Thoughts on Housing

I find myself reading and discussing the housing market often theses days, given the current credit crunch and housing slump. Here are some thoughts I have had recently.

First, the pervasive (and false) belief that we had come to believe, housing prices always rise. I am sure your Realtor told you that, or at least made the implication. Like all assets, we have had booms and busts. One concept borrowed from the world of finance is mean reversion. Mean reversion is a theory suggesting that asset prices and returns eventually move back towards the mean or average. This suggests that a period of price appreciation of 20% over four years might be followed by a negative return for a few years as the asset class returns to its mean. The graph above is good evidence for mean reversion. In hindsight, no one should be surprised by the falling housing prices, given the unbelievable increase in the price the last few years have seen. This can also be called the “greater fool” method of investing. People may knowingly buy an overvalued asset as long as they believe a greater fool will come along and buy it at a higher price. This works for awhile, but someone is always left holding the bag when prices start to fall.

Second, the tax treatment of housing makes it an attractive “investment”, actually houses are assets, not investments. Strictly speaking, an investment will provide a stream of income. Stocks provide dividends and the hope of capital gain. CDs and Bonds provide interest. Rental property provides rent payments. Your house is not an investment it is an asset. The tax code gives you a tax deduction for mortgage interest, which is a housing subsidy for those who use debt to purchase housing. Any time you subsidize an activity, you cause more of it to happen. We also subsidize the secondary mortgage market with government subsidized enterprises such as Fannie Mae and Freddie Mac. The code also excludes the capital gains on housing appreciation for most people. One the other end, there is no subsidy for the purchase of stocks and bonds, and the tax code taxes capital gains and dividends. As a result, Americans often choose housing over other assets. No wonder we are the land of huge houses and a negative savings rate. Many economists say our long term growth potential may suffer because people choose housing over more productive assets. More productive assets? If people put more money into financial markets and less into the housing market, more financial capital would be available to firms looking to expand and for entrepreneurs looking to innovate.