Comment: As with many things, COVID has turned the real estate market upside down. Instead of the more typical drop in house prices during a recession, this time around, prices have gone up. Here in Las Cruces, for example, the average home price rose 27% year over year in August.
Analysts have cited several reasons for this, from city dwellers fleeing plague-infected urban centers to reluctance to trap potential buyers with viruses in otherwise sanitary houses. Regardless of the reasons, it is the strength of the property market that has led many economists to predict a quick rebound.
While real estate is the hero of the current rebound, it has played a less beneficial role at other times. In the 1990s, the collapse of Thai property values sparked the Asian currency crisis. Closer to home, the Great Recession was caused by the collapse of apartment buildings, which ultimately led to a financial panic. In view of this, it is not surprising that an extensive literature on the subject of housing has emerged. Lately there has been a consensus on how the housing markets work.
First, the slow adjustment of the supply of housing to changes in demand means that property prices are very persistent. There is considerable momentum; Real estate bubbles are common. And most importantly, we can use this price momentum to predict what will happen. Price increases last year can predict price increases in the next year. A clever real estate investor can devise a strategy that can generate additional profits. This is in contrast to the stock and bond markets, where even predicting tomorrow’s prices is very difficult.
A second lesson: rents are not a good indicator of house prices. The thought would be that higher rents make the home more valuable. The owner can live in the house to avoid high rents. Alternatively, the owner could rent the house to someone else and benefit from the high rents. In any case, higher rents make home ownership more valuable, so you would expect higher prices. But we don’t think so.
The reason for this is the slow adjustment of rents compared to apartment prices. Rents are determined by rental contracts that last months or even years. Added to this is the reluctance of existing tenants to raise rents, and you can see that rents are only slowly adjusting to higher prices.
A third lesson is that credit terms are key to understanding house prices. Any inflow of credit allows marginal buyers to buy houses, which drives demand. And given the slow adaptation of the housing supply, this means higher prices. The real estate bubble in the mid-2000s was driven by credit inflows. Similarly, rising prices during the pandemic were driven by economic controls.
Finally, spatial price differences are explained by differences in the responsiveness of the housing supply. Places like Las Cruces with lots of empty lots to build houses on have more stable house prices and are less prone to housing bubbles. Places like Southern California, with a lack of arable land and with strict zoning laws that restrict construction, are much more likely to have real estate bubbles.
Christopher A. Erickson, Ph.D., is a professor at NMSU. He recently bought a new home. The opinions expressed must not be shared by the regents or the administration of the NMSU. Chris can be reached at [email protected]