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WILL THE REAL ESTATE
BUBBLE BURST?
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By Bryan Bezold
RCGA Director of Research and Chief Economist
 In
March, Federal Reserve Bank of St. Louis President William Poole
spoke to RCGA members at a “Breakfast with the Gazelles” meeting
about housing markets. His topic choice was not a surprise; the
state of housing markets across the country has been a common topic
in financial and non-financial news outlets. Of course, Dr. Poole’s
remarks were far more insightful than the usual discussion of housing
markets; you can view them in their entirety at http://www.stlouisfed.org/news/
speeches/2006/03_08_06.htm.
Home prices and real estate markets have been an increasingly popular
topic partially because they are something many people can relate
to—a majority of Americans own their own homes, so most people have
some idea of how much a home is worth or how much they think a home
should be worth. Accordingly, much of the popular discussion of
housing markets centers around home price gains and the question
of a real estate ”bubble” that might burst.
Housing markets affect more than just the people shopping for a
house; activity in the housing sector affects the broader economy
as well. For that reason, the potential that a housing “bubble”
exists isn’t just a matter of concern to people thinking about putting
their house on the market.
There are two channels through which housing affects the U.S. economy.
The first is the direct addition GDP, the broadest definition of
the size of the U.S. economy, due to housing activity. The construction
of a new home adds to GDP, because in the accounting framework economists
use to measure the economy it represents an investment; according
to the BEA, residential investment amounted to $756.3 billion in
2005. That $756.3 billion was roughly six percent of nominal U.S.
GDP.
The housing market also affects the U.S. economy through its effect
on consumer spending. Traditionally, home price appreciation boosted
the economy through what economists call the wealth effect. As home
prices rise, homeowners feel wealthier. When they feel wealthier,
they tend to spend more and save less. Although saving less and
spending more may or may not be good for an individual household,
it will be reflected by an increase in overall GDP.
In recent years, the combination of rising home prices and lower
interest rates provided another boost to consumption because existing
homeowners could refinance their existing home loans at a lower
rate. The lower housing payment gave those households more money
to spend, ultimately boosting GDP. In many cases, homeowners took
advantage of “cash-out” refinancing in which they used both the
rising value of their home and lower interest to take out some of
their home equity as a lump sum of cash and still have a lower monthly
payment. In a 2005 paper, Former Fed Chairman Alan Greenspan and
James Kennedy estimated that homeowners took $599.5 billion worth
of equity out of their homes through refinancing in 2005.1
That’s why there’s concern about housing’s effects on the broader
economy. If there is a real estate bubble, and it bursts, there
could be negative consequences for the broader U.S. economy.
But what do we mean by housing “bubble”? One way to define a bubble
is to call it an increase in prices beyond what supply and demand
would predict. The rate of the formation of new households, the
rate of income growth of those households, and mortgage interest
rates would be some of the important factors on the demand side
of the equation. On the supply side, geography and zoning laws would
be important factors. It is worth noting, as Dr. Poole did in his
remarks, that the interest rate is only one of those factors that
doesn’t vary considerably across states and metropolitan areas.
Local economic conditions are important drivers of home prices.
Put more simply, the price of a home in Miami or San Francisco is
not a factor for a family who is interested in selling a home in
Clayton and buying one in Webster Groves.
There are large variations in the rates of home price appreciation
across the country. The chart below shows the rates of home price
appreciation in San Francisco, Miami, Las Vegas, St. Louis, and
in the U.S. overall. In some ways the data on the chart is easy
to understand; San Francisco has high-income levels relative to
the U.S., and some obvious supply constraints (you can’t build a
home in the ocean). Miami has a similar supply constraint, and the
large number of vacation homes probably boosts demand for homes
across the state of Florida and vacation oriented rental properties
in the state. Las Vegas doesn’t have the supply constraints that
coastal cities have, but it does have vacation-related demand and
above average income growth.
Although there are logical explanations for different rates of home
price appreciation, it’s impossible to know whether or not the rapid
pace of home price appreciation in places like Miami, Las Vegas,
and San Francisco represents a bubble, or prices consistent with
market fundamentals. However, if homes are becoming over valued,
a series of small bubbles in some local housing markets is more
likely than a national one. It’s difficult to look at that chart
and think that home prices in the St. Louis region are primed for
a fall.
The most likely scenario is that the rate of housing appreciation
across the nation will slow but remain positive; a few regions may
see out right price declines.
If that turns out to be the case then the macroeconomic effects
of slowing housing markets will probably be small relative to GDP.
With the pace of job creation accelerating in recent months, the
effects might even be overshadowed by growth in employment-based
income and consumption.
There’s one rarely discussed downside to the housing boom: affordability.
Rapid home price appreciation is good for existing homeowners, but
bad for prospective homebuyers. According to the National Association
of REALTORS, the median price of a home in San Francisco is $715,700,
compared to $139,000 in St. Louis.2 It’s true that incomes are higher
in San Francisco, but the gap isn’t nearly as high as the gap in
home prices. The median home price in San Francisco is 11 times
the median household income there; in St. Louis it’s just 2.4 times.
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