Its hard to avoid talking about housing in the US right now. From the supposed ’sub-prime’ meltdown to slow sales and rising mortgage rates; writers, pundits, and traders are having a field day. Check out this fascinating Op-Ed by David Ranson in today’s WSJ (sub required). He offers some great economic insights from Milton Friedman and argues that US housing is undervalued right now. Its always nice to listen to theories that challenge the conventional wisdom. Read the long snippet below and let us know if its time to go house hunting for a bigger place!
posted by David
Is Housing Undervalued?
by David Ranson
The housing market isn’t nearly as mysterious as it
seems. Much public confusion stems from our failure to clearly define
our terms. Take the popular, long-standing belief that housing is
overpriced and unaffordable relative to income. It was said 30 years
ago and it is still being said today. The key to solving this puzzle is
to widen the definition of income so that it includes the increase in
existing wealth. Milton Friedman, in the course of the work on consumer
spending that won him a Nobel Prize, introduced a much broader,
long-term measure of income called "permanent income" — including
capital gains, physical assets and factors like education that would
affect a consumer’s earning potential.
Permanent income grows at the same rate as wealth, and
generally faster than conventional forms of income. Friedman
demonstrated that households base their spending decisions on permanent
income rather than on narrowly defined income, such as short-term
wages. Fifty years later this idea has yet to sink into our national
consciousness. Yet, in a highly developed and wealthy country such as
the U.S., annual gains in the value of pre-existing assets are getting
larger and larger relative to annual cash income from wages, rents and
dividends.
Home prices behave the way they do because housing is
not a typical consumer good. Rather, it is a capital asset for which
the price is set by the markets for capital assets. These markets
continually clear in a way that typical consumption markets do not, and
housing is therefore being constantly re-priced. In this limited sense,
real-estate prices behave like the prices of other tangible assets such
as commodities. Of course, in other ways housing is quite unlike a
commodity — it is immobile, provides services such as shelter to its
owners, and its price is geographically very specific. Still, the
general level of housing prices, when measured as an index, is as
acutely and promptly sensitive to an uptick in inflationary pressures
as are other forms of financial or tangible capital.
Inflation tends to boost housing prices in the same
way that it boosts the price of any tangible asset. And inflation is
surely a major part of the housing-price story. Over the past three
decades, the price of housing at the national level has risen at a rate
similar to the growth of nominal GDP, and the correlation between
housing prices and GDP is statistically significant. But the
relationship between housing prices and the prices of highly
inflation-sensitive assets such as commodities is much more impressive
than the relationship with the economy. There is a particularly strong
correlation between percentage changes in housing prices and percentage
changes in the price of gold — especially when a short time lag is
taken into account.
When paper money is depreciating rapidly, as in the
last five years, it is normal for tangible assets such as housing to
appreciate more rapidly than usual, while financial assets such as
stocks and bonds tend to perform relatively poorly. This can be
understood in terms of the flow of financial capital from one economic
haven to another. Capital is mobile. It flows out of assets that are
vulnerable to the dollar’s depreciation, and into assets that are
invulnerable. Capital promotes growth and price appreciation in the
sectors into which it migrates, at the expense of the sectors from
which it escapes.
Instead of viewing the price performance of housing
during the first half of the current decade as a "bubble," I see it as
having appreciated for the same reason that the prices of commodities
and other tangible assets have appreciated. In nominal dollar terms
these prices have to rise in order to maintain the status quo in real
terms. The rise in housing prices is one more symptom or early warning
of the inflation of which the Fed (rightly) is so fearful.
To better understand housing-market trends, we need to
clearly distinguish between real and nominal terms. I define the "real
price of housing" as the ratio of the national home-price index to an
index of precious-metals prices, while the nominal value refers to the
price in dollars. Failure to draw this distinction can cause great
confusion. For example, the annual gain in the nominal price of housing
averaged 4.8% in all the years in which the Fed lowered interest rates,
and averaged 7.3% in all the years in which the Fed pushed interest
rates up. This calculation, at least in nominal terms, directly
contradicts the popular belief that higher interest rates bring
real-estate prices down. When the above calculation is repeated using
the real price of housing instead of the nominal price,
however, the inverse relationship appears. Higher interest rates do
tend to depress real housing prices, and this can happen without any significant fall in nominal housing prices.
Expressing the price of housing in real terms not only
clarifies the interest-rate confusion, it also changes the overall
housing picture. The accompanying graph shows the history of the real
national home-price index over the past 30 years. Notice how, during
the current decade, instead of the continuing rise in nominal housing
prices that made everyone so fearful, in real terms there has been a
significant decline. Far from a bull-market bubble that has begun to
collapse, housing when viewed in real terms has been in a bear market
since the beginning of the decade.
Moreover, like the real price of oil, the real price
of housing consistently reverts to the norm. In particular, housing
prices have a strong tendency to rise when they have underperformed
precious-metals prices. The graph illustrates how the real price of
housing sticks to a steadily rising trend over the long haul,
occasionally diverging from this trend but afterwards reverting to it.
According to the same data, the real price of housing was 30% above its
norm as recently as 2001.
Since that time commodity-price inflation has
escalated, and nominal housing prices have lagged far behind. The graph
suggests that housing prices are now 30% below their equilibrium in
terms of the precious-metals benchmark. Any further decline in the
ratio plotted in the chart would transcend the bounds of historical
experience. The last time that housing prices underperformed the
precious-metals market as dramatically as this was in the 1978-80
period, after which they bounced back dramatically…
Housing prices are thus much less enigmatic than they
seem. The nation’s wealth and its permanent income are growing
consistently, and housing is the largest of all the capital asset
vehicles in which wealth can be lodged. At the national level, housing
prices are not bounded by the growth of wages or other forms of
conventional income. Nor are they subject to "irrational" booms or
busts. Instead, they respond perfectly rationally to inflationary
forces that drive other capital assets and commodities. The real value
of housing is much more stable than the currency unit in which housing
prices are expressed.
What do you think?
posted by David
August 17th, 2007 at 11:35 am
How about house hunting for a smaller place, perhaps in a better area?
August 17th, 2007 at 11:45 am
Good point Ken.
August 17th, 2007 at 12:10 pm
Ranson is a rank hack. What a load of baloney……
August 17th, 2007 at 12:28 pm
wages aren’t geared to commodity prices. You can’t spend “permanent Income”. You cannot qualify for a loan based on “permanent income”. You can however qualify for a subprime loan using ficticious income and job documents and count on Home Price Appreciation to bail you out with a refinance. This is what caused the housing bubble. No mistake. Get a dose of reality Mr. Ranson.
August 17th, 2007 at 2:30 pm
I agree with John Q. Public and Econ 101. I think Mr. Ranson needs to re-think his stance.
August 17th, 2007 at 4:06 pm
The article is well-written, researched and reasoned. There are always short-term winners and losers whenever a state of flux (or enlightenment) descends upon a particular market. Many sub-prime lenders and other investors are losing today because they exercised POOR BUSINESS JUDGMENT just as the folks in Detroit have done; accordingly, the market is eliminating them, as it should. That should in no way suggest that the housing market as a whole is inflated, a poor investment vehicle or a reason to be pessimistic generally. It should also be noted, especially here, that much of the rapid property value appreciation can be attributed to URBAN RENEWAL and REVITALIZATION of decayed structures; the improvements to these fixed assets can hardly burst. The depressing news is that short-term capital is being withheld due to a state of fear; that will slow down economic growth during the immediate future.
August 18th, 2007 at 5:40 am
Actually the article by Ranson supports the notion of a huge perhaps 50% decline in real terms of housing in the next few months and years. If you look at the graph of the housing prices on his graph from 1975 to 1980 the index went down by half from 100 to 50. In 1980 the price of gold peaked at over $800 per ounce and there was a monetary crisis with high inflation. Today gold is on an uptrend at $650-$660 per ounce. There is high inflation in commodities such as food and energy. Futhermore, there is a potential dollar crisis with the dollar sitting under 80.50 on the dollar index. If the dollar falls below 80.0 then a there is a good change for a freefall causing imported goods and commodities to shoot up in value while wages stagnate due to offshore outsourcing and globalization. Thus , wages will go down in real terms as well as the real values of the housing prices that depend on American wages. Housing at this time is not a good investment but gold and silver is a good investment.
August 18th, 2007 at 5:55 am
Also, watch out for September 19, 2007 as a day for the start of a possible dollar crisis and market turmoil since Sept 18 is the day the Fed meets and may cut the fed funds interest rate which might start a dollar collapse. Foreign lenders may start withdrawing their money from America in order to get a higher interest rate elsewhere.
August 18th, 2007 at 11:55 am
Interesting analysis, if a little theoretical. Most people aren’t choosing between buying a house and investing in gold, they’re deciding between a house and a new SUV. For the average relatively financially unsophisticated American, housing is an easy and safe decision without wracking their brain over market timing or gold vs. stocks.
Buying a home is an emotional and long-term investment. The average American moves every 7 years, but I’d guess that renters move more often than owners. Someone who stays in a house 10 years, leveraging their investment with a mortgage and deducting interest, almost always makes money when they sell (the 80’s were an aberration in the last half-century).
August 21st, 2007 at 12:05 am
Hayden’s right, “much of the rapid property value appreciation can be attributed to URBAN RENEWAL and REVITALIZATION of decayed structures”. This is the upside of the gentrification that we’re seeing in most creative class cities.
I was also thinking of my neighborhood, which isn’t decaying, but of 10 existing houses on our block, seven have had significant remodels or additions in the last decade — partly because of cheap refinancing. In addition, four new houses have been “infilled” across the street on a slope that was considered unbuildable until prices made it economically feasible.
Is this level of remodeling going on elsewhere, I wonder? If so, how much does it have to do with the increase in house prices? As Hayden says, “the improvements to these fixed assets can hardly burst.”
August 22nd, 2007 at 7:42 am
Real estate business offers lots of opportunities. And the possibility of buying such is growing higher each day.
August 23rd, 2007 at 12:30 am
Intriguing article. Thanks for posting it. I have a different angle of comment from the other commenters…
Looking at that chart, and the issue of the ratio of commodity prices to housing prices recently, I wonder if the story is more the commodity prices being at an unprecedented level (because of the rise of China, trouble in the middle east, increased global consumption generally, etc.).
It seems a better interpretation of this data might be that the “terms of trade” (so to speak) between US real estate prices and commodities may have been permanently altered by shifts in global capital flows and world economic development.
(Incidentally, I’ve been unable to post for a while on this blog. Kept getting time outs using Internet Explorer. Decided to try with Firefox this time. Voila.)