A New, Lower Normal for Home-Price Appreciation?

In the wake of the housing bubble, Americans aren't feeling so keen on the once commonly-held view that a home is a good investment. Sure, it can pay dividends once paid off -- there's no question that you save money when you have nothing more to pay for your shelter other than occasional maintenance. But some analysts have attempted to show that, on average, home prices never really rise if you take inflation into account. This means that there's no reason to expect home value appreciation to exceed the rate of inflation over an extended period. Is this right?

It might depend on what data you're using. Robert Shiller is one such economist who claims that home values are steady if you account for inflation, but Bill McBride at Calculated Risk doesn't like his data. Basically, the quibble amounts to Shiller having used Federal Housing Finance Agency data in the 1970s, which he says doesn't capture the entire market well enough.

In a blog post, he recalculates the Shiller index using Freddie Mac data instead and also considers CoreLogic's index. Doing so, he finds an upward slope in housing prices for both, even after inflation is taken into account. Here's the chart:

RealHousePricesShiller2 CalcRisk.jpg

Although he doesn't provide values, I tried to eye it to come up with annual returns. The red dashed line (Shiller's recalculated) apprears to indicate a return of around 0.5%, while the blue dashed line (CoreLogic) appears to indicate a return of around 0.8%. Neither are going to make you rich, but each is definitely greater than zero.

So why would there be an increase, in theory? McBride says population can make the difference. This makes sense from a theoretical perspective. If an area sees its population boom, its housing supply isn't likely to meet the rising demand for some time. Over that period when demand exceeds supply, prices will rise faster. While supply will eventually catch up, prices should remain at the elevated level even when it does. At that time, however, the return on housing should again approach zero, unless/until another population boom occurs. Of course, if irrational exuberance takes hold and supply ends up exceeding demand for a period of time, then price appreciation could slow below the trend.

The debate on the path of real home prices matters when looking for the housing market's bottom. As you can see from the chart above, if CoreLogic's trend line is right, then home prices might not have that far to fall after all. Of course, they could overshoot.

I wonder, though, whether that overshoot could be a path towards a permanent decline in the appreciation path of home prices. Just like consistently growing population, spread out in various locations across the nation, can cause national prices to rise, too much supply should do the opposite. During the housing boom so much excess supply was created that it seems plausible that it could take many years for population to catch back up.

So you might see prices move below the historical trend to some low point and then eventually proceed upward again at the same slope (rate of change, return, whatever) afterward, though at position consistently below that old trend. Just like population can cause excess demand to permanently raise the trend, it would seem that too much building could cause a prolonged state of excess supply to permanently lower it.

In other words, even if home prices do have a small, real price appreciation historically, that doesn't mean that home prices will necessarily return to that trend line. They could overshoot and follow a new, lower trajectory. With tens of million of distressed properties hitting the market over the course of just a couple of years resulting in millions of vacant homes, it's easy to imagine how big an economic shock that could cause.