Some perspective on the horrible housing market

The news about the housing market is grim. New-home sales plunged in July to the lowest level since the government started keeping track in 1963. The median sale price at $204,000 was down 6 percent from June and 4.8 percent below a year ago. Meanwhile, sales of existing homes dropped sharply. And in Minnesota, the drop was even steeper, down 42 percent from a year ago.

The expiration of the government's first-time home buyer tax credit is getting much of the blame. The tax credit, in effect, pushed sales that would have taken place later this year into the first six months as buyers took advantage of tax credits that ranged up to $8,000. The credits also artificially held prices at above-market levels.

They were a terrible public policy that harmed buyers and wrongly delayed the inevitable home market price adjustment in many markets across the country, including the Twin Cities.

What's the outlook for the housing market from here on out? My sense is that the housing market will stay weak until we start reading newspaper headlines about looming labor shortages rather than stubbornly high unemployment. But the longer-term outlook is more benign. The economic conditions of a region will reassert their power over real estate prices. The ebb and flow of home values will be largely dependent on local job and income growth.

That will be a welcome respite. The residential real estate market has been on a wild ride. In the late 1980s, the belief was that inflation-adjusted home prices were due for a long period of decline. The theory was that too many aging baby boomers would find too few younger buyers for their homes. David Weil and Gregory Mankiw, economists at Harvard University, famously forecast that this demographic trend would drive real housing prices down by about 47 percent, or 3 percent a year, between 1987 and 2007.

Their analysis was solid, but the timing was off. Home prices rose by an inflation-adjusted 67 percent during those two decades. Even more stunning, real home prices surged 86 percent from the residential real estate market's bottom in 1996 to its peak in 2007. A number of fundamental factors sent the market soaring, including falling interest rates, immigrant home buyers, single women with good incomes putting down stakes, and baby boomers trading up. But eventually the market turned toxic from the combination of speculative fever and loose lending practices. Prices spiraled higher until the bubble burst and housing prices plummeted.

But the fact is, homeownership isn't a good investment. Yes, a home offers plenty of tax benefits, including the deductibility of mortgage interest payments and no capital gains taxes due on home sales under half-a-million dollars (for joint filers). But those gains are offset by the costs of ownership, including mortgage interest payments, property taxes and maintenance costs. The improvements homeowners make are expensive, too.

Data going back to the 1850s suggest that the long-term after-inflation return of real estate is about 2.5 percent to 3 percent, according to the recently retired economist Karl Case of Wesleyan College. His colleague and business partner, Yale University finance professor Robert Shiller, figures that even this modest return is too high. He argues that the return on residential real estate over the past 100 years has been "zero."

Now that doesn't mean owning is a mistake. For one thing, you automatically increase your savings as you pay down your mortgage. It's a place where you live with all the psychological and emotional benefits that come with owning.

"This is the true nature of home," said 19th century art critic John Ruskin. "It is the place of peace; the shelter, not only from injury, but from all terror, doubt, and division."

No, the real lesson with real estate is not to overpay for that peace of mind.

Chris Farrell is economics editor for American Public Media's "Marketplace Money." Send questions to cfarrell@mpr.org.

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