When the stock-market bubble burst in 2001, many experts predicted worldwide recession. It never materialized. One major reason for this was the real estate market. In 2001, average real house prices in the U.S. rose 5.6 percent – the biggest increase in America’s history[1]. From 1995 to 2004, they rose 35%.[2]  For comparison, real housing prices increased only twenty percent in the entire period from 1980 to 2001[3]. This trend is accelerating; in 2001, real gross private residential investment was only 100.357% that of 2000, but in 2002 it was 105.178%, and in 2003, 114.392% that of 2000[4].

This is partially due to the stock market decline. Many investors, driven out of stocks, shifted to real estate, which seemed safer. Because real estate is more tangible than stocks, many see it as more reliable. More logical investors cite the return on investment. It is natural for housing prices to rise somewhat over time; the average size and quality of homes in most first-world countries tend to rise, and incomes in the U.S. are also on the rise. Nominal housing prices in the United States have not fallen in more than twenty-five years. Of course, during this kind of boom the return is even more compelling. Additionally, taxation on real estate transactions tends to be lower than on equity transactions.

However, the main cause of the boom is the difference in purchase. A stock investor uses his or her own money almost exclusively, whereas a real estate investor uses far more money from loans. Assuming that revenue from renting the property is exactly equal to the interest on the mortgage plus the cost of upkeep of the property, his percentage return will be the inverse of the portion of the initial cost he made himself times the actual percentage return; that is, if he paid for one third of the property, he will realize a percentage return three times that which he would have realized had he paid for the whole thing himself.

Currently, the interest rate on mortgages is extremely low, as you can see by the following chart (not all rates are available for all years):

source: Freddie Mac Survey of Commitment Rates and Points

This would seem to indicate that real estate is a very good investment, but there are flaws in this reasoning, because it ignores inflation. Inflation is low right now (1.6% in 2002, 2.3 in 2003[5]), which is of course why interest rates are low. Real interest rates are calculated by subtracting the inflation rate from the nominal interest rate. The real inflation rates look like this:

Calculated from preceding graph and Consumer Price Index

Is this truly a bubble? Unquestionably. Just as, in the dotcom era, investors judged stock based on the predicted selling price rather than its direct value, real estate investors ignore the income from rent almost completely. I have been referring to them as investors, but they’re really speculators. The ratio of average house price to average rents in 2002 was 1¹/₆ its thirty-year average[6]. If rents have not increased at the same rate as prices, that can only mean that the demand has not increased sufficiently to account for increased price.

The potential for damage when this bubble collapses is staggering. In 2003, 11% of the GDP was from payment for housing (rent), 5% from purchases of residential structures and equipment, 4% from housing-dependent services such as electricity, and 4% from construction[7]. After a housing market collapse, lost GDP averages eight percent over two or three years, about twice that following an equity price collapse.[8] What’s more, housing busts average eighteen months longer than equity busts, and the following slowdown lasts twice as long as that following equity collapses.[9]

Far more people own houses than stocks; the US homeownership rate was 69% in 2004.[10] In 2004, 15.05% of personal consumption expenditure was on housing, and a further 5.5% was spent on household operation.[11] In 2003, the average American household had thirty percent of its wealth in residential property, compared to five percent in stock[12]. What’s more, there are a number of tangentially connected industries that would be hurt by a housing bust, such as construction.

Because such a high percentage of the initial investment in real estate is borrowed, there is an additional peril. Even if the victims of a crash can afford to repay their loans, they must reduce their spending to a much greater degree than they would if they had simply lost their investment. If they are unable to pay their loans back, things are of course even worse, not just for them but for the bank, which has little use for a house. Even worse, if the value of the house drops enough, it may simply not be worth the remainder of the loan to keep it. The bank will then find itself with a house that is often worth less than their initial loan. Exacerbating this problem is the unusually high rate of mortgage equity withdrawal, which in 2003 hit six percent of disposable income.[13]

 In some cases, over inflated housing markets will level out rather than collapsing, but that seems unlikely this time. The cause of this in the past has been that rising value of houses will close the gap with their inflated value. Currently, however, inflation is very low, so it would take far too long to close the gap. Rising income and quality of houses alone cannot accomplish it fast enough. From 2002 to 2003, real income increased by 3.3 percent[14]. Assuming a constant 3.3% increase in rent and a total cessation of all further increase in real housing prices, it would take almost five years for real estate to be brought back to its fair value from its current 1¹/₆ fair value.

The housing market is currently the primary support of the American economy, and to some extent of first-world countries as a group. When the bottom fell out of the stock market, real estate was the only thing preventing global recession. When it falls, there’s nowhere left to turn. In addition to the traditional issues of any market collapse, widespread mortgage debt will reduce consumer spending further. Banks, having lost money on many mortgage loans, will be seriously reduced in their ability to make loans. Because so many people own houses, even those who did not participate in the buying frenzy will be directly affected. Because houses cost so much, the drop in personal wealth will be dramatic. Because real estate transactions take a lot of time and a lot of money, and because houses must be sold as a unit, it will be even more difficult to sell property than might otherwise be the case.

            In summary, the increase in housing prices is extremely ominous. When the bubble pops, it may easily do tremendous damage to the economies of the US and Europe. A similar collapse in the early nineties plunged Japan into a depression from which it has still not fully recovered. The effect on the US is likely to be smaller, for several reasons. First, our housing market is not as overvalued as Japan’s was in the nineties[15]. Second, the rest of our economy is in better shape than Japan’s was. Third, a much smaller percentage of the US’s assets are held by banks, which are the hardest-hit institutions[16]. Nonetheless, the effect will be severe.