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The House Price Bubble: Won't Get Fooled Again

Despite widespread talk, the evidence for a housing bubble is still murky. Here's where we should expect problems.

| Mon Apr. 10, 2006 2:00 AM EDT
Article created by The Century Foundation.

One of my all time favorite rock albums is The Who’s “Who’s Next” and one of my favorite tracks on that album is “Won’t Get Fooled Again.” Right now there is much talk of a housing bubble, making for the possibility that a lot of people are getting fooled.

There are two ways to assess whether there is a housing bubble. The first can be termed the “historical approach,” and it involves looking at the historical relationship between house prices, levels of income, interest rates, and demographic factors. According to that approach house prices look significantly out of whack.

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The second can be termed the “comparable cost approach,” and it involves comparing the relative cost of renting versus buying. A recent study by Professors Gary and Margaret Smith of Pomona College in Southern California uses this approach and concludes that house prices are generally not over-valued. Their findings have quickly been advertised by the mainstream media (New York Times, Saturday April 1, 2006), but the comparable cost approach has serious limitations. In the spirit of openness, here are some cautions about their conclusion.

People buy houses to enjoy the accommodation services that houses provide. An alternative way to get those services is to rent an equivalent house. If over the lifetime of occupancy, a house can be rented for less than it can be purchased this would suggest house prices are over-valued. Such a comparison involves a complicated calculation involving assumptions about future rents, future home ownership costs, and future house price appreciation that determines what an owner gets when they sell. Using this method, and assuming future annual rent increases and house price appreciation of three percent, the Smiths found that house prices were fair to under-valued, except in a few areas.

The main problem with the Smith’s study is that it assumes away the bubble. Their baseline calculation assumes a three percent annual increase in house prices, which automatically means no bubble. If prices keep rising, there cannot by definition have been a bubble.

That leads to the core problem with the comparable cost approach, which is that it provides no insights into future prices of houses or rents. Instead, it compares existing house prices with existing rents and factors in an assumed future path for prices and rents. That makes it a good tool for framing the “rent or buy” decision, but not for predicting future prices. It is possible that rents today are too high and could fall and drag down house prices. Alternatively, house prices could fall and drag down rents. There is some evidence that both may happen, but this vital evidence is ignored.

House builders are reporting record profits, which means that cost of building homes is significantly below the price of homes. Consequently, builders have an incentive to keep building homes and adding to the supply of homes until prices return closer to building costs. Given today’s prices and costs, new house construction promises to keep the lid on home prices and possibly lower them.

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