Environment and Media & Marketing and Real Estate & Retail

ECONOMIC ANALYSIS: Study casts new light on rising house prices

February 27, 2006

I have always been amazed at the confidence and certainty projected by those who stand before the television cameras at the end of the day and explain to us-in 90 seconds or less-why the stock market behaved as it did. I suppose if we are silly enough to ask for a simple explanation for the 5 million or 6 million trades conducted on any given day, we should expect nothing more in return.

Of course, those trades take place for a nearly equal number of reasons, as varied as the people and institutions that conduct them. But a large number of them take place between people who have different points of view-and possibly different quantities of information-about the future. And in the extremely sophisticated financial markets we have today, the rapidfire buying and selling of stocks in companies tends to quickly incorporate fresh news about the future into stock prices.

There's been a lot of action in an entirely different marketplace lately, where the traders aren't quite as sophisticated: namely, housing. Americans own their homes for an average of 10 years. And when they sell, the new mortgage created on behalf of the buyers is, on average, double the size of the one the sellers retire. Transaction costs in real estate are substantial, and the tax system influences many of the decisions people make at many stages in the process.

That's not quite as fast-paced as the stock market. But houses are still an asset and, like any asset, their price should reflect expectations about the future. Some people-perhaps most-feel that, in parts of the country, that connection has gotten out of whack. People who talk about real estate bubbles rarely pause to exactly define them, but it usually means a price based upon expectations that cannot be met.

And there are some eye-popping statistics still rolling out of real estate markets these days. The National Association of Realtors identified Phoenix as the No. 1 metropolitan area for price growth last year, thanks to its astounding 46-percent surge in median home prices. Several populous Florida and coastal California areas were right behind, with equally blistering appreciation rates. After several years running, it is now a sad fact that less than 17 percent of California households can afford the median-priced home.

Those kinds of returns have attracted a lot of hot money into real estate, with fears growing that a collapse in prices as expectations adjust to more realistic levels could trigger a reprise of the stock market crash at the end of the last decade.

But a pair of economists from Southern California have produced a research report that brings a refreshing clarity to the debate. Their first contributions are purely logical. Just because real estate is high-priced, or even unaffordable, does not mean it is overvalued.

Berkshire Hathaway stock, which flirts with a price of $100,000, may be unaffordable to most of us, but that does not mean it is overpriced. And the rapid upward swing of recent years that suggests overpricing can equally be said to be a signal that prices are coming into line with expectations from an underpriced situation three or four years ago.

But analytical results, and the way they're arrived at, are even more compelling. Distrusting appraisals as measures of home value, they rely instead on homes that have actually turned over to get data on prices. They compare those prices with something equally amenable to direct measurement-the rent commanded by comparable homes-for 10 geographically dispersed markets nationally. The idea is that the value of home services, as measured by rent, and the price paid for an asset that delivers those services should, with a few technical manipulations, be in balance.

Their conclusion is that, for most cities, current prices are supportable by the cash flow in rents they could generate. In fact, even in some high-priced environments, real estate remains an attractive investment. Even if none of us can afford it.



Barkey is an economist and director of economic and policy study at the College of Business, Ball State University. His column appears weekly. He can be reached by e-mail at pbarkey@ibj.com.
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