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Saturday, September 24, 2005

Housing Bubble or Housing Froth?

Recently, as discussed in this post, Chris Mayer of Columbia Business School, Charles Himmelberg of the New York Fed, and Todd Sinai of Wharton argued there is no housing bubble.  Peter Coy of BusinessWeek Online's Hot Property blog is not persuaded.  Neither is Jan Hatzius, a Goldman Sachs economist who has written extensively on the housing market:

Housing Markets Are Stable ... Until They're Not," Hot Property: Three top economists made a splash on the Wall Street Journal's editorial page this past Monday with a piece headlined "Bubble Trouble? Not Likely." But ... [t]hey assume, without strong evidence, that buyers in each market will continue to expect the same kind of price gains that they've averaged over the past 60 years. If you expect prices to keep rising rapidly, you'll be willing to pay a whole lot today. The market will be stable. But what if buyers in, say, San Francisco suddenly turn pessimistic about the rate of future price increases? ... If they lose faith that the market will climb steeply ad infinitum, then ... the market will tank. That's practically the definition of a popping bubble. By assuming from the start that such a thing won't happen, the authors are assuming their conclusion. ... I spoke with Todd Sinai ... co-author on the paper ... Sinai defended the paper. He said ... hot cities like San Francisco are pretty much built-up, so people are competing to live there by outbidding each other ... That ... can continue as long as there are rich people in other parts of the country who would really rather live in San Francisco. I'm not so sure. It feels to me like San Francisco, San Diego, Los Angeles, New York, Miami, Boston, and other costly markets are pricing themselves out of reach. ... If they stop expecting rapid house appreciation, their willingness to pay will fall. And the market could drop rather suddenly. The authors certainly didn't persuade me that there's no bubble.

Goldman Sachs Economist on the Bubble, Hot Property: Just got off the phone with Jan Hatzius, a Goldman Sachs economist who has written extensively on the housing market. He gave me permission to post a research note ... he wrote ... about the same academic study that I questioned in a post yesterday. Hatzius says he's not sure I'm correct that the authors of the study assumed their conclusion. His criticisms are different. The biggest one is that the authors ended their analysis too soon--last year--missing the further inflation of housing prices since then. Here's what he wrote:

Bubble Trouble? Probably Yes

Monday's Wall Street Journal featured an op-ed by Christopher Mayer and Todd Sinai, two academic real estate analysts, who argue that worries about a housing bubble are overblown. ... Himmelberg, Mayer, and Sinai (HMS) calculate the total cost of owner occupation as the sum of interest, depreciation, property taxes, and a risk premium for taking on house price risk, and then adjust these costs for the tax deductibility of mortgage interest and property taxes as well as a term for expected capital gains. They call the resulting measure 'imputed rent,' divide it by an index of actual rents, and set the resulting ratio equal to 1 for the average of the 1980-2004 period. They then argue that a metropolitan housing market is overvalued relative to its own history when the ratio is above 1 and undervalued when the ratio is below 1. Their main result is that 31 out of their 46 metropolitan housing markets had values below 1 as of 2004. Of the markets usually considered 'hot,' New York, San Francisco, and Phoenix had values below 1, while Boston, Los Angeles, and Washington DC, had values just marginally above 1; only Portland, San Diego, and Miami showed some cause for concern. HMS conclude that there is no evidence for a general housing bubble, and not even much evidence for a localized bubble.

What do we make of this analysis? Of course, HMS are right that interest rates matter for valuing capital assets such as residential homes. ... But ... on the narrower point, namely whether house prices are out of line with rents and interest rates, we are somewhat skeptical ... First, the results are sensitive to minor changes in the assumptions ... For example, HMS assume that households require a constant risk premium of 2 percentage points for owning instead of renting, and that they expect the rate of capital gains to be equal to the 1940-2004 average for their metropolitan area. Of course, it is impossible to know whether these or any other assumptions about unobservable concepts such as risk premia or expectations are correct. ... the precise choice of numbers can make a qualitative difference to the results... Second, the analysis uses annual data that end in 2004. This is unfortunate, because the case for an outright housing bubble was still quite weak as of 2004 but has grown much stronger since then. ... Thus, an analysis along the lines of the HMS paper that used more up-to-date inputs would probably come to a considerably more cautionary conclusion.

Of course, comparing the economic costs of owning with the economic costs of renting is not the only way of adjusting house prices for changes in the fundamentals, including interest rates. Our own preference remains with an 'affordability' concept that asks what percentage of their disposable income households must expend to cover mortgage payments on the median-priced home. This approach not only relates house prices to incomes -- compared with rents, probably a more meaningful comparison for most US households residing in the suburbs -- but it also recognizes that the vast majority of households are unable to borrow as much as they want and therefore cannot engage in the theoretically 'pure' arbitrage considerations assumed by HMS. As we described in detail in the May-June Pocket Chartroom, housing affordability is deteriorating quickly. ... For example, the National Association of Realtors -- not an organization known for excessive bearishness on the housing market -- reports that their US affordability index now stands at the lowest level since 1991. Thus, housing valuations are stretched, and are becoming more stretched the longer the current boom continues.

Jan Hatzius

Thanks to Jan Hatzius for allowing us to reproduce the above note.

    Posted by on Saturday, September 24, 2005 at 12:48 AM in Economics, Housing | Permalink  TrackBack (0)  Comments (13)


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