Booming housing market today presents serious risk for future

We are currently in the midst of a six-year boom in home prices. Aided by a growing economy, favorable demographic trends, monetary accommodation, lax government housing agency underwriting policies, and consumer expectations of continuing home price appreciation, the demand for housing is booming. If the past is prologue, prices will correct when demand flattens as the economy cools or credit conditions tighten.

Large swings in asset prices are nearly always driven by changes in investor demand. Investor demand is volatile, while asset supplies change slowly over time. This is true for traditional financial assets like stocks and bonds, for real assets like homes, and for nontraditional assets like bitcoin and digital currencies. Most government policies impact asset prices by altering investor demand and housing is no different.

{mosads}But many argue that we are in the midst of a housing shortage, so this time will be different. A comment by the Urban Institute typifies this view that the “rapid increase in house prices is being driven largely by a shortage of housing units.” The problem is that asset boom and bust cycles are nearly always driven by changes in demand. When the boom in demand subsides, housing supply conditions have little predictive power regarding the size of the resulting home price correction.

When demand temporarily exceeds supply, prices rise. Whether or not the price increase is sustainable depends primarily on whether the strength in demand is sustainable. For this, credit conditions are key. In the case of housing, lax government lending policies directly impact housing demand through the activities of Fannie Mae, Freddie Mac, the Federal Housing Administration, and the Veterans Administration.

In his 1949 classic textbook, “Urban Land Economics,” Richard Ratcliff states that the “essential nature of housing demand is changeability” and the “nature of housing supply is rigidity.” When the pace of home sales picks up and inventories fall, expectations of future price increases stoke demand as potential buyers who have “missed out” and speculators become increasingly willing to bid up prices. Procyclical government credit policies provide the leverage that enables purchasers to chase rising prices. When expectations change, a market correction occurs.

One way to measure the balance between supply and demand is how long it would take to clear the inventory of home listings. In March, the United States had the lowest supply of existing homes for sale in 18 years. In 2005 and 2006, near the top of the last housing cycle, it took four months of sales to clear listings. In both cases, tight home  inventories correctly predicted price increases in the coming months, but neither the inventory sales ratio nor the rate of new home construction can accurately be used to estimate whether price increases will be sustained over time.

We analyzed the price change patterns experienced by the 50 largest metropolitan areas during the last housing cycle. Home prices uniformly rose between 2002 and 2006 and uniformly declined from 2007 to 2011, regardless of above or below normal trends in new construction. In areas that added new homes over the boom period at a pace that was twice the average rate over the prior 20 years, home prices boomed by about 51 percent over five years, and fell by 25 percent during the bust.

In metropolitan areas that added new homes during the boom just above their historical average, prices rose by 46 percent on average during the boom and declined 32 percent on average during the bust. For the group of metropolitan areas that experienced a below normal pace of homebuilding, home prices rose 80 percent on average during the boom, but declined by 31 percent on average over the bust.

In Fort Lauderdale, new home construction averaged 40 percent less than its long run average during the price boom, yet it experienced a 54 percent decline in prices from 2007 to 2011. San Jose similarly underbuilt but suffered only a 32 percent decline during the bust. Phoenix famously built homes at a rate unseen in its history and subsequently suffered a 56 percent price decline. Austin also built at twice its historical average between 2002 and 2006 and experienced little price decline during the Great Recession. All four of these metropolitan areas had less than six months supply of inventory for sale in 2005.

In housing markets, demand evaporates once home prices begin to decline. Not only does demand decline from those chasing capital gains, but from borrowers at the extreme margins of qualifying for a home mortgage. Once the market enters the bust phase, negative economic shocks are amplified when marginally qualified households are forced to sell their homes in a buyers market. Restrictive land use policies can contribute to the price pressures generated by homebuyers, speculators and lax credit standards, but history clearly shows that home supply responses alone will not eliminate the risk of substantial price corrections once these demand pressures are withdrawn.

The housing market today has too much highly leveraged demand from investors and buyers chasing available supply. As a result, real home prices have increased 25 percent since the early 2012 low, a pattern mirroring the early years of the last price boom. So long as this price boom continues, the risk of a serious correction increases. Tightening government housing agency underwriting policies today is the best way to reduce the potential for large home price declines in the future.

Lynn Fisher and Edward Pinto are the directors of the Center on Housing Markets and Finance at the American Enterprise Institute. Paul Kupiec is a resident scholar focused on finance at the American Enterprise Institute.