Was there a housing bubble? Is it deflating?

The housing market has finished a remarkable run of price increases and construction spending. Inflation-adjusted national price growth has been well above long-term trend for the past ten years, and the number of housing units built in 2005 was 1/3 higher than the number built in 2000--and we thought 2000 was a very good year.

Within the past couple of quarters, this all seems to have come to a screeching halt. According to the National Association of Realtors, the nominal median house price has been flat over the past year, meaning that in inflation-adjusted terms, prices are falling. Moreover, the median house price masks certain things--it doesn't take into account the mix of housing sold (people generally by bigger houses when prices are not rising), and doesn't take into account concessions such as free cable, closing-cost help, free cars, etc.

The question, then, is whether this means that a "bubble" has burst--that a sepculative frenzy in housing has wound or is winding down. The answer is likely "no."

A bubble implies an asset market that is out of equilibrium--that cannot be explained by fundamentals. In the case of housing, there are two basic fundamentals--rent (which is the dividend that housing pays) and the cost of capital. Even owners pay rent--they just pay it to themselves. As rents rise, so do house prices; as the cost of capital falls, house prices rise. In the vast majority of markets in the United States, it made economic sense for households to buy houses at market prices until recently; the exceptions were some places in California and Boston, about which I will say more in another post.

Two important fundamentals of changed over the past couple of years. First, mortgage interest rates have risen, and mortgage rates on adjustable rate mortgages have risen a lot. This fact by itself will depress house prices. A paper I wrote with Pat Hendershott and Dennis Capozza in the 1990s used data from 63 metropolitan areas to show that the relationship between house prices and rents is sensitive to the cost of capital. Second, planning boards have come to understand that the only way to make housing more affordable in areas with expensive land is to allow more density. We have consequently seen a boom in condominium construction. This places downward pressure on implicit rents. Hence the fundamentals have changed in a direction such that we would expect to see real house prices retreat.

The market is regulating itself somewhat already. Building permits are off 7 percent from last year, and will likely fall even further. This has serious macroeconomic consequences that I will discuss in another post. But it also is an important precurser to the housing market having a soft landing.