US Real Estate Boom Turning Bust?

The magnitude of home price increases in recent years, especially on the two coasts, has been great enough to inspire comparisons to that other recent boom, when the NASDAQ index seemed to reach inexorably for the sky and if you were not in technology, you were surely a fool or an old economy dullard. Those who purchase homes today, either as a residence or investment, typically view the investment as low risk, and those who question the fundamentals of the current market are scorned with enough fervor to recall those heady days in 1999 and 2000 when tech skeptics were relegated to the local mental ward. Prices always go up, they say, and look how cheap the mortgage is! Los Angeles is up 25% in the past year. San Diego is up 20%. Miami has exploded for a 23% gain. Could Americans be suffering a national delusion with greater implications than those of even our largest financial mania to date, the stock boom of the nineties?

The numbers say yes.

After years of strong percentage increases, home prices in most parts of the nation have turned down in recent quarters. According to the National Association of Realtors, of the 131 metro areas tracked in the fourth quarter of 2003, 80% showed price declines compared to the third quarter of 2003. And 56% of the metro areas showed price declines compared to the second quarter of 2003, six months prior. Leaders in the declines include: Philadelphia (11% decline compared to previous quarter), Denver (7%), New Orleans (8%), Newark (10%), Pittsburgh (10%), and St. Louis (10%). Even in California, it appears, home prices are topping out, as the January numbers provided by the California Association of Realtors showed that 53% of the areas tracked experienced declines compared to the prior month, and in February the general trend continued with 28% of the areas showing declines. Texas seems to be in the incipient stages of one of its legendary busts, as home prices have declined on a year over year basis in cities such as Dallas and Houston, and fully 42% of the MLS areas tracked by Texas A&M showed annual price declines during the first two months of 2004.

The culprit for the end to boom times is apparently an accumulation of excessive debt, as opposed to the usual rise in interest rates. According to The Federal Reserve, household debt increased by 45% since 1999 and now stands at $9.4 trillion. The overall indebtedness of the nation is $34.5 trillion, approaching 350% of GDP, a level never before witnessed in a major developed economy.

According to historical measures, home prices are reaching relative levels not seen since the late 1970’s. One reliable way to measure relative home prices is to compare the average price to the average rent. Another is to compare home prices to income. In the chart below, I’ve compared the annual House Price Index (HPI) supplied by the Office of Federal Housing Enterprise Oversight (OFHEO) to the national income per capita (GDP/capita) for each year since 1975. As can be seen from the graph, home prices compared to income are at their highest levels since 1980, a year that was followed by price declines in many markets.

Americans have become reliant on debt, in the form of inexpensive mortgage credit and consumer credit. Debt has been wonderful as real estate prices have spiraled upward, yet when asset values begin to decline, as they have now, the cycle of descent is only reinforced by the debt burden, which ensures sales by increasingly overextended homeowners. The national foreclosure rate has recently hit a historical high, indicating that the stress of excessive debt has already begun to impact the supply of homes coming to market.

Many observers label the current stock market rally Act II of the great mania of the nineties. 

Perhaps the real encore is taking place in each American family's home.

(Update as of May 17, 2004:  statistics released for the first quarter show that home prices have continued to fall in most of the nation's metro areas, with quarterly declines taking place in 49% of all cities tracked, and declines over the quarter six months prior taking place in 74% of all cities tracked.)