Friday, October 22, 2004

Housing bubble possibility concerns many homeowners

Though we have witnessed a period of rapidly increasing housing prices, similar increases in price have occurred in the recent past without resulting in a major drop.

Additionally, the housing market has historically demonstrated the ability to withstand a sharp increase in interest rates without sustaining a major correction in housing prices.

Still, given that most American households retain the bulk of their wealth in their homes, even the possibility of a housing bubble is a cause for concern. An additional factor that concerns many experts is the prevalence of adjustable rate mortgages and its potential effect on the stability of the housing market in the event that interest rates rise.

Let's start with a look at prices. The chart below shows median home prices from 1968 to the present day (1968 is the year the National Association of Realtors began tracking housing prices). Despite several corrective cycles in the U.S. stock markets during this period, housing prices have, overall, increased steadily. The few downward adjustments have been small relative to the steady increases in the home prices.

For instance from November 1972 through November 1982, home prices increased 250 percent from $28,800 to $100,800. Subsequently the home prices suffered one of the worst periods between 1982 and 1983, when prices fell from $100,800 (November 1982) to $90,900 (September 1983). This translates to a 9.8 percent price decline, and prices did not recover to 1982 highs until May 1986. Another decline in housing prices occurred from April 1991 through February 1993 when prices declined 8.7 percent (from $140,600 to $128,400), and prices did not recover to the highs until June 1994.

What about interest rates? Many who argue that a housing bubble currently exists cite that an extended period of historically low interest rates has artificially escalated prices, and so a rise in interest rates will cause a fall in prices. There is little doubt that the period of falling and historically low interest rates since the mid-1990s has helped to increase prices. But the assertion that higher interest rates will lead to a downward trend in housing prices is incorrect. In fact, history tells the opposite story.

Consider the period between April 1977 and September 1981, when interest rates (10 year U.S. Treasury Bond Yields) increased from 7.2 percent and touched as high as 15.8 percent. During this same period real estate prices increased from a median value of $58,100 to $95,500, a 64 percent increase.

A possible explanation is that real estate generally fares well in periods of high or rising inflation. A period of rising interest rates typically coincides with rising inflation, which would tend to increase housing prices. When inflation is present, household incomes tend to rise, as do the costs of construction, labor and other inputs, all of which would tend to increase prices.