What investment return should you expect for your home and what leads to housing booms and bust.
In this episode, you’ll learn:
- What is the baseline expectation for housing price appreciation.
- How much have have homes appreciated year-over-year throughout the world.
- Why do homes depreciate over time on a real basis.
- How productivity improvements impact home prices.
- How much of a home’s value is due to land.
- What contributes to housing booms and busts.
- How can you tell if homes are overvalued or cheap.
Homes Depreciate Just Like Cars
We’ve been staying on the Southern California coast for a few weeks and this should come as no surprise, houses are really expensive here.
Used homes cost over $1,000 per square foot on small lots. That compares to used home prices of $80 to $100 per square foot where I live in Idaho
Houses Get Old and Go Out of Style
Robert J. Shiller, the Nobel Laureate economist and leading housing expert, wrote in the New York Times, “Real home prices should decline with time, except to the extent that households shell out some money and plow back some of their incomes into maintenance and improvements, because homes wear out and go out of style.”
A real home price is the price after adjusting for inflation. According to Shiller, for the 100 years ending 1990, before the recent housing boom and bust, U.S. home prices adjusted for inflation on average increased 0.2% per year.
Presumably, if homeowners hadn’t put additional money into their houses for upkeep and improvements then real home prices would have fallen.
Home prices can deviate substantially from their long-term trend and appreciate greater than inflation. Bubbles can form and bubbles can burst.
Historical Home Appreciation
According to The Economist, from its base in 1990 U.S. real home prices increased 50% before falling back to earth. They are now priced where they were in 1990.
Real home prices in Germany are also the same as they were in 1990. In Japan, which has suffered from deflation, real home prices have declined 50% since 1990.
Yet, there are countries such as Australia and Canada where homes have increased substantially since 1990 and remain elevated. Of course, the same could be said for the Netherlands where prices increased over 160% and have since fallen 40%. The annual increase in Canadian home prices has recently moderated but Australia is still going strong as home prices increased over 9% year-over-year.
There are some locations, particularly highly desirable areas with high densities such as along the Southern California coast where much of the value of a home is the land. There is a limited supply of land with majestic views of the ocean and nice weather. This can keep prices appreciating above inflation as long as the populace values living near the sea.
For most homeowners, though, land represents only a minor portion of a home’s cost.
According to data compiled by Morris Davis of the University of Wisconsin and Jonathan Heathcote of the Federal Reserve Bank of Minneapolis the share of U.S. non-farm home value accounted for by land has averaged 32% since 1975.
Last year, land comprised 27% of home values but it got as high as 48% of home value at the peak of the housing bubble in 2006. Like many assets, land prices can be volatile.
What Causes Housing Bubbles
Why do home prices appreciate faster than inflation before they eventually peak, then fall and bottom out?
Certainly the supply of new homes has an impact on prices, but the real culprit is demand.
When interest rates are low, credit readily available, the economy is growing, incomes are rising and the vast majority of potential buyers believe housing prices will continue to appreciate then exuberance takes hold and there is a palpable fear of missing out. A bubble is born.
When those conditions reverse, then bubbles burst.
How To Tell If Homes Are Overpriced
How can you tell if there is a housing bubble?
By comparing the price of homes to average household income and by comparing the annual increase in home prices to the annual increase in rent for a primary residence, such as a home or apartment.
Consumers have a choice of buying a house versus renting. If the price for homes gets too high relative to income or rent then more consumers will rent, which lessons the demand for houses and eventually impacts prices.
Since 1982, median existing home prices in the U.S. have sold on average for three times the median family income. During the peak of the bubble, homes sold for 3.9 times median family income and at the trough they sold for 2.7 times. Homes are currently selling for just under 3.2 times median family income.
If over the long-term, nominal home prices only keep pace with inflation and only if one continually maintains and updates their home then what is the financial advantage if any of owning a home?