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Historically Speaking, Homes aren’t a Good Investment
Dr. Robert Shiller has long advocated for the idea that housing should be considered a consumption good and not an investment. He helped develop the widely-used Case-Shiller Index measure of home prices and has suggested that over the long run real estate offers a rather poor return when considered alongside alternate investments. In fact, real home prices rose 0.6% per year on average from 1915 to 2015. On the other hand, the Wall Street Journal reported that “The long-term average annual compounded (realized) return on U.S. large-cap stocks has been about 10% before inflation and 7% after inflation over the past 100-plus years based on data from Morningstar, Inc.”
The shift in the perception of housing from mere shelter – a roof over your head – to a means to get wealthy has considerable effects on home price expectations. That is to say, the wide gap between expected and actual real estate returns is astounding; in a widely-cited 2003 paper, Drs. Shiller and Case found that homeowners in major U.S. cities expected that their homes would appreciate between 6.1-15.3% in the next year. An expectation of outsized gains from real estate transactions fueled the housing bubble that preceded the financial crisis, and a search for the phrase ‘home flipping’ on Google Trends shows a rapid increase in search volume starting in the spring of 2005. Clearly, one wouldn’t ‘flip’ his or her primary residence but would buy and perhaps renovate property in the hope of making a quick buck.
Homes Make Better Savings Accounts than Investments
It’s true that purchasing a home is one of the primary ways that a nation of notoriously poor savers builds wealth; in late 2016 USA Today cited a survey that showed 69% of Americans have less than $1,000 in their savings account. A mortgage is a forced savings vehicle that makes it easier to accumulate wealth over time for those who struggle to regularly stash a portion of their monthly earnings. The NAHB reported in 2010 that equity in a primary residence makes up 30% of U.S. household balance sheets.
However, unrealistic expectations of investment-like returns on one’s home can lead to over-reliance on home equity for one’s financial well-being later in life, and it can cause home prices to outpace inflation, leading to asset bubbles like that of the mid-2000s.
How Bubbles are Formed
The boom and bust cycle is accelerated by those that are willing to stretch their budgets and/or bid thousands of dollars over the asking price because, after all, it becomes common belief that “home prices will always go up.” Economist Joseph Stiglitz wrote in a 1990 paper that an asset bubble exists when “the reason that the price is high today is only because investors believe that the selling price will be high tomorrow – when ‘fundamental’ factors do not seem to justify such a price.” The harsh reality is that home prices can only outpace the rest of the economy for so long before the irrational exuberance evaporates and pessimism takes hold.
Home Price Gains are Outpacing the Overall Inflation Rate
Here we can see that for roughly ten years starting in the late 1990s the year-over-year percent change in the Case-Shiller Index outpaced the Consumer Price Index (the core inflation rate, the measure of inflation preferred by some economists because it excludes volatile food and energy prices).
In October 2005 the Case-Shiller Index had increased by over 14% year-over-year while the CPI had risen just 2.1% in the same period. As we all know, home prices proceeded to plummet in the following years as the relentless housing demand enabled by fraudulent underwriting and mortgage securitization disappeared.
Taking a closer look, we can see that following the correction experienced during and shortly after the recession, home prices have accelerated and the gains have outpaced the headline inflation rate for over four years.
To be sure, some of this was due to an underpricing of housing caused by a glut in housing inventories that swelled with foreclosed homes. Still, we should be wary of any sustained mismatch between the overall inflation rate and the pace of home price gains.
Income Growth isn’t Keeping up with Home Prices
Further, research published in 2016 by the government-sponsored mortgage giant Freddie Mac showed that the median ratio between home prices and incomes was 3.5 between 1993 and 2003 before the house price bubble took hold. The authors point to price-to-income ratios over 4.1 as worrisome outliers that indicate unsustainably-high house prices.
Worrisome Home Prices
It’s noteworthy that geographically-constrained markets (think San Francisco) may consistently demonstrate price-to-income ratios that are higher than this threshold, but those markets should be the exception to the rule. According to our calculations in the Housing Tides Index, 35 of the top 41 major homebuilding markets that we track have median sales price-to-income ratios in excess of 4.1 when calculated using April 2017 sales data from Redfin and 2015 metropolitan area per capita personal income from the Bureau of Economic Analysis (the latest MSA-level data available from the BEA).
Surely, these ratios are slightly exaggerated due to the outdated nature of the income data, but the general message holds true: all parties – homebuyers, homebuilders, and lenders alike – would be better off if we collectively stopped expecting stock market-like gains from our homes and considered them simply as a place to live. This is what they were originally intended to be, after all.
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