U.S. Real Estate: Ongoing Boom or Looming Bust

U.S. Real Estate: Ongoing Boom or Looming Bust

The topics of discussion that financial planning clients bring to initial or review meetings tend to shift over time. Education planning was a major theme last year, as parents and grandparents grappled with how to pay for private high school or college tuition or both. This year, real estate has been a primary topic of conversation for several reasons.

Refinancing, for one, has been a helpful way for couples to reduce their living expenses or to subsume other, more costly debts. Alternatively, some individuals or couples have used cash out refinancing to create additional liquidity. And since their new mortgage rates are inevitably lower than the prior rates, in many instances they can keep their mortgage payment constant, even with a higher mortgage balance.

But the recent focus on real estate does not end with matters relating to clients’ homes. Clients are also becoming interested in real estate as an investment. This is due to the fact that last year was a good one for real estate, particularly in certain areas of the country. Housing prices in metropolitan Phoenix, for instance, rose 23% in 2012 according to the S&P/Case-Shiller Index, which measures the cost of residential real estate in the United States. While that kind of appreciation is difficult to ignore, it is important to consider history before getting too excited.

According to the Case-Shiller Index, in the period from 1896 to 1996, the market price of the average American home increased an unremarkable 6% after adjusting for inflation. That’s 6% total, not annualized, over the 100-year period. The exceptions to these pedestrian real returns only occurred during real estate booms, and there have only been two on record from 1896 to the present time.

The first occurred between 1940 and 1960. During that stretch, an important cultural shift occurred. Post-Depression, post-WW II Americans not only created a baby boom, but an age of prosperity, and at the same time became dedicated savers. This created a situation in which the rate of homeownership rose from 44% to 62%. The price of the average American home rose by 60%.

The second real estate boom took place in the 2000’s, but there was less fundamental economic support. The sharp declines after this boom suggest that this second boom was more of a debt-fueled bubble.

Many have made the case that if this is a boom, it is not fragile—yet. The current inventory is low. In fact, the number of homes for sale—approximately 1.6 million—is the smallest since 2001. Artificially low mortgage rates have made owning a bigger home more affordable. The family with a $500K mortgage at 6% can now afford a $630K mortgage at 4%. That is more house for the money, but we also should take a look at the new household formation statistics.

New household formation statistics track the number of college graduates who move into rental properties or buy a home, as opposed to moving back in with their parents after college. New household formations have trended low in recent years, a possible reason that the Housing Vacancy Survey of the Bureau of Census shows a slight drop in U.S. homeownership rates from 66.0% in 2011 to 64.4% in 2012. If these “boomerang kids” eventually become employed and move out of their parents’ houses into homes of their own, additional pressure will be placed on the limited inventory of homes available and lift home prices again. It’s simply too soon to tell. In any case, when viewed from the long-term perspective provided by the Case-Shiller Index, the dream of “making a killing” in the real estate market is much harder to realize than many are willing to admit.

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