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Economic Research

On the Bubble: When Real Estate's Long Haul Took a Shortcut

A home is often a person's biggest investment. But as home prices began their dramatic appreciation, the stage was set for the once-solid investment strategy to show cracks in the foundation.

house in a bubble about to be popped

When housing prices began to fall after the housing bubble burst in 2006, the drop represented more than a loss of wealth to a wide swath of Americans. It was a contradiction of what homeowners assumed was a universal truth: that home ownership was always a good investment. That assumption seemingly had been in place since the passage of the Home Owners Loan Act of 1933, which paved the way for long-term amortized mortgages.

But beginning in 2006, home values began to take an epic fall in many markets. The S&P/Case-Shiller Home Price Index, which reflects home pricing trends by comparing repeat sales of single-family homes in 20 U.S. markets, offers one compelling illustration. In the first 78 quarters tracked by the index created in 1987 by economists Karl Case, Robert Shiller, and Allan Weiss, only 13 quarters (16.6 percent) showed negative growth.

Beginning in the third quarter of 2006, the next 13 quarters all ranked among the lowest 15 quarters in the history of the index. Prior to this span, the index's biggest quarter-to-quarter decrease had been a modest 1.6 percent. That decline was dwarfed by the post-bubble stretch from the fourth quarter of 2007 to the first quarter of 2009, which featured decreases ranging between 5.5 percent and 11.2 percent quarter over quarter. Price declines continued without interruption until the second quarter of 2009, when the Case-Shiller index posted a 3.7 percent increase.

Related Links
On this site:
Audio icon Indexing the Housing Market podcast (MP3 14:57)
Karl Case, an economics professor at Wellesley College and codeveloper of the S&P/Case-Shiller Home Price Index, discusses house prices and the state of the housing market.
On the Web:
Case-Shiller Home Price Indexes
U.S. Census Bureau's housing information
Federal Housing Finance Agency

Long-held assumptions rocked
While the stock market and other investments have had highs and lows in the past eight decades, investment in single-family homes generally grew along with their price appreciation. Although some housing bubbles have occurred in the past, none has had the same adverse impact on average home values nationwide as the bursting of this one. Further, the severity of price declines has varied regionally, making it challenging for homeowners to assess the investment performance of their own homes and leaving them searching for an explanation of this investment's sudden fluctuation.

"It's a complicated story," said John S. Adams, author and professor emeritus of geography at the University of Minnesota. "It doesn't make for very good headlines to say that we've got over 300 metro areas in this country, and each one is a separate housing market. When you say that, the audience's eyes start to glaze over because what they really want you to tell them is where to invest money to make a quick buck."

That sort of analysis, filled with nuances and exceptions, runs counter to the common wisdom that Americans could count on their homes for making a buck, even if it wasn't always a quick one.

"People have viewed their house as investments for a very long time. That's part of the mantra of why people own houses," said Kelley Pace, professor of finance and director of Louisiana State University's Real Estate Research Institute. "The difference between now and then is that then houses were long-term investments. They were illiquid. There was really not much people could do with that investment. That was going to be something that was going to help them out later in life, typically."

When renters became owners
In 1920, according to the U.S. Census Bureau, 46 percent of American households were renters. However, a number of factors, both political and economic, eventually transformed the landscape of home ownership in America.

In 1922, future president Herbert Hoover, then serving as President Harding's secretary of commerce, implemented the "Own Your Own Home" program, which encouraged builders to increase residential construction and called for new banking rules allowing nationally chartered banks to increase lending for residential properties.

Although some housing bubbles have occurred in the past, none has had the same adverse impact on average home values nationwide as the bursting of this one.

In addition to passing the Home Owners Loan Act in 1933, Congress created additional institutions during the 1930s to promote home ownership: the Federal Home Loan Bank system to provide a stable source of funds for banks; the Federal Housing Administration (FHA) to insure mortgages; the Federal National Mortgage Association (Fannie Mae) to buy the insured mortgages; and the Federal Savings and Loan Insurance Corp.

Meanwhile, a surplus of savings Americans accumulated during World War II, and assistance from the GI Bill for soldiers returning home, launched a housing boom in the late 1940s that saw the homeownership rate in America rise to 55 percent by 1950, according to the U.S. Census Bureau. That percentage has steadily inched upward, reaching 69 percent in 2005 before receding slightly.

A place to call home—and invest
During that period of expanding home ownership, the appreciation of home values along with tax incentives made housing an attractive investment for many Americans. In some cases, it wasn't just the best option; it was one of few options because investment opportunities were not as plentiful as today.

"Nowadays, mutual funds are easy to get into," said James Kau, chair of the University of Georgia's Department of Real Estate and cofounder and coeditor of the Journal of Real Estate Finance and Economics. "When I was young, they didn't even exist. It was difficult to get into alternative investments. You had to do things like find a stockbroker. Now there are retirement plans, and a lot of people have both stocks and housing. Housing has been the consumer durable that most people take advantage of. In many cases, it's because of taxes."

photo of row of houses

While many homeowners may not be aware of the annual appreciation of their homes in dollar terms, filling out an Internal Revenue Service 1040 long form is an annual reminder of a home's tax benefits. Through the years, Americans have been able to take advantage of a variety of tax benefits from home ownership, including mortgage interest deductions, property tax deductions, and an exemption for homeowners over 55.

In addition, when homeowners have examined the change in home value, they liked what they saw. According to U.S. Census Bureau data converted into 2009 dollars, the inflation-adjusted median U.S. home price grew from $30,600 in 1940 to $58,600 in 1960, $93,400 in 1980, and $119,600 in 2000. The median home values in the Southeast are generally below the national average, but all states have seen increases, with Florida and Georgia having the region's highest median prices (see the chart). For decades, Florida's median home price led the region, starting at $28,889 in 1940 and rising to $131,937 by 2000. Georgia, which had a median home price of $25,512 in 1940, surpassed Florida in 2000 with a median value of $139,065. At the other end of the spectrum, Mississippi's median value of $15,507 in 1940 had jumped to $89,292 by 2000.

Chart 1
Median Home Values in the Southeast, 1940–2000
chart of Median Home Values in the Southeast, 1940–2000
Note: Figures represent 2009 dollars.
Source: U.S. Census Bureau

While these increases in value hold obvious appeal to homeowners, Adams said hidden costs offset some of the asset's appreciation and disguise a home's true value as an investment.

"All the analysis I've seen shows that housing as an investment, if you hang on to it long enough, is not much different from other kinds of investments of a reasonable sort," said Adams, who did extensive research in the field for his book Housing America in the 1980s. "I bought a house in 1973 that I paid $53,000 for. It's now assessed at something like $600,000. I've done the math and know how much I've put into the house in remodeling. You might say 'Wow, isn't that great?' But you need to look at what it's worth today minus the present value of the money that was put into the house. If you compare that in compound interest rates from 1973 to the present, it's appreciated about 4 to 4.5 percent." He added that if a homeowner is not investing 2 percent of the value of a home annually into its maintenance, it's losing value to deterioration. (See the interview with Adams.)

A tale of two spikes
The housing bubble earlier this decade was not the first. Industry watchers remember well the biggest home price spike of the last half of the 20th century.

"One of the big parties in real estate was in the late '70s," Pace said. "Now we've had another big party lately. But these parties occurred for very different reasons. The '70s bubble was financially induced partly by the combination of inflation and taxes. The latest one was induced largely on the finance end by relatively easy money with no standards, comparatively."

Although spurred by different forces, the run-up in prices across the two bubbles was historically significant. According to data from the National Association of Realtors, the median price for existing housing jumped from $35,300 in 1975 to $62,200 in 1980, a 76 percent increase. The latest bubble saw median prices for existing homes jump from $139,000 in 2000 to $185,000 in 2004, a 33 percent increase.

"Back in those days, real estate was the best choice," Pace said. "In the '70s, there was no other place to go the way the taxes worked. Any gains you had were taxed at 50 percent. If I made 17 percent on a money market, I got 8.5 percent back after I paid my taxes. If you factor inflation at 10 percent, now I'm 1.5 percent worse off after tax and inflation."

Other than historic price appreciation, Pace said the most recent housing bubble had its own character.

"Until relatively recently, the transaction costs for flipping a house were very high," Pace said. "In other words, it wasn't that long ago that the closing costs were very expensive. Title insurance was more expensive. All sorts of things were more expensive, and that was a big drag to making a short-term investment.

"Another aspect was that you historically could not borrow easily as much money on a house," he added. "The lowering of transaction costs allowed you to use your home as an ATM."

Photo of cash falling out of a mail slot

The relaxation of standards and decreased transaction costs swelled the number of potential buyers in the housing market, driving demand and prices upward. But while home values rose, many owners didn't want to defer the rewards from their appreciating asset. Data from the Federal Housing Finance Agency (FHFA) dramatize a shift in the philosophy of home buyers. Beginning in 1991, when the FHFA began tracking the nature of refinanced mortgages, the percentage of home owners withdrawing equity was 10 percent or less in half of the first 18 quarters. Since the first quarter of 2001, between 30 and 49 percent of homeowners have pulled out equity each quarter. Eleven of those quarters show withdrawal rates higher than 40 percent.

Homeownership had become more than merely a long-term investment for many Americans.

Homeownership in the future
Certainly, homeowners were encouraged when the Case-Shiller index showed a net increase in home values for the second quarter of 2009. It was the first such increase since the second quarter of 2006.

The big question going forward is whether the housing market's first "green shoot" in some time will take root. At least one industry observer thinks Americans' relationship with homeownership will undergo change.

"Backing up from all of this, I expect fully that we're going to be hunkering down and building fewer houses," Adams observed. "We're going to be occupying housing more intensely, and the value of housing is going to take a hit all across the country, especially in what were the nation's fast-growing areas, simply because of the costs for maintenance and borrowing money."

Pace foresees change as well but is somewhat hopeful of what change might bring. "We'll be in a reactionary, conservative phase for a little while," he said. "But we'll be back in equilibrium before too long as the population increases. I'm not expecting a reversion back to smaller houses up next to each other as some are forecasting. It may go another direction for a while, but it will probably settle down to something that's appropriate relative to our income, which would be a new house in the 2,000 square foot range. I don't anticipate the death of the suburbs or any of these other kinds of things that some people throw out."

Whatever changes homeownership undergoes, it seems probable that more Americans will regard their home primarily as their domicile rather than an investment that comes with a roof over their heads.

This article was written by Ed English, a staff writer for EconSouth.