Wednesday, May 12, 2010

Was There Good Reason for a Housing Boom?

Copyright, The New York Times Company

Several factors regarding housing supply and demand have changed since the turn of the century and will change in the years to come, in the direction of increasing the nation’s housing inventories. As a result, at least part of the construction boom of the last 10 years served a legitimate economic purpose.

Motivated in large part by extraordinarily high housing prices, the nation’s home builders were busy building and renovating from 2000 to 2006. As a result, the housing inventory at the end of the housing boom was 3 or 4 percent above the trends of the previous decade.

One perspective says that most of the housing boom was a colossal market mistake: an unfortunate consequence of easy money, lax regulator oversight, subsidies to home ownership and irrationally exuberant buyers. In this view, public policy would ideally have pushed back, and housing construction would not have boomed anywhere close to the way it did. Let’s call this the “bubble theory.”

The opposing view says that there were good supply and demand reasons to significantly increase the amount of housing above previous trends. With the advantage of hindsight, we might have preferred to have stretched out the 2000-2006 construction activity over a longer period, or to have put some of the new houses in different locations. Still much of the housing built in the 2000s will ultimately prove desirable. Let’s call this the “fundamentals theory.”

The various supply and demand forces can be distinguished according to whether they affect the amount of rent paid by a home’s occupants, or whether they affect the fraction of the rent that a landlord and his creditors can keep as a return on their capital investment. (For the sake of exposition, my discussion treats the landlord and tenant as distinct, even though with owner-occupied dwellings they are the same.)

The pie chart below shows the distribution of tenants’ rental payments to various uses.

The largest piece of the pie – “cash flow to owners and creditors” – is the amount going to the owner of the home or apartment, and his creditors, that serves as a return on investment. It includes the principal and interest paid on mortgages, and any surplus the owners may have after making a mortgage payment.

The other pieces include property taxes, payments to employees who manage and repair the property, and payments for intermediate inputs such as real estate agents and mortgage industry employees. (This last piece does not include principal and interest paid on mortgages, but would include the mortgage closing costs that finance the salaries of industry employees).

The “cash flow” piece is an important determinant of housing prices, because the “fundamentals theory” says that homes sell for the present value of the cash flow. The cash flow to owners, and therefore housing prices, would increase if rents increased, so that the total pie expanded. But the owners would also get more, and homes would be worth more, if owners could pay less to real estate agents, property managers, and mortgage brokers.

In other words, housing prices can also go up because the entire pie is expected to increase in size, or because the cash flow piece is expected to get larger while some of the other pieces get smaller.

An extraordinary population growth rate would be good reason to build houses at a faster pace and would cause prices of housing to increase for occupants. Yet the human population of the United States grew at about the same rate 1995-2005 that it did 1980-95 (about 1 percent per year during both periods, although the total pounds of humans have probably grown more in the recent period).

But let’s not forget about the non-humans in our homes – the stuff!

Consumer durable statistics from the Bureau of Economic Analysis confirm the obvious: From 1995 to 2005, ownership of furnishings and appliances increased at a rate of 4.5 percent per person per year (as compared to 2.2 percent in the earlier period), and ownership of recreational goods rose 9.1 percent per person per year (as compared with 5.4 percent earlier).

In case you still doubt that Americans have genuinely increased their demand for space, note that the self-storage industry has more than doubled its share of the national economy since 1995, according to employment data from the Bureau of Labor Statistics.

Another way to distinguish supply and demand forces is whether they have their effects on owner net cash flows before 2005, or were expected to affect those flows after 2005. To the extent that houses were more valuable during the boom because of favorable cash flows – perhaps because home occupants had a high demand for space to keep their stuff – rents probably would have risen faster than home prices, because home prices are a kind of average of current and future cash flows.

According to the Bureau of Labor Statistics, inflation-adjusted housing rents did increase in the late 1990s and early 2000s, but much less than home prices did. This is why I, and several other economists, have concluded that the majority of the housing boom derived from market expectations about the future, rather than something that happened to housing demand before 2006 (this same logic says that home prices were only moderately stimulated by the fact that mortgage rates were lower in the 2000s than they were in the 1990s: see these items from Professor Paul Krugman and me for more on that point).

Undoubtedly, Americans will continue to accumulate stuff, and will have commensurate increases in their housing demand, which could partly explain why housing prices increased more than housing rents during the boom. But the accumulation of stuff by itself would be unlikely to produce the housing bust we saw after 2006 because our furniture, clothing, toys, etc., did not suddenly disappear in 2007, but housing prices came crashing down.

That brings me to a second set of housing market factors that reinforce the increased demand for space: anticipated advances in information technology. Information technology will likely reduce home ownership costs – shrink the “real estate, mortgage industry employees, and other intermediate inputs” and “compensation of employees” pieces of the pie – but for now we cannot be sure exactly when and how much.

House shopping began an ongoing transformation over the past several years, with shoppers able to take spectacular virtual tours of properties. Arguably information technology will someday enable most home shoppers to do without a human real estate agent, and this would be a significant cost savings for home sellers. Don’t forget that a home is built once but typically sold many times, with each sale creating a fee for real estate agents, and many of the sales involving a vacancy period during which no one gets value from the structure.

Market participants might have also hoped that mortgage loan screening could improve, and become less labor intensive, thanks to information technology. The economists Robert Hall and Susan Woodward pointed out in 2008 that “Recent years have seen great improvements in data, especially the introduction of credit scores, which gave lenders new powers to forecast mortgage defaults and to adjust interest rates offered to prospective borrowers. In 1990, credit scores were rare; by 1996, they were standard.”

All of these things are expected to someday significantly reduce the costs of owning a home, managing it and keeping it occupied. But it will be years until we know exactly when and how much; in the meantime, the housing market may gyrate as it adapts to these historically rare, but ultimately beneficial, changes.

Housing bubble-theorists have not yet seriously considered factors like these. Until they have, it is too early to blame a majority of the housing boom on irrationally exuberant home buyers, because even without these things a historically unusual housing boom may well have been efficient.


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