Tuesday, July 7, 2009

Remind Me Why Your House Should Be Worth More Tomorrow?

Over at Economist's View, Mark Thoma discusses the widespread belief that housing prices will rise long-term, versus evidence that shows that this may not be true. Since I think many people would dismiss this evidence, I'd like to take a quick look at why this might be the case.

I'd start by asking why we would assume that a class of assets would appreciate over time. In order for this to happen, we would need the supply of them to decrease, or demand to increase, or both.

It occurred to me that it might be helpful to list the reasons that home prices might increase, as well as the reasons that they might decrease. Feel free to add to the list in the comment section.

Reasons for price increases:

1. The supply of homes on the market decreases, resulting in competition among buyers and a bidding up of prices.

I can see no reason why this would result in a long-term increase in prices, as the market would presumably respond by increasing the supply until the prices return to an equilibrium. Unless

2. There is a limited supply of new homes.

While in certain localized areas (Jackson Hole, where I live, for example), there is a limited amount of land available for new homes, overall, there is no reason to believe that we are on the verge of running out of room in the foreseeable future. Of course, if people believe that we will run out of room, this could certainly impact prices. But I don't think that it would impact them in the long-term, as market corrections would tend to make people recognize the reality.

3. There is a demand for bigger and more expensive homes.

If the trend is to buy more expensive homes, then the average price of all homes will increase. This could result in long-term price increases, but only if it's sustainable- in other words, only if consumer preferences stay the same and income levels remain sufficient to pay for them. If every homeowner believes that they need to buy a 6000 square ft home with a pool, then prices will increase.

4. New regulations, commodity, or labor increases increase the cost of building a new home.

This is certainly possible, although it cuts both ways. Builders are getting more efficient at building, as well.

Here are some reasons prices could or should fall.

1. A home should depreciate in value.

A 30 year old home should not be worth more than a new one, if for no other reason than wear and tear. It should be worth less, unless there is a greater increase in value due to one of the reasons above. So we should start with this premise. Every day, your home should be worth less, and you need an increase in value due to demand or supply changes just to keep up.

2. Homes become less expensive to build.

If builders become more efficient at building homes, and labor, material, and regulatory costs decrease or stay the same, homes could easily become less expensive to build. So the house that cost $300,000 to build 2 years ago now only cost $200,000. This could result in sustainable downward pressure on prices. As someone who has personally helped build a house, I can attest to that fact that technological advances are making home-building less costly.

If you think this is not possible, look at the recent prices decreases in computers, for example, or HDTV's. Increases in efficiency will be long-term. How much do you think that state of the art desktop you bought 5 years ago is worth today, even if it's never been used?

3. There could simply be a long-term trend away from preferences for expensive homes.

I think that this is not only possible, but likely. While we may not see large-scale use of these anytime soon, it's very likely that consumers will start to see the folly in wasting money on homes that are mostly for show and inconvenient and costly to live in. If this happens, then the prices on these large homes will continue to drop. The impact of changing attitudes towards environmental issues could devastate the market for large homes.

4. Demand could drop overall. There is no reason that population increases, which drive demand, will increase forever. Population growth rates are already negative in many European countries, and this is a trend that could easily affect us as well.

Taken together, it looks at first glance as though there are plenty of reasons for short-term gains in housing prices, but even more reasons for long-term decreases.

I think we need to stop looking at homes as investments. They generally do not produce marginal wealth. You can invest in a building that will be used as a factory, for example. But you purchase a home. Fundamentally, it's no different than buying a car or a computer or a boat, except that you pay for it over a much longer period of time. During bubbles, people have a tendency to look at these sorts of assets as investments. But they really are not. And this is a critical point that many people fail to see.

Having said all that, I think I should put my money where my mouth is and get my house listed.


  1. I think two scenarios are likely. One of them you have touched on.
    1)A regulatory overhaul embracing a "green policy" could place premiums on already existing inventories as these are presumably not subject to new "green" standards. Also, further restrictions on land developement could price artificial premiums into the mix.

    2)Inflation. The Federal Reserve has massively expanded the monetary base in the US. That money has to go somewhere eventually. Inflation will probably trigger an increase in nominal prices of homes.

  2. Good point about further regulation.

    And real estate could be a good hedge against inflation if nominal wages keep up. But I don't know how likely this is. And if they don't, expensive houses will be hard to afford.