#135 May/Jun 2004

The Housing Bubble

It is widely believed that homeownership is the best way for low-income families to accumulate wealth and enter the middle class. There are reasons for questioning the wisdom of this […]

It is widely believed that homeownership is the best way for low-income families to accumulate wealth and enter the middle class. There are reasons for questioning the wisdom of this view in general – many low-income homebuyers find that they are unable to hold onto their home due to job loss or a change in family circumstances, and are forced to sell after a short period of time. However, a bubble in the housing market across much of the country may make this a particularly bad time for low-income families to move into homeownership.

In the last eight years the country has experienced an unprecedented run-up in housing prices, as home prices nationwide have risen by 35 percent (adjusted for inflation). In the past, home prices have risen at approximately the same pace as other prices. While it is likely that the gains in home prices have been sharpest among higher end homes, there is evidence that even the price of homes owned by low-income families have been inflated by the bubble.

The basic facts on the housing bubble are striking. Housing prices began to substantially outpace inflation in the second half of 1995, the same time the stock bubble began to inflate. The most obvious explanation for the housing bubble is that stockholders used some of their gains to buy bigger homes. Since the supply of housing cannot adjust quickly, the increased demand pushed prices higher.

With housing prices rising rapidly, homebuyers began to anticipate that prices would continue to rise and factored future price increases into the purchase price. In other words, homebuyers who may otherwise have viewed a $200,000 home as being too expensive, were suddenly willing to pay $200,000 because they assumed that the home would sell for $250,000 or $300,000 five or ten years down the road. This expectation of rising prices is exactly what causes a bubble.

Some economists have argued that fundamental factors, such as immigration, rising family incomes and environmental restrictions on building caused the run-up in home prices. These factors can play a role in raising home prices, but they don’t provide a plausible explanation for the soaring housing prices of the last eight years. In the case of immigration, we did see a rapid pace of immigration in the 1990s, but we had substantial immigration in the 1980s as well, with no comparable increase in home prices. Besides, the impact of the huge baby boom generation first becoming homebuyers in the 1970s and ’80s was far larger. Rising family incomes can increase the demand for housing, but the rate of income growth in the late 1990s was no more rapid than in the 1950s and ’60s – decades that did not see substantial increases in home prices.

Environmental restrictions are also not new, and probably did not get stricter in the late 1990s as Republicans took over Congress and many state houses as well. “Smart growth” initiatives may have limited housing construction in some areas – leading to localized shortages of housing – but the rate of housing construction for the nation as a whole has reached record levels over the last five years. This surge in supply should mean that areas of shortage-driven price increases are offset by glut-driven price declines, which we have not seen.

One final point; if higher home prices are being driven by fundamental factors, then home prices and rents should rise by roughly the same amount. This is not happening. Rents rose somewhat more rapidly than inflation from 1995 to 2001, although not as fast as home prices. However, in the last two years, the rate of increase in rents has slowed. Rents are now rising less rapidly than inflation. In fact, in some of the bubble markets, such as Seattle and San Francisco, rents are actually falling. While falling rents may not yet be benefiting low-income renters, the decline in rental prices generally provides compelling evidence that the run-up in home prices is not being driven by fundamental factors.

The weakening of the rental market is the result of a record rental vacancy rate. The number of vacant rental units is increasing at a rate of more than 400,000 a year. This will continue as long as home prices stay near their current level, giving builders an incentive to build homes at a near record rate. Eventually, the glut in the rental market will put downward pressure on home sale prices as people opt to rent rather than buy, and landlords look to sell off vacant rental units. This will bring home sale prices back in line with rental prices.

The run-up in home prices has not been even across the country. The largest price increases have been concentrated along the two coasts, with inflation adjusted home prices rising by 49.4 percent in the Pacific states (primarily California) and by 59.6 percent in New England.

The rest of the country has been less affected, although there are pockets of rapid home price appreciation, such as Chicago and Denver, in the middle of the nation as well. The areas that have seen the largest price increases will probably lose the most in the bursting of the bubble, although some of the regional differences do reflect underlying economic conditions.

The run-up in home prices has also not been even across types of housing. The most expensive homes probably experienced the largest increase in price, and therefore are likely to fall farthest when the bubble bursts. However, the bubble has affected housing in all income brackets.

My colleague, Simone Baribeau, found that the largest increases in home prices in Los Angeles over the years 1995 to 2002 occurred in the zip codes with middle priced homes. However, there were also substantial home price increases, in excess of overall inflation, in the zip codes with lower priced homes. In most low-priced areas, increase in home prices was more than 20 percent. In several areas, the rise in home prices exceeded the inflation rate by more than 30 percentage points. While some of the increases in home prices in neighborhoods with lower cost homes may be attributable to efforts at neighborhood revitalization or gentrification, this cannot explain the fact that home prices rose substantially more than the overall rate of inflation in every zip code.

These data indicate that the housing bubble has even affected the lower-income homes. While the price declines may be smaller than for higher cost housing, many lower-income homebuyers may still see the price of their homes fall by 20 to 30 percent when the housing bubble bursts. This could mean, for example, that a home bought today for $160,000 sells for $120,000 to $130,000 in two or three years, if the housing bubble bursts.

Price declines of this magnitude will be devastating for families who have struggled to afford the homes they purchase. While some homeowners may live in their houses long enough for inflation to eventually restore home prices to current levels, few would be happy to sell their house in twenty years for the price they paid today. And most will not hold their home that long. In the past, half of low-income homebuyers sold their homes in less than four years. The dynamics of the bubble and its eventual collapse are likely to hasten this process.

As with other speculative bubbles, exotic methods of finance and questionable ethical practices have become common. Increasingly banks are finding ways to issue mortgages with far less than the traditional 10 percent down payment. Some government programs are fostering this practice as well. For example, The American Dream Act actually allows families to borrow more than the full cost of their home by adding closing costs to their mortgage. In addition, according to some accounts, appraisers frequently exaggerate home values in response to pressure from banks. This means that many new low-income homebuyers already have no equity in their home. If they face a major repair or lose their job, they will not be able to borrow against their home to meet immediate expenses.

A substantial downturn in the housing market will make matters much worse, leaving many new homebuyers with mortgages that considerably exceed the value of their homes. In addition, with nearly a third of new homebuyers opting for adjustable rate mortgages, many homebuyers are going to see substantial increases in their mortgage payments as soon as interest rates start to rise. While many “first-time homebuyer” loan programs aimed at lower-income buyers generally involve fixed rate mortgages, those who obtain loans on their own may be enticed into adjustable rate mortgages.

The prospect of falling home prices and rising mortgage payments would put enormous strains on the finances of any family, but lower-income households are least likely to have the resources to get themselves through tough periods, and therefore the most likely to end up losing their homes. This will not only be disastrous for the households directly affected, but it raises the prospect of large-scale foreclosures in the low-income communities in bubble areas. It is impossible to predict the actual course of a housing bubble deflation, but rapid turnover in homes in low-income neighborhoods is not likely to be a positive development. It raises the possibility of vacant and abandoned housing, and large declines in property values.

At this point, it is probably too late to avoid the pain and destruction that will be caused by the collapse of the housing bubble. However, it is possible to at least minimize the harm. This can be done in two ways. First, potential homebuyers should be made aware of the inflated nature of the housing market. It is simply wrong to tell people that housing prices never fall – they do and they can fall from bubble-inflated levels. Second, government policies that promote homeownership rather than renting, especially for low-income families, should be curtailed. Whether or not the promotion of homeownership is generally a good idea, it is definitely not a good idea in a bubble-inflated housing market. Persuading families to buy homes at bubble-inflated prices is encouraging them to throw away their life savings. This is not a good direction for government policy.


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