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Housing Perspectives

Research, trends, and perspective from the Harvard Joint Center for Housing Studies

What Do Runaway Home Prices Mean for the US?

On September 28, the Federal Housing Finance Agency (FHFA), the regulator of Freddie Mac, Fannie Mae, and the Federal Home Loan Banks, reported its monthly index of house prices for July. It showed an astounding increase of 19.2 percent over the prior 12 months and that, in the 17 months since the pandemic began, the increase has been 22.5 percent. This is the fastest increase since record-keeping began, including in the run-up to the bubble in 2007-8. By the time we reach the second anniversary of the pandemic, given today’s momentum for more increases, a reasonable estimate is that prices may have climbed by at least 30 percent over those two years. (If the most recent rate of increase—a very high 1.4 percent in just one month—continues, the two-year increase would actually be about 35 percent!)

In short, we are in the midst of what can reasonably be called runaway home prices, far beyond anything justified by the general rate of inflation (worrisome today at only about 5 percent) or household incomes (inflation-adjusted median household income went down in 2020 and is estimated to do so again this year).

This is nowhere close to normal. It shows how the pandemic, combined with the government’s response via unprecedentedly large budget expenditures and unprecedentedly loose monetary policy, has caused tremendous dislocation in the economy. This has been particularly impactful in terms of house prices increasing so much, so fast. (With similar government policy responses to the pandemic in many developed countries, this unusually rapid rise in house prices unsurprisingly is happening overseas as well.)

The media and policy community have reported many reasons why this is happening. I see the biggest falling into three categories. First, the pandemic began when the US already had a decade-long production shortage of new homes due to various forms of NIMBY (Not in My Backyard) at state and local levels (e.g. land use restrictions) and also construction labor and materials shortages, leading to a wholly inadequate supply of homes for sale. Second, the pandemic generated a major jump in the demand for housing (e.g. families wanted more space to work from home, wealthier families accelerated the purchase of second homes, and so on). And third, government policy—mainly in the form of record-low interest rates—made financing a home much cheaper, allowing buyers to bid up prices without proportionately increasing required monthly payments.

What I have not seen broadly discussed is the impact such runaway prices will have more generally. I have identified four such impacts that could be highly consequential, and policymakers need to be well aware of them. First is a beneficial impact, followed by three that are definitely not.

1. Helping GDP to grow

Household consumption spending is the biggest source of GDP and it is influenced not just by the wages and other income of the typical family but by the household’s net worth. This is known as the wealth effect: the more a family’s wealth appreciates in value, the likelier it is to consume more, mainly because of a perceived reduced need to save out of income. According to government statistics, owner-occupied homes—valued at about $19.7 trillion as of year-end 2019—have increased in value by 23 percent, or $4.5 trillion, as of the middle of 2021. This translates into more than $50,000 per household, which then should translate via the wealth effect into more consumption spending. Also helping to increase such spending is the fact that many homeowners refinanced their mortgages at record low interest rates, creating room in their household budget to spend more on other things if they so wished.

This will all help drive GDP growth higher than it otherwise would have been, contributing towards better employment growth and wage increases (but hopefully not inflation), in the next few years.

2. Making economic inequality noticeably worse

The homeownership rate in America is about 65 percent. The vast majority of the families in that 65 percent (i.e. excluding the small percentage who have sustained major income declines or illness) have done rather well financially during the pandemic because, among several reasons, of the large increase in home prices. The net worth they have in their homes increased collectively by $4.5 trillion, and the approximately $50,000 market value appreciation per household is probably tax-free as no additional tax will likely be due upon sale of the house. (By comparison, the latest estimated median household net worth, for both homeowners and renters combined, was just over $120,000, while the average—very much skewed up by wealthier families—is close to $750,000.) And there is more house price appreciation to come, as the increase in prices is still going strong. Of course, the 35 percent of America’s families who rent have shared in none of this.

On top of that is the reduction in monthly expenses from refinancing that most homeowners have undertaken. By contrast, renters (who already, on average, have lower incomes than homeowners) have faced continuing increases in rent payments; the median rent increased 3.1 percent in 2020, and probably by at least that much this year.

While politicians tend to focus on “millionaires and billionaires” in their rhetoric on income and wealth inequality, in this case we are seeing a $4.5 trillion gap opening up between homeowning families (mostly middle- and upper-middle class, and less diverse) and the renting ones (mostly working class, and more diverse). Thus, “have” and “have-not” is increasingly becoming synonymous with whether a family owns their home or not.

3. Pushing down the homeownership rate

In a recent paper, I showed how the homeownership rate was extremely sticky, having been at or near 65 percent (except during the run-up to the bubble) for the last fifty years. The runaway home prices we are seeing today are so severe that they may end this five-decade long run, but in a bad way. The simple fact is that a family looking to buy their first home is suffering a major decline in purchasing power. This starts with that 22.5 percent increase in house prices since the pandemic began, but it is offset to a degree by lower mortgage interest rates generating lower monthly payments. The latest Urban Institute Housing Finance Monthly Chartbook reports that, net, the combined impact is to make affordability considerably worse, not better, since the pandemic began. My own calculations similarly show a decline of purchasing power, again net of both house prices going up and interest rates going down, of over 10 percent. This specifically means that a typical family in February 2020 looking to buy a starter home for, say, $200,000 would now, 17 months later, only be able to afford a home that back in February of 2020 would have cost under $180,000 (i.e. more than 10 percent less), although its market value today would be far higher. And during this period, real median household income has dropped, not increased, pushing down even more on how much that typical family could afford.

The result of this has to be significant downward pressure on the homeownership rate. This would be particularly acute for first-time homebuyers, who tend to be younger and more diverse as a group. For example, the homeownership rate for families whose head is under 35 years old is currently just 38.1 percent. Not surprisingly, those younger and more diverse families tend to have a more volatile homeownership rate. This is where I would expect the impact of the rapid rise in house prices to be the most damaging. By comparison, older, well-established homeowners (e.g. those over 65, who have a homeownership rate of 79.3 percent) should be little impacted.

There may be other factors pushing up on the rate (e.g. families switching a greater percentage of their monthly budget towards housing and away from the expense of pandemic-restricted activities like eating out, commuting, or long-distance vacations), and the Biden administration at this time is pushing for many homeownership-increasing subsidies and programs. Net, an increase in the homeownership rate, at least for the next few years, seems unlikely. In fact, in my view, it will require a lot to go right just to avoid a significant decline.

Unfortunately, one can’t yet tell if this is indeed happening. The homeownership rate spiked massively at the beginning of the pandemic (the second quarter of 2020), in what most observers think was a distortion, and has been plummeting since, most recently to 65.4 percent, which is almost exactly the same as the 65.3 percent it was before the pandemic. The next few quarters are needed, then, to get beyond this distortion, and to show whether my thesis about the rate going down—especially for younger families—is correct.

4. Inadvertently causing reports of inflation to be misleadingly low

How are we to square the following three facts? One, the cost of homes is skyrocketing. Two, the cost of housing is the largest portion of a typical family’s monthly budget. And three, the government says that inflation is about 5 percent, which the Federal Reserve says is mainly due to supply chain disruptions and should come down smoothly to near 2 percent over the next year or so. On the surface, they certainly seem inconsistent.

The explanation is that the government uses an arcane approach to calculate the inflation rate for what it calls “shelter” with respect to the 65 percent of families living in homes they own. This is because calculating inflation for owner-occupied homes is extremely challenging. If one calculates this type of inflation by considering the total economic cost of homeownership, the result today would likely be negative inflation, because the market value of a typical home right now is going up by more than the required monthly payments. If you only consider the cash cost of homeownership, there are massively different realities faced by current homeowners (whose cash cost is not directly impacted by home prices rising) compared to first-time homebuyers (who are subject to the full impact of today’s giant price increase in what it takes to buy a house). There are even further challenges because, while the impact of today’s house price inflation factors into the size of the needed downpayment, monthly payments are far less impacted due to the decline in interest rates.

Years ago, in response to this challenge, the government developed an unusual approach to calculating the inflation rate for owner-occupied homes: a survey that generates what it calls the owners’ equivalent rent (OER). The survey question for owner-occupants is, “If someone were to rent your home today, how much do you think it would rent for monthly, unfurnished and without utilities?” In other words, there are no actual transactions behind the OER, and the survey question asks something that the surveyed homeowners can only guesstimate. (I own my own home, and I have no idea what my answer would be.)

While the OER approach may be the best option to deal with an admittedly messy situation, its results today are highly problematic: while the FHFA is saying that house prices went up 19.2 percent over the past year, the OER says that the cost of shelter for owner-occupied homes went up by only 2.43 percent! That’s a lower percentage increase than even for the median rent of an actual rental unit.

This result fails the common sense “smell test.” The OER approach may work adequately well in normal times, but it does not seem to be working properly under the stress of today’s unprecedented increases in house prices. I can imagine government officials claiming that the technique is nevertheless the best available (which may well be true) and that the 19.2 percent will eventually work its way into the OER on a smooth basis. This would presumably occur over time as surveyed homeowners acclimate to the increased market value of their homes, and then in turn increase the estimated rent they provide in the monthly survey until it delivers a decent return on the home’s higher market value. Given this type of price increase is so unprecedented, it is unknown how long this acclimation process would take – perhaps even several years. 

Unfortunately, given the high percentage of the typical household budget that is taken up by shelter, claims of today’s inflation being transitory may therefore not be well-founded. This suggests that policymakers are flying more than a bit blind, not seeing the inflation that the citizenry feels (especially those looking to buy their first home). That does not bode well for those policymakers, especially at the Federal Reserve, making the best decisions.

This story of house prices increasing so much since the pandemic began is likely not over yet. Certainly, the latest monthly percentage increases are at cyclical highs, showing no signs yet of abating. This means we may get even more into uncharted territory with larger impacts in the four areas I have described above, as well as others - good or bad - that may yet emerge.