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Economic trends.


In the past few years, several attention-grabbing articles have been written proclaiming the collapse of housing prices. "We think real estate is heading for a fall" proclaimed the investment strategy team of Comstock Partners Inc. in the August 22, 1988 issue of Barron's. "...Real housing prices will fall substantially" wrote Harvard economists N. Greg Mankiw and David N. Weil late in 1988. Although approaching the issue in significantly different ways, these two highly publicized articles contributed to growing concerns that home prices may decline, or at least not keep pace with inflation.

Like many flashy predictions, there is a kernel of truth underlying each of their analyses, but their predicted outcomes are likely to be highly exaggerated. Let's consider each of these articles in turn.

The Comstock article is weaker than the Harvard study. The main argument of the Comstock group is that real estate is highly leveraged and that debt loads are getting out-of-hand. They contend that home price increases in recent decades were supported by rising debt burdens and expectations of capital gains. Once prices peak, which I believe occurred in 1988, homeowners and prospective buyers will conclude that expected capital gains are inadequate to justify the debt load and prices will collapse. They emphasize that this is especially likely because real estate prices rose--with only brief pauses--for nearly 50 years. In effect, they make a "what goes up, must come down" case.

Over the years, there have been many voices proclaiming economic disaster as a consequence of rising debt. To date, these proclamations obviously have been overstated. The key to their argument is that markets are highly sensitive to expectations. If market expectations of price appreciation turn decidedly negative, softness in current prices can result as buyers hold off purchases and sellers rush to lock in previous gains. The market-clearing price under such circumstances can easily decline. It is common for real estate markets that have experienced a boom to go through such a correction and to give up part of the previous gain, but rarely all of it. After prices stabilize, appreciation typically resumes in response to fundamentals, such as income growth. The upshot is that declaring an eminent collapse in housing prices due to rising debt is not very convincing.

The Mankiw-Weil study approaches the issue from a different perspective, and one that has considerably more merit. They build their case on the widely recognized fact that the baby boom generation--those individuals born from 1946 to 1964--produced a tremendous surge in the demand for housing as they came of age in the late 1960s through the early 1980s, and that many baby boomers have now formed households and will not be a source of housing demand in the 1990s.

As a result of significantly reduced housing demand, real housing prices (i.e., housing prices adjusted for inflation) are estimated to decline about 3 percent per year, or a total of 47 percent by the year 2007. For example, if the inflation rate averages 4 1/2 percent--roughly the rate in recent years--home prices, in the estimation of Mankiw and Weil, would only rise about 1 1/2 percent per year, resulting in a decline in real home prices of about 3 percent per year (approximated by subtracting 4 1/2 from 1 1/2 percent).

According to their analysis, demographic changes are going to strongly influence the demand for housing in the 1990s. There will be fewer household formations; but the impact on prices is far from certain.

To their credit, Mankiw and Weil recognize this and hedge their bet. They point out that homeownership has several significant advantages, such as not having a landlord, eliminating (or at least limiting) the uncertainty of future housing costs, and substantial tax benefits. Consequently, prices may not behave as their model predicts. There are reports that the principal author is taking no chances; Mankiw evidently bought a home recently.

There are other reasons to doubt the collapse of housing prices in the 1990s besides those already mentioned. Let's review six.

First, real incomes will continue to grow in the decade ahead. Consequently, many buyers will be able to afford significantly higher prices, and that will exert upward pressure on prices.

Second, although household formations will slow because of demographic shifts, the very same process will move many existing households into age groups that have higher homeownership rates than their younger cohorts. This factor could significantly influence the homeowner-renter decision in favor of homeownership and could exert upward pressure on housing prices.

Third, people must live somewhere, and no matter what is happening to the age distribution of the population, the fact remains that the population itself continues to grow. An important, and perhaps growing component, is the large number of immigrants who enter the U.S. both legally and illegally. In either case, they contribute to population growth and are likely to contribute to upward pressure on housing prices.

Fourth, houses are not built for free. The components underlying construction costs (land costs, lumber and other materials costs, wages, regulatory expenses, etc.) affect the supply side of the market forces that determine housing prices. With these costs likely to continue to rise in the 1990s, housing prices are also likely to rise.

Fifth, affordability problems kept many potential buyers out of the market in the 1980s. Any easing of real interest rates, softening of prices, or other factors affecting affordability would likely soon exert upward pressure on housing prices as this pool of would-be homebuyers entered the market.

Finally, homeowners probably would not stand for a sharp and sustained drop in prices. There is evidence that homeowners are often willing to keep their homes on the market for longer periods of time, rather than accept a price below what they perceive to be fair. If that attitude is pervasive, it puts a floor on prices from which to build.

The upshot is that a collapse in housing prices in the 1990s seems extremely unlikely. Further, because real estate markets are essentially local in nature, there will be some markets booming all the time. Very few homeowners in Seattle worried in 1989 about the collapse of home prices predicted for that year; they experienced average appreciation of more than 25 percent.
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Title Annotation:housing prices
Author:Holloway, Thomas M.
Publication:Mortgage Banking
Date:May 1, 1990
Previous Article:Secondary market.
Next Article:Servicing: a real cliff-hanger.

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