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Framing Home Price Inflation
The ever-increasing cost of homes obviously causes a lot of people a lot of angst. Chief among those groups, naturally, are the people who are planning to buy a home but do not yet have one; and, since higher home prices are very highly correlated with higher rents, renters too are alarmed that the rent is too damn high! (if that reference eludes you, educate yourself at this link: https://www.youtube.com/watch?v=OUx_32ABtw4 )
Right behind the people who have to actually buy homes and rent apartments, though, are the economists who seem to be perennially alarmed that home prices are “in a bubble” again. Certainly, if you look at nominal home prices (represented here by the S&P Case Shiller U.S. National Home Price Index, normalized like all of the charts in this article so that December 31, 1989 = 100 and the latest figure is for the end of September 2024) then you can see the cause for concern. Home prices are up 75% since the peak of the home price bubble of the late 2000s! If a house at $241,000 was in a bubble in 2006 (and subsequently declined in price to 175k), then surely it’s in a bubble if it’s now at $425k?
You can see in this chart the rapid acceleration in 2021-2022, and that should be a clue about one of the things that is going on with home prices. The overall price level is a lot higher than it was in 2006; the dollar simply doesn’t go as far as it did back then. Indeed I’ve chronicled how, thanks to the supercharged increase in the money supply, consumer prices are up 23% since just before COVID. Obviously, then, we have to adjust the dollar price of a home for the change in the measuring stick (the dollar) itself. Here are real home prices.
This still looks like a bubble, if real home prices are 13% higher than the bubble peak. After all, homes are unproductive real assets. Over a long period of time, home prices have risen less than 0.5% per year after inflation. In this way a home is like a lump of gold. Ten years from now, the lump of gold is still a lump of gold and so you would expect the real return to be roughly zero (you have the same amount of stuff at the end that you started with). In the case of home prices, there is deterioration of the housing stock over time but also new construction and homes have historically gotten larger and more comfortable, so some small drift higher in real prices makes sense. But home prices since 1989 are up 70% in real terms, when they should be up roughly 25 * 0.5% = 12.5%. And since the 2006 peak, we’d expect 9% (18 years x 0.5%) would represent a similar peak. We’ve risen more than that!
So, definitely a bubble, right? That deflation everyone keeps promising us is imminent, along with the collapse of banks and all the other stuff? Not so fast; there is one other important thing to consider and that is household formation. Or, rather, household formation compared to housing-unit formation.
We start by imagining what could plausibly push real home prices above or below a long-run flattish trend, that would represent a legitimate effect and not a bubble. What immediately comes to mind for me is the fact that for at least the last few years we have seen a massive increase in the US in the number of heads over which we need to put roofs. Something in the ballpark of 10 million new residents need roofs, and we surely have not constructed that many new roofs. For a long time, I’ve been highlighting this as one really good reason to not expect rental or home price deflation: the demand relative to the supply is out of whack. However, it turns out that we don’t actually need to rely on the ‘unofficial’ increase in the population to conclude that the “bubble” isn’t so bubbly.
The chart below, covering 2004 to the present, shows the real home price (the second chart above) on the y-axis. On the x-axis, I have a ratio of the number of households in the United States (source: US Census Bureau) divided by the total number of housing units in the country (source: US Census Bureau). As the ratio moves higher, it means there are more households for every housing unit or alternatively, fewer vacant units. I only have the housing unit data back to 2004, as that’s what was on Bloomberg.
There is a pretty clear relationship here between real home prices, and the occupation ratio. I have highlighted two areas. One, in red, is the January 2006 through June 2007 period – sort of the teeth of the housing bubble. Those points are well above the line, suggesting that prices were high relative to the occupation ratio. In fact, January 2007 is the point that is the highest above the regression line. On the other hand, we have the most-recent point in green. This is right on the regression line. Yes, real home prices have gone up a lot. But that’s mostly because the construction rate of new housing units has not kept up with household formation.
As an aside, the three points at (0.91, 130) or so are from mid-2020, when there was a surge of household formation but home prices (and rents) were being constrained by the lockdowns. In retrospect, it was a great time to buy a house!
Note that the charts above do not include undocumented residents in the US, except inasmuch as the Census Bureau is including them. Since the total increase in households since January 2021 is only about 6mm…and for the prior 4 years, the increase was 5mm…I am fairly confident that the recent surge in illegal immigration is not reflected on this chart. Ergo, you could make the case that home prices are too low in real terms. If every 5 illegals form one household, the ratio would rise from 0.912 to 0.926, and we would be off the chart to the right-hand side.
Now, this does not mean that real home prices will not decline. In fact, I am very confident that at some point they will, as building catches up with household formation. That does not mean that home prices will fall in nominal terms, however; I suspect that what is more likely to happen is that over a number of years, home prices will drift sideways to slightly higher while overall consumer prices continue to rise. But, if 10 million illegal immigrants are deported, the building of new units will catch up a lot more quickly and nominal prices and rents could decline in that case.
If that happened, rents really would be ‘too damn high’. And that is one very big reason that mass deportation is not inflationary. It also is not very likely; I have the over/under at 1mm deportations.
“Why Aren’t Home Prices Falling?”
From time to time, I like to point out errors that we make because we think in nominal space, or because we had 25 years of inflation being so low that we didn’t have to think about it very much. I do think that at some level, we should consider pointing the finger at economics education, which teaches static equilibria until you get into fairly advanced (graduate level) classes – and even then, generally in nominal terms.
There’s a very good videocast that I like to check in with occasionally, by Altos Research, which runs through recent data on home buying trends along with useful commentary. It tends to be more thoughtful and to not fall victim to the wild swings of emotion that seem to affect a lot of housing market observers. I think it’s important for me to say that I like this channel, since I’m about to criticize an episode they recently put out.
It was called ‘Why Aren’t Home Prices Falling?’ and you can find the quick 15-minute video here: https://www.youtube.com/watch?v=J-0bkqeFZEE. You can get a good feel for the videocast, and the useful analysis they bring, from this episode.
But the question ‘why aren’t home prices falling?’ is an odd one. Median CPI is still running at 4.2% y/y. Sticky CPI is +4.1%. Apartment rents are +5.0% and never declined y/y, even when there was a rent moratorium. Asset prices in general are quite a bit higher over the last few years also, so whether you’re looking at homes from the standpoint of an investment or a consumption item, it’s hard to see why one would naturally default to ‘home prices should be falling.’
The thought process is that ‘home prices went up so much, no one can afford them! Therefore, prices should fall.’ This thought process does not originate with Altos; they are just trying to answer the question being asked. In my view, though, they aren’t answering the right question. Really, when you think about it, the whole framing of the question evokes Yogi Berra saying that ‘no one goes to that club any more because it’s too crowded.’ Home prices going up a lot is a pretty serious piece of evidence that supply and demand has previously cleared at a price that (it is assumed) is too high for people to afford. That should sound odd.
The thought process goes further by noting that the volume of transactions has really declined markedly over the last couple of years, thanks to high interest rates keeping supply off the market as homeowners with current low interest rates locked in recognize that buying a new home would involve an effective refinancing to more expensive money. But if that restriction in supply is the main reason that home prices didn’t decline, then why have home prices in Australia and the UK also generally been rising, except for a dip around the same time that we had a dip in the US? Australian mortgages are normally floating-rate, and in the UK a 5-year fixed rate is the standard. But the low y/y change in Australia (according to the Dallas Fed’s index of Australian home prices – don’t ask me why they track Australian home prices) in 2023 was -4.3% (now +7.7%), the low in the UK was -2.5% (now +2.2%), and the low in the US was -3.4% (now +2.9%, using Existing Home Sales Median y/y). All of those markets saw very large rises, small and brief declines, and are now rising again.
These are very different property markets, very different mortgage markets, very different governments, taxation regimes, populations, and yet they have strikingly similar patterns of home price changes in a market that classically is all about ‘location, location, location.’ This should lead the thoughtful analyst to think that there’s something else going on.
The something else – not to beat a dead horse again – is the change in the quantity of money, which has followed a very similar pattern in every major economy in the years after 2019. And this is where conventional Economics education falls short. Here is a chart of the y/y changes in US M2, alongside the y/y change in Existing Home Median sales prices.
Not all of the price changes you are seeing in homes is a ‘real’ price change. Much of what you are seeing is a change not in the value of a home, but in the value of the currency unit relative to durable physical assets. But in Econ 101, they’d tell you that you should look at changes in supply and demand, and that will predict changes in the price and quantity at which the market clears. In that narrow frame, you might look at the large increase in home prices and attribute it to changes in demand due to declining interest rates, although you’d be confused when the massive increase in interest rates caused only a modest and temporary drop in nominal home prices. (In late 2022, the Case-Shiller futures for end-of-2023 were pricing in a 19% decline in nominal prices with inflation at a positive 3-5% per year, implying an unprecedented collapse in real prices).[1]
Obviously, that frame doesn’t make sense when the underlying price level is rapidly changing, and the underlying quantity of money is rapidly changing. This is often more obvious when we make it extreme. Suppose the money supply went up 400%, and prices quintupled as well, and interest rates went to 100%. Would you expect home prices to decline in nominal terms? That would be absurd – the price level going up by a factor of 5 means that the value of the measuring stick is what is changing. And remember, it is entirely consistent to have the volume of transactions decline sharply while the nominal price increases. Homebuilders care about the volume of transactions; homebuyers care about the price. You may be absolutely bearish on homebuilders, while still expecting home prices to increase, especially if the price level is increasing.
That’s exactly what we have been experiencing. And, with the money supply growing again and median prices still rising at 4% per year, it does not seem to me that there is any natural reason to expect home prices to decline. So the short answer to the question ‘Why Aren’t Home Prices Falling?’ is ‘There’s no reason they should.’
[1] Markets are where risk clears, not where investors ‘expect’ prices to be, and there were wonderful gains to be made even well into 2023 by helping the nervous real estate longs clear their risk. https://inflationguy.blog/2023/08/29/home-price-futures-curve-still-looks-weird/
Homes Have Gotten Cheaper by Running in Place
As the Fed started lifting interest rates aggressively in early 2022, pundits almost universally declared the end of the housing market. Taking the rather lazy approach of projecting what happened in 2008-2010 and just changing the year, utter disaster was forecast for home construction, home sales, and home prices. The more clever analyses mused about how the higher interest cost of a mortgage lowered the amount of home that can be bought by a given payment, and suggested that home buyers would naturally back up their bids by that much and sellers would be obliged to hit those bids.
The Case-Shiller Home Price futures, which are (thinly) traded on the CME,[1] went from pricing in additional upward movement in home prices to pricing in a collapse worse than the post-financial-crisis debacle. For example, the February 2024 futures dropped 22% between May and November 2022. Keep in mind that these futures track nominal prices, so at the worst levels the futures market was pricing in something like a 25% drop in real prices.
That was never going to happen, especially in a housing market that was much, much tighter than in 2007. In the summer of 2007 there were approximately 3.4 million existing homes on the market; in the summer of 2022 the figure was about 1.2 million. And, as it turns out, homeowners did not hit any bid that was shown, which would have been irrational in an inflationary environment. Nominal home prices are sticky on the downside anyway, because buyers don’t like to sell below other recent prices which serve as an ‘anchor’ for their expectations. All of which is to say that 2007 really was an amazing outlier in a lot of ways: price, activity, builder activity, financial buyer activity, mortgage structuring, and home inventory. The current situation is much different.
Naturally, we all know that now as we have noticed that home prices have not in fact collapsed. But they have declined in real terms, because the overall price level has advanced while home prices have been flat. Given the level of inflation, this has actually changed the level of home valuation fairly substantially in a short period of time and I thought it worth pointing out.
Consider the following chart (Source: BLS, ADP, National Association of Realtors, author’s calculations). It plots the Existing Home Sales Median Price divided by the Median Annual Wage. I’ve used the Atlanta Fed’s Median Wage figures and converted them to annual wages so that the series matches, for the most recent point, the median annual wage reported by ADP.) By doing this, we can see roughly how many years’ wages it would take to purchase the median home outright. Note that one of the series is seasonally-adjusted and one is not, which causes the scalloping effect you see. I could correct for this, but figure this is close enough to make the main point.
And the main point is that as home prices have stagnated and wages have been rising rapidly to keep pace with inflation, the cost of a home relative to the wages people are receiving has dropped pretty sharply.
Although this measure doesn’t tell the whole story, you can see how there was a reasonable concern that home prices may have been getting ahead of themselves somewhat (although with extremely low inventory, that’s not necessarily unsustainable in the medium-term). However, since last summer homes have gotten much cheaper, by just staying in one place.
Don’t get locked in on the nominal price. That’s called money illusion, and in an inflationary environment it leads to mistakes.
[1] In full disclosure, we use the housing futures for one of our strategies.
