Arnold Kling  

Housing Bubble Revisited

Revealed Preference vs. Happin... The Common Sense of Scapegoati...

The New York Times reports,

Gary and Margaret Hwang Smith spend a lot of time musing about real estate...

In a paper the two presented at the Brookings Institution this week, "Bubble, Bubble, Where's the Housing Bubble?" they said that even though prices had risen rapidly and some buyers unrealistically expected the trend to continue, "the bubble is not, in fact, a bubble in most of these areas."

They argued that the value of a home is determined by the rent it could fetch. Calculate the future rents, subtract mortgage payments, taxes and other costs, factor in a good annual rate of return of 6 percent or more, and one should be looking at the proper price of a house or condo.

There is nothing new here. There are two ways to look at house prices.

1. Relative to historical norms, prices are very high

2. Relative to rents, prices are reasonable

Both statements are true. The first implies a bubble, and the second does not.

Historical norms are for prices to be low relative to rents. That might reflect a risk premium or a liquidity premium for owning a house. In my view, there are good reasons for a liquidity premium to have shrunk over time. The mortgage market has become more efficient, so that the cost of having money tied up in a house has fallen. This story suggests to me that the rise in prices from historical norms could be rational.

Of course, that story is very similar to the story that Glassman and Hassett gave for Dow 36,000. They said that the risk premium from stocks was going away, and so the Dow was not overvalued back in 1999. Well, in retrospect, they don't look so good, and those of us who were more inclined to see a bubble were vindicated.

For housing, I would rate the probability of a bubble at about 20 percent. My uncertainty comes from applying what I call the profitability formula:

profitability = rental rate + appreciation rate - interest cost

The appreciation rate in this case is the assumed rate of increase in rents going forward. If you think that rent is going to stay flat for the next ten years, then prices are definitely too high. If you think that rent is going to go up 5 percent per year, then prices are probably too low. I don't think it's an easy call.

Comments and Sharing

COMMENTS (24 to date)
KipEsquire writes:

"subtract mortgage payments"

The "this time it's different" problem is that for an increasing number of homeowners, mortgage payments are no longer fixed -- either because of adjustable rate mortgages or increasing payments as equity is continually extracted via follow-on "home equity loan" borrowing.

For such people, unless you believe long-term interest rates have peaked (a foolhardy assumption), you need to incorporate a growth rate into the cost equation. Doing so can easily refute the assertion that "Relative to rents, prices are reasonable."

ErikR writes:

Shiller's long-term price indices from multiple countries show that the most reasonable guess for appreciation rate is about 0%.

So, in your formula, the interest and maintenance costs better be darn low if you expect 5% rent increases per year to make a good investment.

spencer writes:

Anytime you assume that the rate of price appreciation will be higher then the interest rate you will get the results they did. The critical issue is whether or not their assumption of 6% price appreciation is realistic.

Who knows?

Xmas writes:

Weird. I'm thinking about your formula. The demand for rental property and the demand for housing are related. A increase in the amount of home ownership means a decrease in the demand for rental properties. The decrease in demand for rental properties means that rents will likely stay stable or could even decrease.

For example, Boston seems a likely candidate to be a under the spell of a housing bubble. With such a high rate of home ownership these days, the demand for rental properties is low enough that rents in Boston are stable or even lowering. Just to confirm, I found some market analysis data that indicates Boston's rental rate growth for next year is 2.2% (

Bob writes:

My first thought after reading the NYT article combined Arnold's alternatives - does anyone know of solid research on how current price/rent stack up against historical norms? Not in a simple P/E sense, but controlling for other observable factors (e.g., interest rates, tax rates, etc.). As others have pointed out, given the assumptions necessary to run a cash flow model, it would be useful to know what assumptions are implicit if you backtest the model on historical data.

Bob writes:

Xmas makes another good point - if high prices attract investment capital, supply will grow at higher-than-normal rates during a boom, which will suppress rents (and future price appreciation). But there is a lag before the new supply hits and rents fall, which would be the "bubble" driver if everyone uses the proposed formula.

aaron writes:

I think a housing bubble is different than a stock market bubble. Housing is viscous, more like the job market. I think if anything happens, returns will be low for a period of time to compensate for previous high returns. These bubbles don't pop, they collapse. This will be more like the job market bubble collapse of 2000. People owning houses won't be hurt, but people entering the market will not get much out of it in the short-term.

People like me, who were hit hard by the job market collapse (graduating form undergrad in late 2000) and who are just now getting on their feet and ready to buy a house will likely get hit again with higher interest rates and paltry returns on housing value.

T.R. Elliott writes:

I'm having a little trouble understanding aaron's comment. I agree that the stock market is liquid, and the housing market more viscous or sticky. But using that last popping of the bubble here in So Cal, I watched houses that sold for $650K dropping to $430K over a time period of perhaps a year (or two at most). This happened all over So Cal in LA and San Diego.

I agree that one is not hurt if one isn't selling, but the same goes for the stock market. If you don't sell when a bubble pops, you aren't hurt in the same way. But your net worth has decreased in either case. Stocks can drop quickly, though even the Nasdaq dropped over a three year time period. It didn't happen over night.

In that sense, I see no difference between the collapse of the stock market and the collapse or popping that could occur with housing (if it follows what happened here in So Cal in 1990). 40% losses may be in store, so there are a lot of people who will be underwater.

In the end, the reality is that the value of something is only what some other person is willing to pay for it. Value is psychological. Whether gold or any other quantity, the monetary value is largely psychological. And in the case of housing, the psychology can change (it already is changing as we speak) and that will have implications on many other aspects of the economy, e.g. construction and services jobs dependented on the real-estate business.

I think the main problem with the Smith paper (full paper available on the internet) is that it is always true that, if costs are comparable (after taxes and other considerations), borrowing to own is better than renting because in the end I have something I can sell afterwards.

So in the long run, their analysis will almost always show buying to be better. Because in the long run, you own the home.

But if we see 40% drops, which is entirely possible, and you need to sell in 4 years (e.g. to move), you will face enormous losses.

MjrMjr writes:

2. Relative to rents, prices are reasonable

By what measure is this true? It's much cheaper to rent right now. I bet there's not a single property here in Fairfax County, VA that could be bought as the Smiths describe(20% down and a 30 yr fixed rate mortgage) and used as a rental property to generate positive cashflow. Any takers?

I live in an older neighborhood of townhouses in Western Fairfax County. Looking on I see that of the houses in my neighborhood currently for sale, the median price is about $360k. They rent for about $1300/mo. Suppose a buyer put down 20% and financed the rest
via a 30 yr fixed mortgage at 6.35% on the $360k house. That's a $288k loan, 6.35%=payment of about $1800/mo. Taxes will run about $220/mo. HOA fee is $55/mo. Granted, you'd get some of this back via the mortgage interest tax deduction but renting is still cheaper by about $500/month.

I got the 6.35% rate via:

My guess is that if I had reliable rental price data, I could spend hours on and not find a single property in the area that would yield a positive cashflow. Ditto for San Fran, San Diego, large parts of FL and AZ, NYC, Boston, etc. Since 2000 rents haven't gone up by that much in these markets. House prices have roughly doubled. I'd say the price:rent ratio is way out of whack.

It's hard to time any market, but it right now it's reasonable to predict that house prices in NoVA will decline in the near future. Inventory is surging and prices have been dropping since about August. Once the "real estate only goes up" meme is broken, I think a lot of folks will rush for the door at once. I predict that April or May will be the first year-on-year price decline this area has seen since... I don't know when. is a great source of statistical data for the NoVA market.

ErikR writes:

It seems the thesis that price-to-rent ratios have not increased is wrong. See, for example, this blog post:

Barkley Rosser writes:

According to the second edition of Robert Shiller's Irrational Exuberance, price to rent and price to income ratios for housing in the US are at all time highs.

jaimito writes:

The rent is influenced by the number of families owning no homes in the area they work: mobility of the population and levels of immigration - legal and otherwise. Since life-style is becoming more transient and fewer people marries and form stable roots, and immigration is unstoppable, rents are not going to fall in the next 6 - 7 years.

aaron writes:

I don't think that people will be willing to sell for large losses, this will keep the prices from falling much. If people sell and then buy again, they will pay higher interest. Keeping their low interest rate will stop them from putting their homes on the market.

I'd look at the demographics, prices will only come down if a lot of people decide to downsize or die off and the people taking their places don't have the income to afford at current prices. When people downsize, it's usually because they retire, this will eventually mean rising income for the people who will be filling the void. When old people die, their income shifts to a younger demographic.

Bill writes:

According to Arnold's formula, San Francisco has a real estate bubble. Rents are in many cases less than half of the costs. The risk is high as well due to a potential earthquake. Homeowner's insurance doesn't cover earthquakes here anymore. A homeowner must pay a significant premium to obtain earthquake insurance, so many if not most homeowners go without.

Since I'm a renter, I certainly hope it's a bubble and it pops. It's getting more and more difficult for me to ever afford a home in my home state of California. Does this mean that I'm a jerk? Are homeowners who've made huge gains jerks for wishing for ridiculous gains at the expense of those who cannot afford to buy a home? I don't want my home to be an investment. I want a home that I can pay off and retire in.

ErikR writes:


Even if people don't want to sell, a significant number will be FORCED to sell as their ARMs or exotic mortgage payments increase beyond their ability to pay. All it takes is a few people selling down to start a panic as others try to sell before prices fall too much...and so it begins.

ErikR writes:

Here's a link to some of Robert Shiller's long-term housing data from multiple countries.

It looks like one would have to ignore the lessons of history to expect house price appreciation of more than 2% per year.

Robert writes:

Because of high transaction costs & lag in creating new supply, the housing market is not an efficient market: over time, one can find a correlation between this year's appreciation and next year's appreciation, so there is publically available information not yet incorporated into prices. As a result, the housing market has historically been cyclic. The difficult-to-answer question is of course how dramatic will the correction be this time around?

Robert Book writes:

Seconding Mjrmjr, ErikR, and Bill: The price-to-rent ratio is much higher than previously.

In my townhouse complex in Fairfax, VA, rents have been stable for at least the last 5 years -- and prices have DOUBLED in that time. The same units that rented for $1600/month then rent for $1600/month now. But the units that sold for $210,000 then sell for almost $439,000 now.

In fact, when I moved in 5 years ago, I could either rent for $1600/month or buy for $1600/month (with 5% down). Now there's no way you could buy for $1600/month with even 20% down.

MjrMjr writes:

I agree with ErikR's response to you re:people won't sell and take it one step further. Not only will individuals/families owning one home be in the "have to sell *now* due to rising rates on an ARM" boat, so will speculators who "own" five, ten, or more homes via ARMs. In areas like Fairfax and other bubbly locales a very large component of housing demand in the last couple years has been investors buying multiple homes via ARMs and other mortgages with payments that are soon due to adjust upwards. Those properties are currently being rented, in many cases for negative cashflow. These speculators are losing money every month; they've bet the farm on price appreciation. Very soon they'll be faced with a choice. Sell now for a relatively small loss(and stop the monthly bleeding via rent not covering the mortgage) or try to hold on for a while and end up selling later for an even bigger loss.

The rational choice for said speculators, imo, will be to sell now and cut their losses. I think this is why NoVA inventory jumped 25% last month. Speculators are holding such a large amount of inventory that the market can turn on their activity alone.

mousebender writes:

Item 2 should read:

Relative to rents plus expected appreciation, prices are reasonable

Leaving out the expected appreciation, the cost of renting in some bubble markets is much less than the cost of owning.

See this chart from Business Week, which is sorted by rental cost as a percentage of ownership cost.

(BTW, love the blog!)

aaron writes:

Fairfax definately sounds like a potential bubble, hopefully it will just be speculators who get burnt. I think this will generally be the case. I'm not worried about them, it's their own fault.

I think that if prices fall for those homes, it simply means that people who have more stable financing will be able to move in.

Robert Book writes:

Prices of single-family homes in Fairfax are already down 10% from a year ago. Sales volume per month is down 45%, and inventory (the number of active listings) is up by a factor of 5.

The bubble is already bursting -- and rents are still only 50-75% of the monthly cost of owning, so prices still have a way to go (down) before hitting equilibrium.

TMEX12 writes:

Is there a bubble? Use my rule of thumb. If rent is way out of whack from the cost of ownership then there is a bubble. If two (though related) markets value the same asset differently - its simply a arbitrage opportunity. I live in the south ohio, there is no bubble here.

MB writes:

I haven't read the paper in detail but it looks like they used a 6% after-tax discount rate. It seems to me that this is WAY too low for such a highly levered investment. The volatility of the homeowner's equity (as a function of the home price) would be extreme with 20% down. I would think at 10-12% discount rate would be more appropriate and would surely change their outcome. Thoughts?

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