There is no housing bubble

April 2006

A paper entitled Bubble, Bubble, Where's the Housing Bubble? claims there is no housing bubble in 9 of 10 Urban Markets. Additionally the reports authors claimed that not only are fears of a bursting housing bubble overblown, but that homes remain undervalued in many markets.

Professors of economics, Gary Smith and Margaret H. Smith, say they used a new methodology to gauge the existence of a housing bubble which compared the cash flow generated by owning a home to the cost of renting a comparable house. They found bubble conditions in only one of the 10 metropolitan U.S. housing markets evaluated.

The methodology evaluates housing as a long-term investment, similar to stocks and bonds. In each market studied they matched similar homes, comparing the cost of buying versus renting, using Multiple Listing Service data from summer 2005. They projected homeowners' net savings on rent over time, discounted by a required after-tax rate of return of 6 percent, because the money sunk into the home purchase could presumable be invested elsewhere, for example, in stocks and bonds. Their analysis factored in expenses such as one-time closing costs, taxes, maintenance and insurance. Also factored in were tax benefits from ownership and the assumption that rents will rise over time, while payments on a fixed-rate mortgage will not.

The analysis assumes a 20 percent down payment, with a 30-year mortgage at a 5.7 percent fixed rate. Under their model, in many cases, the home purchase initially generates negative cash flow, as the expenses of owning exceed the rental value and tax benefits. But over time cash flow becomes positive. And in some of the more dramatically undervalued markets, such as Indianapolis, owning a home generated an immediate positive cash flow.

The Smiths' concluded that buying a home generally remains an attractive long-term investment - even if buyers are conservative in their assumptions about how much home prices will rise in the future. "Most of the country is certainly not in a bubble if you define a bubble as prices far above fundamentals," said Gary Smith, who is the Fletcher Jones Professor of Economics at Pomona College. "The average person in the U.S. is still better off buying than renting."

Of the regions studied only San Mateo County in the San Francisco Bay area were homes considered overvalued, in this case by a whopping 54 percent. Elsewhere in California their model suggested that Orange County home prices prices were about right, while homes in Los Angeles and San Bernardino counties were still somewhat undervalued by11 percent and 20 percent, respectively. Outside California, homes also were undervalued in Boston (12 percent under) and Chicago (17 percent under). Under valuation was dramatic in Dallas (40 percent), Atlanta (53 percent), Indianapolis (65 percent) and pre-Hurricane Katrina New Orleans (46 percent).

The professors dismiss talk of a housing bubble questioning the assumption that home prices have exceeded their fundamental value. "Perhaps housing prices were too low in the past and recent prices have brought market prices more in line with fundamental". They claim that existing methods, using indirect measures or values predicted by regression models, cannot show if housing prices are justified by the anticipated cash flow. They feel their model, using unique rent and price data for matched single-family homes, is a more accurate measure of fundamental home values.

"Housing bubble discussions generally rely on indirect barometers such as rapidly increasing prices, unrealistic expectations of future price increases, and rising ratios of housing price indexes to household income indexes. These indirect measures cannot answer the key question of whether housing prices are justified by the anticipated cash flow."

Their approach is based in large part on rejecting the notion that a defining characteristic of a housing bubble is that housing is viewed as an investment. "To the contrary, we believe that the correct way to gauge a bubble is to view housing as an investment". They see a bubble when the market price of real estate rises far above the present value of the anticipated cash flow.

Gary Smith says their model also can be adapted to calculate the likelihood of housing being a good investment under different scenarios, such as an adjustable rate mortgage instead of a fixed. However, the Smiths' model assumes buyers will hold on to the house for the long haul, not selling in a couple of years.

He advises against trying to predict which direction home prices are headed, telling the cautionary tale of a Claremont, Calif., professor who in 2003 decided against buying because he had read in the newspaper that home prices were 20 percent too high. It turns out home prices rose dramatically in the area. Prices instead continued to rise dramatically. "You've got to run your own numbers," Smith said.

They conclude that a "house is fundamentally a sound investment if bought for keeps with no assumptions about future house prices or with conservative assumptions about future housing prices".

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