Home Is Not Where the Returns Are


By Christopher Farrell The swings in the Dow Jones industrial average command the headlines. And with stocks hovering near a five-year low, more Americans are fearful for their financial future than at any time since the dark days of the '70s. Yet the investment that truly matters for most people is their home. The news on that front has been good. Over the past five years, when stocks have journeyed nowhere during a wild roller-coaster ride, home prices have appreciated by more than 20%.

Individuals and families are pouring money into residential real estate. By almost every measure -- home sales, price growth, homebuilding, mortgage refinancing, remodeling expenditures -- the housing market has been on a record run.

FEAR OF A BUBBLE. Historically, home-price gains have roughly tracked inflation, but for the past two years, they have outpaced the consumer price index (see table below). The property frenzy is raising widespread fears that it's a bubble poised to burst. "And if this bubble were to burst, and housing prices were to decline, it could have more of an impact on the economy than the bursting of the stock market bubble at the beginning of 2000," says Hofstra University economist Irwin Kellner (see BW Online, 7/31/02, "Housing: Is It a Bubble If It Doesn't Pop?").

The fear doesn't seem irrational, especially with signs that the economy is rapidly losing momentum. Home prices are unhinged from the economic fundamentals in some parts of the country, such as the San Francisco Bay Area. "The clearest case of a speculative bubble in the U.S. recently, I believe, is the Bay Area -- San Francisco, Oakland, San Jose, Silicon Valley -- where prices were rising at a tremendous clip," says Robert Shiller, economist at Yale University.

But nationwide? Not likely. Yes, it's a concern that "the housing market has become the darling of people," says Carl E. Case, economist at Wellesley College. "But then I look at the fundamentals. I think there are sound reasons why the market has been as strong as it has been."

In fact, the risk is not a housing bubble. The danger is that thousands upon thousands of people are wasting valuable savings investing in an asset at the top of the market. Real estate agents are pushing people to buy, hyping recent price increases and threatening that if buyers hesitate, they'll only end up paying more later on. Hokum. Odds are that the housing market is at or near a peak. The next move could be down. Demand could finally cool if the economy weakens and job losses mount.

What has been driving the housing boom? The biggest factor is low mortgage rates, which are almost as low as they were in the 1950s. The aftertax cost of mortgage payments absorbed 18.5% of household income in 2001, down slightly from 18.7% in 1995 and considerably from 22.5% in 1990, according to the Joint Center for Housing Studies at Harvard. Fierce competition in the home-mortgage market has lowered fees and loosened down-payment requirements. Home equity toward the end of 2001 had also soared to a record $6.7 trillion. Many households cashed in hefty equity gains, selling existing homes to trade up to better dwellings.

CONCRETE ASSETS. Owning a home also has an added lure at a time when nearly $8 trillion in stock market wealth has vaporized: A four-bedroom, center-hall colonial, a one-bedroom condo with a brick wall, a townhouse nestled along a mountain ridge, and a mobile home blocks from the ocean are all made of solid materials. If you owned and held on to Enron or WorldCom stock, you have essentially nothing of value but a tax-loss carryforward today.

On the other hand, if the price of your house goes down, you still have a place to call your own, a kitchen to cook in, and a family room where you can entertain friends. What's more, unless the unemployment rate soars into the stratosphere as it did during the Great Depression of the 1930s or the Southwest Oil Bust of the 1980s, home prices rarely collapse. They can fall considerably or stagnate for long periods of time, but the downside is limited as sellers simply take their houses off the market.

Of course, a dollars-and-cents return-on-investment calculation barely captures the emotional pull of a home. "This is the true nature of home," said 19th century art critic John Ruskin. "It is the place of Peace; the shelter, not only from injury, but from all terror, doubt, and division." That said, in this market, the smarter course is to be a seller rather than a buyer.

And if the economy resumes its upward momentum, mortgage rates will start climbing. "You can't quarrel with a change in the fundamentals," says Susan M. Wachter, professor of real estate and finance at the Wharton School. If you want to make an investment, stocks offer a far more intriguing prospect of earning decent returns than real estate.

Home Price Gains Are Now Outpacing Inflation

Farrell is contributing economics editor for BusinessWeek. His Sound Money radio commentaries are broadcast over Minnesota Public Radio on Saturdays in nearly 200 markets nationwide. Follow his weekly Sound Money column, only on BusinessWeek Online


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