Cheap Advice on Real Estate

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Dean Baker
Truthout, September 17, 2007

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The recent downturn in the housing market has left me inundated with emails from people I know and people I don't know asking for advice about buying or selling a home. I don't want to get into the investment counseling business, but in an effort to discourage questions about your personal finances, I can quickly share what I know.

The basic story is that we have had an unprecedented run-up in house prices over the last dozen years. From 1895 to 1995, house prices have just kept even with the overall rate of inflation. Since 1995, house prices nationwide have risen by more 70 percent after adjusting for inflation. There is no economist who has a remotely plausible explanation for this run-up, except that the housing market is experiencing a speculative bubble, just as the stock market did in the late 90s.

Bubbles burst. While the timing is impossible to predict (at least for me), it was entirely predictable the stock market would come back to earth; and, it is entirely predictable house prices will fall back towards their trend level. If house prices fall all the way back to their trend level, this would imply a real decline of approximately 40 percent compared with their current level. It's possible some of the run-up will prove real, so that the real decline will only be 25 percent to 30 percent; but it is very difficult to imagine a scenario in which there is not a large reduction in real house prices.

Having given my two cents, I will address a few of my favorite comments from the housing bulls.

1. Housing is always a good investment in the long run.

I am not sure where this one comes from - wisdom passed down from great-grandparents or graffiti on bathroom stalls - but it is a claim that is just obviously not true. There are endless examples of cities where house prices have declines in real, and sometimes even nominal, terms over long periods of time. Most of these cities are currently depressed economically (places like Detroit and St. Louis come to mind), but the existence of such places is sufficient to show housing is not always a good investment. Many people lost their life's savings because they invested everything they own in housing.

2. Housing may decline in other areas, but New York, Boston, Washington, San Francisco and (fill in your city) is different.

People will always want to live in these places. These are all great cities, as are many others that could be added to the list. That fact tells you absolutely zero about whether house prices are over-valued. To make an analogy to the stock market, General Electric and Microsoft were both hugely profitable secure companies, but their stock price still plummeted (by 58 percent and 62 percent, respectively) in the 2000-2002 crash. Neither company's stock has yet come close to its 2000 peak, meaning that putting the money under your mattress would have been a much better investment.

The fact that people may want to live in New York or Washington doesn't mean ridiculous house prices can be sustained. If a modest middle class home costs $500k or $600k, will people working middle-class jobs be content to never be able to own a decent home? That seems unlikely; most likely they would leave, putting downward pressure on house prices. One point that should scare people owning homes in these markets is rents have not risen anywhere near as much as house sale prices. That means it is far cheaper to rent than own. Rent and house sale prices have always moved together; with rents now weakening in most areas, homeowners should be very worried about the direction of sale prices.

3. You can always live in your home.

This is my favorite because it is not clear what it is supposed to mean. You can always drive your car, but how many people want to pay $30,000 for a car that is worth $20,000? Similarly, it doesn't make sense to pay $500,000 for a house that is worth $350,000, even though you can live in it. If you want to give your money away, find a charity.

In the last 60 years, the government has pushed homeownership as a matter of public policy. While homeownership is often a good way to ensure good and secure housing, as well as to accumulate wealth, that is not true everywhere and always. Those who pushed moderate income families into homes that are now plunging in price have much to answer for. As for the higher-income people who bought into a bubble, well, we have to do something to redistribute wealth.

Dean Baker is the co-director of the Center for Economic and Policy Research (CEPR). He is the author of The Conservative Nanny State: How the Wealthy Use the Government to Stay Rich and Get Richer (www.conservativenannystate.org). He also has a blog, "Beat the Press," where he discusses the media's coverage of economic issues. You can find it at the American Prospect's web site.