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August 17, 2007

« Super-Star Neighborhoods | Main | Room to Grow »

Edag270_ranson_20070816230756_2 Its hard to avoid talking about housing in the US right now. From the supposed 'sub-prime' meltdown to slow sales and rising mortgage rates; writers, pundits, and traders are having a field day. Check out this fascinating Op-Ed by David Ranson in today's WSJ (sub required). He offers some great economic insights from Milton Friedman and argues that US housing is undervalued right now. Its always nice to listen to  theories that challenge the conventional wisdom. Read the long snippet below and let us know if its time to go house hunting for a bigger place!

posted by David

Is Housing Undervalued?

by David Ranson

The housing market isn't nearly as mysterious as it seems. Much public confusion stems from our failure to clearly define our terms. Take the popular, long-standing belief that housing is overpriced and unaffordable relative to income. It was said 30 years ago and it is still being said today. The key to solving this puzzle is to widen the definition of income so that it includes the increase in existing wealth. Milton Friedman, in the course of the work on consumer spending that won him a Nobel Prize, introduced a much broader, long-term measure of income called "permanent income" -- including capital gains, physical assets and factors like education that would affect a consumer's earning potential.

Permanent income grows at the same rate as wealth, and generally faster than conventional forms of income. Friedman demonstrated that households base their spending decisions on permanent income rather than on narrowly defined income, such as short-term wages. Fifty years later this idea has yet to sink into our national consciousness. Yet, in a highly developed and wealthy country such as the U.S., annual gains in the value of pre-existing assets are getting larger and larger relative to annual cash income from wages, rents and dividends.

Home prices behave the way they do because housing is not a typical consumer good. Rather, it is a capital asset for which the price is set by the markets for capital assets. These markets continually clear in a way that typical consumption markets do not, and housing is therefore being constantly re-priced. In this limited sense, real-estate prices behave like the prices of other tangible assets such as commodities. Of course, in other ways housing is quite unlike a commodity -- it is immobile, provides services such as shelter to its owners, and its price is geographically very specific. Still, the general level of housing prices, when measured as an index, is as acutely and promptly sensitive to an uptick in inflationary pressures as are other forms of financial or tangible capital.

Inflation tends to boost housing prices in the same way that it boosts the price of any tangible asset. And inflation is surely a major part of the housing-price story. Over the past three decades, the price of housing at the national level has risen at a rate similar to the growth of nominal GDP, and the correlation between housing prices and GDP is statistically significant. But the relationship between housing prices and the prices of highly inflation-sensitive assets such as commodities is much more impressive than the relationship with the economy. There is a particularly strong correlation between percentage changes in housing prices and percentage changes in the price of gold -- especially when a short time lag is taken into account.
When paper money is depreciating rapidly, as in the last five years, it is normal for tangible assets such as housing to appreciate more rapidly than usual, while financial assets such as stocks and bonds tend to perform relatively poorly. This can be understood in terms of the flow of financial capital from one economic haven to another. Capital is mobile. It flows out of assets that are vulnerable to the dollar's depreciation, and into assets that are invulnerable. Capital promotes growth and price appreciation in the sectors into which it migrates, at the expense of the sectors from which it escapes.

Instead of viewing the price performance of housing during the first half of the current decade as a "bubble," I see it as having appreciated for the same reason that the prices of commodities and other tangible assets have appreciated. In nominal dollar terms these prices have to rise in order to maintain the status quo in real terms. The rise in housing prices is one more symptom or early warning of the inflation of which the Fed (rightly) is so fearful.

To better understand housing-market trends, we need to clearly distinguish between real and nominal terms. I define the "real price of housing" as the ratio of the national home-price index to an index of precious-metals prices, while the nominal value refers to the price in dollars. Failure to draw this distinction can cause great confusion. For example, the annual gain in the nominal price of housing averaged 4.8% in all the years in which the Fed lowered interest rates, and averaged 7.3% in all the years in which the Fed pushed interest rates up. This calculation, at least in nominal terms, directly contradicts the popular belief that higher interest rates bring real-estate prices down. When the above calculation is repeated using the real price of housing instead of the nominal price, however, the inverse relationship appears. Higher interest rates do tend to depress real housing prices, and this can happen without any significant fall in nominal housing prices.

Expressing the price of housing in real terms not only clarifies the interest-rate confusion, it also changes the overall housing picture. The accompanying graph shows the history of the real national home-price index over the past 30 years. Notice how, during the current decade, instead of the continuing rise in nominal housing prices that made everyone so fearful, in real terms there has been a significant decline. Far from a bull-market bubble that has begun to collapse, housing when viewed in real terms has been in a bear market since the beginning of the decade.

Moreover, like the real price of oil, the real price of housing consistently reverts to the norm. In particular, housing prices have a strong tendency to rise when they have underperformed precious-metals prices. The graph illustrates how the real price of housing sticks to a steadily rising trend over the long haul, occasionally diverging from this trend but afterwards reverting to it. According to the same data, the real price of housing was 30% above its norm as recently as 2001.

Since that time commodity-price inflation has escalated, and nominal housing prices have lagged far behind. The graph suggests that housing prices are now 30% below their equilibrium in terms of the precious-metals benchmark. Any further decline in the ratio plotted in the chart would transcend the bounds of historical experience. The last time that housing prices underperformed the precious-metals market as dramatically as this was in the 1978-80 period, after which they bounced back dramatically...

Housing prices are thus much less enigmatic than they seem. The nation's wealth and its permanent income are growing consistently, and housing is the largest of all the capital asset vehicles in which wealth can be lodged. At the national level, housing prices are not bounded by the growth of wages or other forms of conventional income. Nor are they subject to "irrational" booms or busts. Instead, they respond perfectly rationally to inflationary forces that drive other capital assets and commodities. The real value of housing is much more stable than the currency unit in which housing prices are expressed.

What do you think?

posted by David


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How about house hunting for a smaller place, perhaps in a better area?


Good point Ken.

John Q. Public

Ranson is a rank hack. What a load of baloney......

Econ 101

wages aren't geared to commodity prices. You can't spend "permanent Income". You cannot qualify for a loan based on "permanent income". You can however qualify for a subprime loan using ficticious income and job documents and count on Home Price Appreciation to bail you out with a refinance. This is what caused the housing bubble. No mistake. Get a dose of reality Mr. Ranson.

Louisville real estate

I agree with John Q. Public and Econ 101. I think Mr. Ranson needs to re-think his stance.

Hayden Fisher

The article is well-written, researched and reasoned. There are always short-term winners and losers whenever a state of flux (or enlightenment) descends upon a particular market. Many sub-prime lenders and other investors are losing today because they exercised POOR BUSINESS JUDGMENT just as the folks in Detroit have done; accordingly, the market is eliminating them, as it should. That should in no way suggest that the housing market as a whole is inflated, a poor investment vehicle or a reason to be pessimistic generally. It should also be noted, especially here, that much of the rapid property value appreciation can be attributed to URBAN RENEWAL and REVITALIZATION of decayed structures; the improvements to these fixed assets can hardly burst. The depressing news is that short-term capital is being withheld due to a state of fear; that will slow down economic growth during the immediate future.


Actually the article by Ranson supports the notion of a huge perhaps 50% decline in real terms of housing in the next few months and years. If you look at the graph of the housing prices on his graph from 1975 to 1980 the index went down by half from 100 to 50. In 1980 the price of gold peaked at over $800 per ounce and there was a monetary crisis with high inflation. Today gold is on an uptrend at $650-$660 per ounce. There is high inflation in commodities such as food and energy. Futhermore, there is a potential dollar crisis with the dollar sitting under 80.50 on the dollar index. If the dollar falls below 80.0 then a there is a good change for a freefall causing imported goods and commodities to shoot up in value while wages stagnate due to offshore outsourcing and globalization. Thus , wages will go down in real terms as well as the real values of the housing prices that depend on American wages. Housing at this time is not a good investment but gold and silver is a good investment.


Also, watch out for September 19, 2007 as a day for the start of a possible dollar crisis and market turmoil since Sept 18 is the day the Fed meets and may cut the fed funds interest rate which might start a dollar collapse. Foreign lenders may start withdrawing their money from America in order to get a higher interest rate elsewhere.

Michael Wells

Interesting analysis, if a little theoretical. Most people aren't choosing between buying a house and investing in gold, they're deciding between a house and a new SUV. For the average relatively financially unsophisticated American, housing is an easy and safe decision without wracking their brain over market timing or gold vs. stocks.

Buying a home is an emotional and long-term investment. The average American moves every 7 years, but I'd guess that renters move more often than owners. Someone who stays in a house 10 years, leveraging their investment with a mortgage and deducting interest, almost always makes money when they sell (the 80's were an aberration in the last half-century).

Michael Wells

Hayden's right, "much of the rapid property value appreciation can be attributed to URBAN RENEWAL and REVITALIZATION of decayed structures". This is the upside of the gentrification that we're seeing in most creative class cities.

I was also thinking of my neighborhood, which isn't decaying, but of 10 existing houses on our block, seven have had significant remodels or additions in the last decade -- partly because of cheap refinancing. In addition, four new houses have been "infilled" across the street on a slope that was considered unbuildable until prices made it economically feasible.

Is this level of remodeling going on elsewhere, I wonder? If so, how much does it have to do with the increase in house prices? As Hayden says, "the improvements to these fixed assets can hardly burst."

michael jones

Real estate business offers lots of opportunities. And the possibility of buying such is growing higher each day.


Intriguing article. Thanks for posting it. I have a different angle of comment from the other commenters...

Looking at that chart, and the issue of the ratio of commodity prices to housing prices recently, I wonder if the story is more the commodity prices being at an unprecedented level (because of the rise of China, trouble in the middle east, increased global consumption generally, etc.).

It seems a better interpretation of this data might be that the "terms of trade" (so to speak) between US real estate prices and commodities may have been permanently altered by shifts in global capital flows and world economic development.

(Incidentally, I've been unable to post for a while on this blog. Kept getting time outs using Internet Explorer. Decided to try with Firefox this time. Voila.)

Apartment Buildings

Interesting site for tips on selling you apartment complex and other ideas. Also appears to have some information on HUD and other goverment apartment building mortgages. www.apartmentbuildingsforsaletips.com

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