The Real Culprit for High Home Prices

John Mauldin | Thoughts from the Frontline
July 2, 2004

This week we once again look at the US housing market. We explore what may be the prime contributor to spiraling home prices. (I bet this once catches 95% of you by surprise, but in hindsight, you will all nod and think to yourself that is what you suspected all along, just as I did.) We look at the relationship between income and housing prices, and even find a new ratio to suggest when it is a good time to buy homes. It will make for interesting reading.

But before we delve too deep into the data, indulge me for a [very] brief commercial. I was happy to learn a few weeks ago that my book, Bull's Eye Investing, remained for the second month on the New York Times Business Best Sellers List, moving up to #9. The new rankings for June will be out soon, and I hope we keep the momentum. One reader, A Keith Murphy from New Jersey, recently wrote on Amazon.com:

"This book is simply the best - probably the most enlightening investment book of the past 40 or so years. Mauldin has done an extraordinary amount of research. He pulls off the wraps on the world of investments that the savvy use, but are unknown to the average mortal, such as hedge funds and other alternative investments...[I have] found no one who is more solidly grounded in how financial investments really work."

A few fellow authors, and true scholars as opposed to your humble analyst, have been kind as well. Peter Bernstein [author of the bestseller Against the Gods ] was kind enough to note, "This book has more wisdom per page than any reader has the right to ask for. John Mauldin knows the score and tells the reader how to join him in keeping count."

"Bull's Eye Investing is a scintillating tour of the art and science of long-range forecasting. With his eye fixed as it should be on the great sweep of history, John throws a much-needed splash of realism onto the wishful thinking of recent years." -- Neil Howe, coauthor of Generations and The Fourth Turning

If you have not bought the book as yet, stop procrastinating and go to your local bookstore, or click on http://www.Amazon.com/bullseye to read other reviews and buy the book today.

Data First, Conclusions Later

And now back to our series on housing, with one small caveat. I have been getting a lot of mail from readers assuming I am going to be either very bearish or very bullish on housing because of some statistic or data I am using. I suppose I should cherish the moment when some accuse me of having rose colored glasses. My normal style is to look at the facts first, and then come to conclusions. This topic [housing] is so big that it will take about 4 weeks of just facts before we can get our hands around any meaningful conclusions. I would suggest you not take one or two facts and couple them with your own local experience and then extrapolate that to the rest of the country.

Further, if you are looking for support for either an end-of-the-world, housing-is-in-a bubble-and-going-to-take-us-down scenario or a housing-prices-are-going-to-rise-forever picture, then you are going to be disappointed.

The Real Culprit in High Home Prices

Let's begin with a brand new study done for the National Bureau of Economic Research (NBER) by Edward Glaeser. (You can see this fascinating study at http://www.nber.org/reporter/spring04/glaeser.html#navbar.)

In a normal economic world, the greater the demand for something the more entrepreneurs who work to supply it. The higher initial demand spurs higher prices which increase the number of businesses trying to make the product which eventually causes a glut on the market and prices fall. It's basic supply and demand.

The same should hold true for housing. If there is high demand, you would think entrepreneurs would be building more homes. And it does happen in many places, but not in all locales. Not surprisingly, the areas where normal supply-demand does not exist are also the places of high prices. "They aren't making any more land," our parents told us. Which is true. But Glaeser suggests available land is not the prime culprit. Let's look at his paper.

"...evidence on construction suggests that demand alone cannot provide the answer [for higher housing prices]. For example, in Manhattan, before 1975, housing price growth was modest, and there was abundant new construction. Since 1980, housing prices have soared and there have been few new units. The physical character of Manhattan has not changed between 1960 and today. If the rise in housing prices during the 1990s were the result of demand pushing along a stable supply curve, then surely we would see an explosion in new construction as we did in the past. The increasingly common combination of rising prices and tiny amounts of construction pushes us to focus on housing supply.

"Differences across regions confirm the need for supply-side analysis. High housing prices are not ubiquitous. The median housing value in the median county in America in the 2000 census is $75,300. More than 95 percent of counties have median housing values below $160,000. Soaring home prices are primarily coastal phenomena that have left the growing states of the American interior untouched.

"If the heterogeneity [def: - the quality of being diverse and not comparable in kind] in price growth with the United States were the result of different patterns of demand, then we would expect to see quantities and prices move together. Places with high price growth would be places with new construction."

Glaeser then shows us a very interesting graph. He compares the rise in housing prices with the rise in new housing starts. In an Alice in Wonderland economic world, what we find is that there is a 50% negative correlation between housing prices and home construction. In general, the areas with the highest prices have the least amount of new home construction, which is the opposite of what they taught us should happen in Economics 101.

"The places that are building have little housing price appreciation and the places that have housing price appreciation are not building. Demand alone can't explain the difference in housing price growth between New England and the South Atlantic. Florida alone permitted almost as many homes in 2002 as all of New England did over the entire five-year period. If we want to understand why housing is so expensive, then we must understand why housing supply in New England, the Middle Atlantic States, and California has become so inelastic. Housing supply research is also necessary because regional growth rates depend on the rate at which these regions build homes."

Housing costs are roughly $80 per square foot and a 2,000 square foot home can be bought for $160,000 in much of the US. That is because in most of the US, cheap land is available. Raw land costs for most of America's homes are not all that much.

(Although I am always amazed at how developers can turn raw farmland into "exclusive" home lots costing 30 times as much as the raw land surrounding the development. Only in America.)

Now they make a very important point as an aside to their paper.

"Of course, even where housing supply is perfectly elastic with respect to positive shocks, housing supply is inelastic with respect to sufficiently negative shocks. Because housing is fixed and durable, a major drop in housing demand can always cause prices to fall. This explains why cities decline so slowly and why declines show up in falling housing prices long before they show up in falling population levels. Indeed, the growth in housing prices in New England has been so spectacular in part because 20 years ago New England was declining and housing cost less than the physical costs of replacing the buildings."

(By the term "elastic" they mean "able to adjust readily to different conditions." Positive shocks, such as a large and quick rise in local employment should ultimately produce a rise in supply in homes and would be "perfectly elastic." Falling demand would not reduce the supply of homes, thus home supply is "inelastic" in a negative shock such as a large drop in employment at the local factory. In short, you do not destroy existing homes when demand drops in order to maintain value of the local housing stock.)

Next week, and in our conclusion, we are going to visit this theme again and again. It is the "major drop in housing demand" and not last year's prices, whether regionally or historically high or not, that may be the driver for falling home prices. Can we predict falling demand and thus lower prices? We will see, gentle reader. But first, let's look at some more data.

So, what's the problem with areas which have so little new home construction? Is it lack of land or possible (drum roll, please) government regulation?

You can read their work for yourself, but their study shows that the availability of land is not the driving factor in high cost areas. If local laws limit new construction, then higher prices result as an area grows. Even in areas where there is new construction, it might not be keeping up with demand. California grew by 600,000 people last year, and 500,000 per year for the last four years. 2,000,000 new people mean around 800,000 new residences (homes and apartments) are needed just to keep up with population growth.

Think about the above mentioned fact: Florida permitted as many new homes in one year as all of New England did in five years. Is it any wonder that home prices in New England soared well above the national average?

(Another very good study, for those who are interested, is a paper done on regulation and the effect on affordable housing last year for the Federal Reserve Bank of New York by C. Tsuriel Somerville and Christopher J. Mayer at http://www.heartland.org/pdf/12606.pdf.)

The Demand for Housing Will Grow

But with the Baby Boomer generation retiring, some argue we will need fewer new homes. But the data does not support that conclusion. The Joint center for Housing Studies at Harvard University issued a lengthy research paper on the state of US Housing. (http://www.jchs.harvard.edu/publications/markets/son2004.pdf)

"Residential construction has been on the rise for most of the last 12 years, adding significantly to the housing stocks in both metropolitan and non-metropolitan areas-particularly in the South and West. While large metros such as Atlanta and Las Vegas have seen spectacular increases in new construction, the rate of growth in many small and medium metros exceeded 25 percent.

"Despite growing concern over the pace of development, housing construction over the next 10 years is likely to exceed that over the last 10. The Census Bureau's newly revised population estimates imply that household growth from 2005-15 will be as much as 1.1-2.0 million more than the Joint Center for Housing Studies previously projected. Add to that the growing demand for second homes and replacements of units lost from the stock, and the total number of homes built in 2005-15 could reach 18.5-19.5 million units. This compares with 16.4 million homes added in the 1990s."

Part of this is the growth in immigration into the US. When looking at the natural growth of minority households coupled with new immigration, the minority percentage of households has risen from 17% in 1980 to about 26% today and is expected to rise to 34% by 2020.

Without the rapid growth of minorities, the renter portion of the nation would have decreased over the last decades. "Instead, the renter population increased modestly and the minority share of renter households surged from 31 percent to 39 percent over the decade. In addition to keeping rental demand from sagging, minorities also accounted for fully two out of every five net new homeowners from 1994 to 2003. Despite these strong gains, though, minority homeownership rates still lag those of whites by nearly 25 percentage points."

Long-term, then, the total aggregate demand for housing -whether owned or rented - is going to rise. So, then can we conclude that housing prices are also going to rise as well solely because of a growing population? The short answer is no. We can point to several periods of rapidly growing population where housing prices did not rise other than due to inflation. There are other factors we need to look at.

The Housing Price to Earnings Ratio

One of my diligent readers (John R.) sent me a study he did, comparing the median per capita income and average housing prices since 1965. He then looked at returns for the next five and ten years.

It was his effort to find a type of Price (home price) to Earnings (income) Ratio for housing. While there was no straight line correlation, overall you can make some very interesting observations. You are better off buying in periods of low "P/E" ratios than high ones. While his home-made housing P/E ratio was in the mid-range only 5 years ago, today it is at the top. Looking at historic norms, one would expect much lower returns, perhaps even negative returns, in the next five years. You simply cannot get too far from the mean before the gravity of the regression to the mean takes hold and pulls price increases down.

I would have rather seen household income than per capita income, but I doubt the actual conclusions would be different. Buying "value" is always a good idea.

Income, Employment and Home Prices

Is there a correlation between income, employment and home prices? The Harvard study group did another study of US housing in 2003, focusing on income and housing prices, and they think they have found one.

"While surging home prices have sparked fears of a housing market collapse, widespread price declines are unlikely because home prices in most areas have increased in line with income growth. History demonstrates that few localities experience the kind of concentrated job losses that precipitate severe home price deflation. Over the past 15 years, fully 53 of the 100 largest metropolitan areas have not experienced a single year of declining nominal home prices. Most areas, in contrast, have experienced slow deflation in real home prices following prolonged run-ups. In fact, real prices in 58 of the 100 largest metros have fallen ten percent or more at least once since 1987. In about a third of these locations, however, the real home values of owners who bought at least two years before the peak exceeded their purchase prices even at the bottom of the real declines.

They do not expect a dramatic decline in home prices. "Furthermore, despite the rise in both delinquencies and foreclosures in 2001 and 2002, problem loans represent a very small fraction of active mortgages. Serious delinquency rates on conventional loans are still under one-half of one percent. Although delinquencies on government backed loans are higher, new ways of working with borrowers promise to reduce the share of problem loans that end in foreclosure."

As a side note, we have seen the number of Americans who are behind on their mortgage payments begin to drop this year. The number of homes in foreclosure fell to 1.27%, down from 1.43% this time last year. "The delinquency rate for prime mortgages, those made to the most creditworthy borrowers, fell to 2.26 percent from 2.40 percent in the fourth quarter. Subprime-loan delinquencies also fell, to 11.19 percent from 11.59 percent; FHA late loans fell to 11.68 percent from 12.23 percent and VA loan delinquencies dropped to 7.37 percent from 7.99 percent." (CBS Marketwatch)

Harvard also has the following more sobering thoughts: "Despite this remarkable buoyancy, housing market risks have intensified in recent years. Job losses have forced more mortgage borrowers into foreclosure, increased the number of homeowners spending half or more of their incomes on housing, and softened some rental markets. In addition, expansion of mortgage credit to borrowers with past payment problems has elevated foreclosure risks.

"Finally, increased mortgage debt levels and growing shares of homebuyers with high loan-to-value ratios have raised concerns about the amount of debt carried.

"Two risks, however, could lead to more serious problems if the recovery stalls. One is the growing number of loans to borrowers with weak credit histories. Though serving many borrowers who just ten years ago were denied access to credit, default rates on these loans are predictably higher than on standard loans. Because these loans are highly concentrated in low-income, primarily minority communities, a wave of foreclosures could put a glut of homes on the market, lowering prices and threatening the stability of entire neighborhoods.

"The second serious risk factor is the dramatic jump in the number of homeowners spending more than half their incomes on housing. About 7.3 million homeowners reported cost burdens of this severity in 2001, up from 5.8 million in 1997. If more job losses occur, some homeowners in the bottom two income quintiles-who make up 84 percent of these vulnerable homeowners-could ultimately face the loss of their homes."

Notwithstanding their note about risk factors, there is a fly in the ointment of their logic. They assume home prices rise with income. And it is reasonable to think that as incomes rise 20%, people will be willing to pay 20% more for a home. But why would they pay 20% more for the same home? Other than inflation, why is rising income a driver for housing prices? As Dean Baker of CEPR notes:

"The Home Price Index [HPI, which the Harvard study uses] tracks the resale prices of the same homes. In other words, if the HPI rises by 5 percent in a year, it means that, on average, every individual home has increased in price by 5 percent compared with the price it sold for last year. There is absolutely no reason whatsoever why it should be expected that individual home prices would rise in step with family income - and it has never happened before during a period when family income was rising.

"Unfortunately, the HPI only goes back to 1975, but prior to 1981, the homeownership component of the consumer price index was constructed in a manner that is similar to the current HPI, tracking the resale prices of the same house. In the years from 1955 to 1973, the shelter index of the CPI (which includes the homeownership component in addition to a rent component) rose by 77.9 percent, or an average of 3.3 percent annually. By contrast, median family income rose by 173 percent over this period, or at an average annual rate of 5.7 percent."

Looking at a graph on page 8 of the 2004 Harvard study, you can easily see that there have been "bubbles" in certain areas of the US housing markets, not in the past few years, but in the 80's. They were all followed by serious corrections. The recent annual run-ups have been tame by comparison. What makes the recent experience so different is that the growth in certain areas (the Pacific, the Northeast and the mid-Atlantic) has been so steady over long periods. In the earlier decades, you would get real spikes in housing prices.

The real link between income and housing prices? Employment. In the 80's we had what was called a rolling recession in the US. Each region seemed to experience its own recession while other parts of the country were booming. Looking at that graph of housing prices, you could see which area was suffering its own boom or recession.

The Real Growth in Housing

Finally, these quick facts, which illustrates the powerful fascination of housing on Americans.

In 1950, the average new house was 983 square feet and cost $11,000. In 2000, the average new house was 2, 265 feet and cost $205,000. In 1950, there were 3.37 people per household, and now there is but 2.6. In 1950, only 6% of homes had a two-car garage. In 2000, 65% had two-car garages and 17% had three (or more) garage spaces.

In 1950, the average cost per square foot was $11. Today it is $91. Much of that is inflation, as inflation alone would increase prices to $76. The actual value of a square foot today is far more however. I grew up in one of those 1950 homes. No air-conditioning, one bathroom, rudimentary appliances, heating was a space heater in the main room. And three young kids and two bedrooms. I truly enjoyed my youth, but I am not nostalgic for the old homestead.

Things got better (and somewhat bigger) over time, not only for my family but for much of America. We will go into the psychological factors in housing prices next week, but homes play a central part in the American psyche. We will also look at affordability.

What have we learned this week? The core thoughts are that in the short-term home prices are more subject to regulation (which reduces supply) and employment. A down-turn in employment is going to affect housing values, perhaps significantly. In prior recessions, employment dropped along with housing prices. There were no parts of the country immune to a drop on housing prices. In the recent recession, we did not see a real spike (in historical terms) in unemployment or drop in overall consumer demand, and thus the negative affect on housing prices was muted. This was a true historical anomaly.

Over the long-term, inflation and a growing population will kick in to increase nominal home prices, but the long term may be a decade or more. But that's a story for later, as this letter is long enough.

Have I Gone Buddhist?

Last week I mistyped a link. I was trying to direct you to the web site of the Mortgage Bankers Association. Their actual link was www.mbaa.org. I left out an "a" so readers got sent to a rather interesting site of the Karma Kagyu School of Tibetan Buddhism. So, I have not gone Buddhist, just the usual embarrassing typing errors which seem to crop up from time to time. (They are also probably wondering why they had a huge spike in internet traffic. It is actually quite amusing, in that regard, to think of some poor monk wondering if the world was finally, after hundreds of years, beating a path to their doorstep.) I am just grateful it was not a more salacious site, which in addition to being somewhat upsetting would have been mortifying. And for those of us who took the time to browse the site, we learned a little history of another time and another place. No harm, no foul. But we are going to check links out a little more closely in the future.

Have a Great Fourth Of July

For Americans, it is a weekend of national celebration, fireworks, family and fun. It is also a time to remember those who have made it possible to enjoy our liberties. I was rather moved by the following tribute to our soldiers from the Nathan Adams Elementary School in Dallas, Texas. http://nathanadams.com/WeSupportU.htm

It is very late on a Friday night. I wish you all a great weekend. Remember to take some time for the more important things of life, and enjoy your home and friends.

Your beginning to wonder when his vacation will ever get here analyst,

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