Is There a Bubble in Home Prices?

Is There a Bubble in Home Prices?

The rapid increase in home prices over the past several years has raised concerns about the existence of a speculative bubble in this asset market. A closely related concern of any existing bubble is whether home prices are at risk to a steep decline that could have a severe impact on the broader economy. Home prices have been rising rapidly. Since 1995, real home prices have increased about 36 percent, roughly double the increase of previous home price booms in the late 1970s and late 1980s (Chart 1). Home prices continued to rise strongly during the 2001 recession, the sluggish recovery through mid-2003, and the recent period of more rapid growth. (Baker, D. 2002)

Analysts argue that the recent growth in home prices is symptomatic of a housing bubble that will burst--just as the stock market bubble did--thus erasing a significant portion of household wealth. They add that such a decline in household wealth would have adverse economic effects, as already overextended consumers reduce spending to boost saving and improve their weakened financial condition. (Bailey, 1963)

By reviewing the evidence in support of a bubble in U.S. home prices and discussing whether a severe decline in these prices is likely finds that a bubble in the housing economy is not likely to happen. We also examine the effects of a steep drop in home prices on the broader national economy. Examining the possible effects of a severe decline in home prices is important because of the large role that real estate plays in total household portfolios. "According to the Flow of Funds Accounts compiled by the Board of Governors of the Federal Reserve System, households held about $14.6 trillion in real estate at the end of 2003. This figure accounts for about 28 percent of households' assets and is more than 130 percent of GDP. (Bailey, 1963)

By comparison, households held about $12.8 trillion of corporate equities and mutual funds in 2000 at the peak of the stock market. Furthermore, equity holdings are concentrated at the upper end of the wealth distribution, whereas housing is the major asset for most households. An additional concern is the effect of a severe drop in home prices on the mortgage market. A sharp fall in prices could lead to more foreclosures and unanticipated losses for lenders, straining the financial system. Given the possibility of a negative economic shock due to deteriorating credit market conditions it is important to examine the evidence suggesting the potential bubble or severe price decline. (Baker, D. 2002)

Constructing an index of home prices across the nation or a region is complex, because home sales do not occur in centralized markets such as corporate equity transactions. Moreover, the price index used can have dramatic ramifications on the assessment of whether a home price bubble exists. Therefore it was helpful to begin our analysis by discussing the properties of the four principal home prices series used to measure national trends in home prices. This trend consists of the median price of existing homes sold, price of new homes sold, repeat sales price index, and constant quality new home price index. (Bailey, 1963)

Before discussing the existence of a bubble, we need to define the term. We subscribe to the definition from Stiglitz (1990):

If the reason 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 - then a bubble exists.

According to the key features of a bubble are that the level of prices has been bid up beyond what is consistent with underlying fundamentals and that buyers of the assets do so with the expectation of future price increases. Although some press accounts treat the rapid rate of increase in national home price series as prima facie evidence of a bubble, our definition dictates that such increases alone are necessary but not sufficient evidence. Additional evidence that relates current home prices to fundamental determinants is required to solidify any claim of a bubble. Two such measurements have been widely used to support claims of a bubble. (Baker, D. 2002)

The ratio of the median home price to median house hold income is one frequently employed measure of home ownership affordability. If this ratio is relatively high, then households should find both down payments and monthly mortgage payments more difficult to meet. Another common way to evaluate home price fundamentals is to compare them with the implicit rents that homeowners receive from owning their homes. Implicit rent is defined as the rent a homeowner would have to pay to rent a housing unit similar to his home, or equivalent, the rent a homeowner could receive if they rented their home to a tenant. (Bailey, 1963)

The two measures of home price fundamentals presented both support the notion of a home price bubble and suggest that home prices are likely to fall in the near future. Neither of these measurements takes interest rates into account. Interest rates should matter in assessing the existence of a bubble because they influence home ownership affordability and because they represent the yield on a competing asset in a household's portfolio. The downward trend in nominal mortgage rates has significant implications for home ownership affordability and for the equilibrium return on housing. Accounting for this trend in interest rates we can doubt the existence of a bubble. (Bailey, 1963)

This concludes that the most widely cited evidence of a bubble is not persuasive because it fails