Is There a Housing Bubble?

"Because real, long-term interest rates are currently so low, housing costs are more sensitive to changes in real, long-term interest rates now than at any other time in the last 25 years."

For some time now, there has been much speculation in the media that house prices are unsustainably high, that there is a "bubble" in the housing market, possibly even that house prices may already be on their way down in the East and West Coast regions of the United States. "House-price watching has become a national pastime," note Charles Himmelberg, Christopher Mayer, and Todd Sinai in Assessing High House Prices: Bubbles, Fundamentals and Misperceptions (NBER Working Paper No. 11643).

The three, though, find "little evidence" of housing bubbles in almost any of the 46 single-family housing markets they studied, at least as of 2004. (The authors have subsequently updated their data through the third quarter of 2005 and come to the same conclusion. Updated tables, downloadable data, and a data appendix are available here.) "While it is impossible to state definitively whether or not a housing bubble exists," the authors add, "most housing markets did not look much more expensive in 2004 than they looked over the past 10 years, and in most major cities our valuation measures are nowhere near their historic highs." Even in high-appreciation markets like San Francisco, Boston, and New York, "current housing prices are not cheap, but our calculations do not reveal large price increases in excess of fundamentals." Recent price growth is supported by basic economic factors such as low real, long-term interest rates, rapid income growth, and housing price levels that had fallen to unusually low levels during the mid-1990s. Expectations of outsized capital gains appear to play, at best, a "very small role" in house prices, the authors hold.

This does not mean, however, that prices cannot fall. An unexpected future rise in real, long-term interest rates or a decline in economic growth, for example, could easily cause a fall in house prices, the authors note. "Indeed, because real, long-term interest rates are currently so low, our calculations suggest that housing costs are more sensitive to changes in real, long-term interest rates now than at any other time in the last 25 years," they write.

House prices are extremely important, both to the economy and to homeowners. By 2004, 68 percent of households owned their own homes. For most of them, housing equity will make up nearly all of their non-pension assets at retirement. Many of the 32 percent who rent are younger households, or potential owners watching housing markets closely to judge whether it is an opportune time to buy, or looking with concern at presumably high prices. Between 1975 and 1995, the authors note, real house prices in the United States increased an average of 0.5 percent per year. By contrast, from 1995 to 2004, national real house prices grew 3.6 percent per year, or nearly 40 percent in one decade. In some individual cities, such as Boston and San Francisco, real home prices grew about 75 percent from 1995 to 2004.

In explaining how to assess the state of house prices, the authors point to what they regard as four common fallacies: first, the price of a house is not the same as the annual cost of owning. So it does not necessarily follow from rising prices of houses that ownership is becoming more expensive. A correct calculation compares the value of living in that owner-occupied property (the imputed rent) with what it would have cost to rent an equivalent property and with the lost income that one would have received if the owner had invested the capital put into the house in an alternative investment. The comparison should also take into account differences in risk, federal and state tax benefits, property taxes, maintenance expenses, and any anticipated capital gains.

Second, high price growth is not evidence per se that housing is overvalued. In some local housing markets, house price growth has consistently exceeded the national average rate of appreciation for very long periods of time.

Third, considerable variability in the ratio of house prices to rents across housing markets can be the result of reasonable differences in expected gains in house prices and in taxes.

Finally, the authors note, the sensitivity of house prices to changes in fundamentals is higher at times when real, long-term interest rates are already low and in cities where expected price growth is high, so accelerating house price growth and outsized price increases in certain markets are not intrinsically signs of a bubble.

For these reasons, conventional metrics for assessing prices in a housing market, such as price-to-rent ratios or price-to-income ratios, generally fail to reflect accurately the state of housing costs. House prices may appear exuberant by these metrics, even when they are in fact reasonably priced. House price dynamics are a local phenomenon. So national-level data can obscure important economic differences among cities. Further, in some cities, the housing supply is relatively inelastic because of the lack of open land, zoning restrictions, or other factors. Thus house prices in such areas may be higher relative to rents, and more sensitive to changes in interest rates.

In this study, the authors create an index of imputed rent and divide this index by an index of actual market rents or an index of per-capita income. The ratios of imputed rent-to-actual rent or imputed rent-to-income are then compared to their 25-year average for each city. During the 1980s, the authors' measures show that houses looked most overvalued in many of the same cities that subsequently experienced the largest house price declines - including Boston, Los Angeles, New York, and San Francisco. Only a few cities in 2004, such as Miami, Fort Lauderdale, Portland (Oregon), and to a degree San Diego, had valuation ratios approaching those of the 1980s, the authors note

-- David R. Francis