When good is bad

The latest home price numbers (through May, according to S&P/Case-Shiller) looked pretty solid: the benchmark 20-City Composite measure was up 9.3% year-over-year (YOY).  All 20 markets posted gains on an unadjusted basis, though 14 showed YOY declines when seasonally adjusted.  Tampa had the largest monthly gain, up 1.8%, while Phoenix saw the smallest, at +0.4%.  Nine markets were up by more than 10% YOY.

It should be noted that the April increase for the 20-City Composite was 10.8%, a point and a half higher than the May YOY pace.  And the seasonally adjusted May change YOY was actually -0.3%, the first negative print since January 2012.  But to read most comments on the May release, you’d think we were returning to 2008.  For example, Econoday’s commentary stated that “softening home prices reflects (sic) the underlying weakness still apparent in the housing sector which, after a respectable 2013, is having a bad year.”

That “respectable” 2013 saw a 13% increase in home prices across the 20-market measure.  Respectable?  That’s stellar, if not bubbly.

First, let’s consider the theoretical reality.  Absent the existence of high demand and low buildable land in a market (think Manhattan), residential real estate shouldn’t return much more than the inflation rate, since it doesn’t throw off cash flows.  The argument here is that without discounted cash flows to model, residential real estate is nothing more than an inflation hedge.  Of course, this harkens back to the day when our homes were (rightly) viewed as a place to live, and not as an investment, a notion that gained traction during the housing bubble.

Lest you doubt the theory, consider its implications: if returns do in fact exceed the inflation rate by a significant amount for a relatively long period of time, a massive correction is due.  We saw the former during the housing bubble, and the latter when it burst.

Now, let’s turn to the historical reality.  The 20-City Composite only dates back to January 2000, and that coincided with the beginning of the housing bubble.  So we don’t really have a normative period against which to compare.  However, the narrower 10-City Composite dates back to 1987, so while it isn’t as broad a sample as the 20-City Composite, it still allows us to look further back to examine a non-bubble period.  (The 10-City Composite includes Boston, Chicago, Denver, Las Vegas, LA, Miami, NYC, San Diego, San Francisco and Washington, D.C., while it excludes 20-City components Phoenix, Tampa, Atlanta, Detroit, Minneapolis, Charlotte, Portland, Dallas and Seattle.  As such, it includes markets that comprise nearly 74% of the current weightings of the 20-City Composite, making an argument for sample significance.)

From late 1989 through early 1998, the 10-City Composite returned virtually nil.  Now, during that period stock prices were up strongly, and inflation fell by half.  So one could argue that there was little need to hedge against inflation, and that rising equity values reduced the need to seek speculative gains in real estate.  But let’s not forget that during those years, homes were still viewed as abodes, rather than as investments.  Also, we should note that stock prices rose sharply during the housing bubble, and that falling inflation generally means falling interest rates, which tend to increase housing affordability and should thus stimulate housing demand, driving prices higher.  (Mortgage rates did, in fact, fall throughout most of the ‘90s.)

The upshot of all this is that a 9.3% YOY rate of home price appreciation is good – really good, given the historical reality of low returns during non-bubble periods and the theoretical reality of a sub-2.0% inflation rate.  And yes, those numbers are unadjusted, but when you look at your home’s value vs. where it was a year ago, do you apply seasonal adjustments for the fact that you’re selling in the summer, or do you simply enjoy the fact that you’re up nearly 10%?

The point is that the housing bubble led us all to believe that double-digit home price appreciation was the norm, and that anything less is – well, bad.  It’s not, and that way of thinking can only lead to further bubbles.  Housing isn’t weak, it’s just not as strong as it was during the bubble of the early 2000s, or of the bubble-like conditions of 2013.  And for that, we should be thankful.