that out of the total $13.6 trillion in home value, apprx. $7.6 million of that, or 56%, is equity. Then add to that figure the reports showing that apprx. 70% of all consumer debt is in home mortgages. Then add to those two figures the fact that median home prices rose 5.8% in 2001 and 5.1% in the last year (ended February), and an interesting picture emerges. Specifically, that 70% of consumer debt held in home mortgages is very well collateralized, generally speaking.

The gloom-and-doom crowd constantly reminds us that consumer debt is at record levels. This is a prominent factor in their predictions of another recession/depression. But what they don’t tell us is that over two-thirds of that debt is in home mortgages which are very well secured, generally speaking.

While the latest round of economic reports was discouraging, the economy is still in positive territory. While economists are revising their estimates downward, the economy is expected to have grown at least 1% (annual rate) in the 1Q. And I continue to believe things will improve, at least modestly, during the rest of the year, especially when the war is won. If so, that doesn’t suggest a new recession or a plunge in home prices.

Final Thoughts & Caveats

I hope this issue has been helpful to you. At the least, it should help you ignore the gloom-and-doom crowd, and especially those who are trying to convince people to sell their homes and invest the money in risky schemes.

It may also be helpful to those who are considering whether or not to buy a home now, while rates are historically low. I know several people who sold their homes a few years ago because they were convinced we were going into a recession and home prices would fall. We did have a recession, but home prices went up anyway, and they’re still renting.

Even if home prices don’t fall on a national basis, there are regional or local developments that can hurt prices in specific areas. The loss of a major employer, for example, can send home prices lower in regional or local areas.

Finally, I would hope that this issue does not encourage anyone to go out and borrow against the equity in your home. With the refinancing boom, it’s obvious a lot of people are doing just that. Unless absolutely necessary, I recommend continuing to pay down your mortgage, not increasing it.

All the best,

Gary D. Halbert

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