Our last two articles discussed how you might use past behavior of house prices to provide an updated value of your house today. We focused upon Los Angeles County and found wide variations in the appreciation rates of properties and ZIP codes relative to the average historical growth rates for the properties and ZIP codes. We encouraged readers to do additional investigative work and take advantage of the enormous amount of data available on this Web site to come up with your best estimate of the value of your home today.
This article continues our “detective” theme. We offer some clues about the future paths house prices might take in different parts of the country. No, we are not going to play Carnac the Magnificent (the prognosticator portrayed by Johnny Carson for many years) and provide specific forecasts. Doing so is both too easy — anyone can lay out projections — and too hard — we have no special insights about the future path of house prices in your particular neighborhood. What we offer in this article are some clues and a guide to the large and ongoing debate about where house prices are going.
Clue #1: What the experts are saying
This seems like an obvious place to begin looking for clues about the future since one of the authors is a card-carrying economist. So we begin with a summary of a very interesting poll published by the Wall Street Journal in November 2006. The WSJ group consists of 56 economists, some who specialize in housing markets and others who are more broadly focused upon the macro economy. They were all asked whether they thought the worst of the house price bust is behind us or is the worst still ahead. Sixty-five percent said the worst is behind us; 35 percent said the worst is still ahead. Although the majority is large enough to override a presidential veto, the results surely show a group largely split on the matter. In fact, a closer look at their specific forecasts shows as much. One or more believes that house prices will grow by 7 percent over the next year. One or more also believes that house prices will dip an additional 10 percent over the next year.
Here are our guesses as to the most likely sources of disagreement among these housing experts. First, unanticipated demand is the key to future house price growth, but unanticipated demand is, by definition, hard to predict! Local employment and population growth are consistently shown to be important drivers of housing demand at the local level. Does this mean that house prices will grow more rapidly in areas in which employment and population growth rates are expected to be strong? Not necessarily. What probably matters most is unanticipated growth in these factors or, alternatively stated, the extent to which a bright future for employment and income in an area has already been incorporated into the current level of prices. The experts almost surely disagree on what those unanticipated growth rates will be since, of course, they are unknown.
Historically, they might have also disagreed about the degree to which information about the future is already incorporated into current prices. Perhaps some still do. However, in our view, and just as with the broader stock market, the highly competitive market for housing and the vast amount of information available to prospective buyers and sellers makes this argument harder and harder to make.
Let us offer an example of what we mean by using an example close to where we live. Recently it was announced that Advance Micro Devices (AMD) will build a $3.2 billion computer microchip fabrication plant not too far from where we live, in Saratoga County, N.Y. As a result, we and others expect house prices to grow faster than elsewhere in this part of the country well before the first chip is produced. Once the plant is in full production and absent new information, house prices will likely behave again like others in the area.
Second, economists may differ in their assessment of the emotional content of future house price expectations. Most of us remember the dot com boom in technology stocks. The NASDAQ composite peaked above 5,100 in early 2000 and then lost about two-thirds of its value over the next year. Numerous forensic studies have been done of this experience; some even called it well ahead of the bust.
Robert Shiller (one half of the namesake of the Case-Shiller house price index) is probably the most famous predictor of the bust in his book Irrational Exuberance. Shiller has also been among the bears in the housing market. In the case of both the stock and the housing markets, and at the risk of greatly oversimplifying, Shiller assigns a great deal of weight to what we’re calling the “emotional” content of future house price expectations. One might think of this as an application of a “herd mentality” to decisions about how much a buyer should pay for a house and how much a seller should expect from a sale. While all housing experts would agree that expectations about the future path of house prices do and should influence your bid or asking price of a home, Shiller sees those expectations as more volatile than many of his peers. During the beginnings of the boom the emotional content tends to lead to unsustainably high expectations about future expectations, and just the opposite happens once the boom is over. This lead to rather sharp declines in the values of technology stocks, as witnessed in the dot.com boom.
Whether it applies to the housing market is another story. We suspect it is much less relevant to the housing market today because of the vast amount of information available to people about the current housing market. Also, at least in our case, Barbara and I probably tend to err on the side of “over analysis” and are less likely to be guilty of “swooning,” at least when it comes to houses.
Besides being less than definitive, the clues offered by the experts also suffer from what we consider to be a rather fatal flaw — they bypass what we consider to be a reality about housing markets. That is, future house price growth rates will vary widely among markets because, as it is often said, “real estate markets are local.” We’re quite sure, if given the chance, each of the economists surveyed by the WSJ would emphasize a wide variation around the mean. But since they were not asked this, we want to make sure that we do.
A few examples from the recent report on U.S. house prices by OFHEO makes this point quite clearly. House prices have increased by 100 percent since 1980 in Oklahoma, which experienced the lowest rate of growth among the 50 states. At the other extreme, house prices increased by over 625 percent in Massachusetts over the same time period. The average among all states was 303 percent (Chart 1). Breaking this down even further among metropolitan areas, between rural versus metropolitan areas, or among ZIP codes would only strengthen the point. In brief, the clue offered by these experts about the average forecast for the U.S. tells us very little about what to expect in your neighborhood.
Searching for alternative clues: Pick the views of your favorite housing economist
Given the split among the experts, what is a potential home buyer or seller to do? You could pick your favorite housing economist and go with his or her advice. But this doesn’t always work. Early in the 1990s, Barbara and I were refinancing our mortgage and contemplating whether to take out a fixed or adjustable-rate mortgage. Jim — who is Barbara’s favorite housing economist — had just written a number of articles for academic finance journals on some of the factors that influence borrower choice. He tended toward an ARM. Barbara, on the other hand, was well-aware that rates at this time — 1993 or so — were as low as we had seen since we bought our first home. Her instincts were to “lock into” the low fixed rates. Despite repeated attempts to influence her to defer to my “expert advice,” we opted for the fixed-rate mortgage, which proved to be a great decision.
Clue #2: Look at the historical record of boom and bust cycles
Another obvious place to look for clues is the historical record. A recent study done by FDIC economists provides excellent clues about what happens to house prices after a period of a sustained “boom” in house prices. They define a boom as a run-up in real (inflation-adjusted) house prices of at least 30 percent over a 3-year period. A bust is defined as a five-year period in which nominal house prices declined by at least 15 percent. Using these definitions they examine the historical experience of a large number of cities in the U.S. over the period 1978-2003. They specifically count the number of “booms” and ask, “Must a bust always follow a boom? Based on our look at history, our answer must be no. Only infrequently do home price booms lead to busts, at least by our criteria.”
They provide a very nice visual presentation of their evidence in a table that is available on line. Here is a link to Table 1 of their study. According to the evidence in their study, there were 54 unique boom episodes among major cities in the U.S. between 1978 and 2003. A substantial bust in house prices followed these boom episodes in just nine cases, or roughly 17 percent of all such boom events. The most prominent instances of a bust took place in the Southwest during the oil crisis in the early 1980s and in Southern California during its economic recession in the early 1990s.
Clue #3: Look at the predictions of the futures market
Here is another alternative source of clues about the future: look to what speculative markets are telling us. This is an avenue open to participants in many other markets. For example, the farmer wishing to lock in a price in March for its anticipated crop in September has long had the option of using futures markets. The farmer agrees to sell the crop at a future price established by the futures market for corn. The futures price reflects a consensus among active participants in the market about what the price will be six months into the future.
Recently, a futures market has been established for some parts of the housing market so we now have an opportunity to see what a group of active traders think about the future price of housing. The market exists for 10 of the largest metropolitan areas in the country. Briefly, a participant in this market agrees to buy or sell a contract based upon the value of a particular house price index at some point in the future. The index used is the Case-Shiller index. Currently, one can engage in a futures contract that expires in February, May, August and November.
Here we focus upon what these markets are saying about the future course of house prices over the next year for the 10 markets in which the futures contracts are traded. We compute the percentage change between the bid prices on the November 2007 futures contract and the latest values of the Case-Shiller Index, which are available for October, 2006. The results are summarized in Chart 2. Note, first of all, the result for the composite of the 10 cities (top bar), which is -1.53 percent. This means that the market believes that house prices are expected to decline by this amount over the next 12 months. The other bars pertain to the other 10 cities. The market is most bearish about Chicago; house prices there are expected to decline by 3.57 percent. The market is most bullish for Los Angeles, where house prices are expected to drop by less than 0.50 percent. The other markets are in between these two.
Jim conducted this same exercise earlier this summer when the futures market first opened. The differences are quite noticeable, especially when placed on top of the previous results, which we do in Chart 3. The markets were much more pessimistic about the future last summer. The expected decline for the composite of the ten cities was -6.2 percent. The markets at that time were most pessimistic about Boston, Las Vegas and San Diego. It appears that the futures markets are also in agreement with the bulk of the economists in the WSJ survey; that is, the worst of the decline may be behind us.
Conclusions and a glimpse of our next clue
We are in the midst of searching for clues about the future direction of house prices. The set of clues examined in this article include expert opinions, a broad historical look at the boom-bust cycle for housing prices and the views offered by the new futures market. Though the clues are not all in agreement, they seem to us to lean toward the “worst is behind us” school of thought. If this is proves to be the case, then a soft landing in house prices in 2006-07 will have happened and conformed to the typical historical experience — booms are typically not followed by substantial and sustained drops in house prices, at least not on a national scale or among a large number of regions within the country at the same time.
This does not mean that your particular house is immune to a steep decline in market value. There almost surely will be smaller areas within the economy in which house prices have grown beyond the level that can be supported by the economic fundamentals. Some of these will be places where demand has not lived up to expectations. Some will be in places in which a herd mentality may have played a significant role. For example, some believe that investors have fueled an unsustainable run up in the prices of condominiums in some parts of the country. Indeed, this is the area we will investigate in our next article. We will focus upon the market for condominiums in some Florida markets and a tool employed by professional investors to measure the value of real estate.