New Study Says Fundamentals, Not Bubbles, Explain Recent Growth of
Housing Prices
With memories of large stock market declines still fresh, many
pundits and even some economists observing the large increases in
housing prices over the past five years, have been quick to declare a
bubble. But a new study released today belies this conventional wisdom
and finds that most cities in the United States show little evidence of
a housing bubble as of the end of 2004.
In a study covering 46 single-family housing markets from 1980 to
2004, Todd Sinai, associate professor of Real Estate at the Wharton
School of the University of Pennsylvania; Charles Himmelberg, senior
economist at the Federal Reserve Bank of New York; and Christopher
Mayer, Paul Milstein Professor of Real Estate, Columbia Business School,
confront misperceptions about the underlying drivers behind the
decade-old real estate boom. The researchers find that recent growth
rates of house prices do not reflect a bubble - and, in fact, are
largely explained by basic economic fundamentals such as low interest
rates, strong income growth among high-income Americans, and unusually
low housing prices in the mid-1990s.
The study, Assessing High Housing Prices: Bubbles, Fundamentals and
Misperceptions, finds no evidence that buyers are bidding up the price
of houses based on unrealistic expectations of future price increases.
The study shows that conventional metrics for assessing the housing
market such as price-to-rent ratios or price-to-income ratios ignore the
effects of lower real, long-term interest rates, and thus fail to
accurately reflect the state of housing costs. To the eyes of analysts
employing such measures, housing markets can appear
"exuberant," even when houses are in fact reasonably and
fairly priced. Amongst the common misperceptions that the study aims to
dispel are:
Misperception #1: The rising price of housing
necessarily means that ownership is becoming more expensive The price of
a house is not the same as the annual cost of owning a house. The study
calculates the actual cost of owning a house relative to rents and
incomes, and finds that these ratios were well within historical norms
at the end of 2004. Previously, during the mid-1990s, housing prices
were actually somewhat undervalued, and at least part of the increase in
house prices over the past ten years reflects a return of these
valuation ratios to long-run historical norms.
Misperception #2: High house price growth implies a bubble
When the real cost of long-term borrowing is low, as it is today, the
study shows that changes in long-term interest rates have a
disproportionately large effect on house prices. Thus, given the decline
in real, long-term interest rates since 2000, it is not surprising that
house prices have risen as much as they have. However, the other side of
the coin is that the housing market may be especially vulnerable to
unexpected future rises in real, long-term interest rates or negative
shocks to local economies.
Misperception #3: The cities with the highest price increases (or
the highest price-to-rent ratios) are the most overvalued
In some local housing markets such as San Francisco, Los Angeles, San
Diego, New York, and Boston, house price growth has exceeded the
national average rate of appreciation for at least 60 years. In cities
with higher long-term rates of price appreciation, the annual cost of
owning is lower, hence house prices should be higher (relative to rents
or incomes). At the same time, house prices in high-priced cities are
more sensitive to real, long term interest rates because interest
expense is a higher fraction of annual ownership costs.
In sum, the study concludes that the current U.S. housing
values are consistent with strong economic fundamentals. The reduction
in ownership costs caused by lower real, long-term interest rates, in
particular, has largely offset the rise in housing prices. However, the
study also cautions that when real, long term interest rates are already
low, further changes in rates can have a disproportionately large impact
on the housing market. An unexpected rise in real interest rates or a
negative shock to household incomes could cause house prices to decline.
But this fact does not mean that today houses are systematically
mis-priced.
Source: Wharton School at The University
Of Pennsylvania
9/19/2005 |
