The 21st Century Housing Paradigm Shift

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by: Eric Basmajian

Summary

For nearly 30 years, housing was a stable asset, growing at ~5% per year.

During the 20th Century, home prices grew nearly exactly at the rate of wages.

The turn of the century came with a shift that caused housing to turn into a boom-bust asset.

Home prices no longer grow in line with wages and that has caused housing to turn into a volatile, speculative asset - It is no longer "safe."

When the volatility of a person's largest asset increases nearly 100%, their consumption becomes less predictable and less stable.

Overview:

(S&P Dow Jones, BLS, BEA)

For the nearly 30 years in the 20th century (as far back as I have the data), home prices and aggregate wages grew at nearly exactly the same rate. Home prices only declined one year (just -1.3% in 1991) and housing was widely considered a safe asset.

After the turn of the century, the dynamic between home prices and wages changed dramatically. Home prices started to grow at multiples of wages and turned into a boom-bust speculative asset verses a safe, stable investment that many hoped to someday own.

The cause of this change is not the focus of this piece. There are likely many reasons for this shift including the Federal Reserve, bank deregulation, easy loan standards and many more. The focus is to highlight how housing has undergone a phase transition and is no longer the "safe" asset that many believe it to be. Homes are now as volatile as some stocks and they are no longer a safe place to park money. Unfortunately, homes have turned into a speculative investment that takes good timing in order to not lose large amounts of money.

30 years ago, you could buy a home at nearly any point in the cycle and expect a positive rate of return or at least expect the value of your money to hold constant. In today's world, the boom-bust speculative housing world, buying a home can be very risky and by no means does it guarantee a positive rate of return. In fact, buying a home can turn into the worst financial decision of someone's life if they purchase at the top of a cycle or the best if they time the bottom.

Buying a home in 2004-2007 caused some owners to lose 30%-50% of their money and took in some cases over 10 years to return to break-even (that is if they held on to their house that long).

Not to mention, a home is a very leveraged asset when a mortgage is involved so a 30% reduction in home prices can be catastrophic.

This is a new phenomenon that investors have to worry about that did not exist 30 years ago.

The increase in volatility of homes is part of the reason homeownership in the United States continues to decline. Consumption also has become less predictable and is more dependent on the real estate market. If a person's largest asset increases in volatility by 100%, the certainty of their net worth is reduced and the propensity to consume becomes more volatile. (Higher during booms and lower during busts.)

In a free market, home prices should increase at the rate of wages, creating a safe, sustainable, long-term asset that creates wealth for Americans over time. I will outline below how this once upon a time "safe" asset has turned into just as large of a gamble as putting all your money into the stock market and why this dynamic is very destructive to the overall economy.

The Housing Paradigm Shift:

(S&P Dow Jones, BLS, BEA)

I don't think many people would argue that home prices increasing at 2x-3x wage growth is not sustainable and would likely result in home prices correcting back to sustainable levels.

That is currently what is going on yet many seem to believe that home prices have to grow at 5%-7% per year because that's what they've done in the past.

Wage growth was regularly over 5% in the past so home price growth in the 5%-7% range makes sense. It doesn't make sense to say wage growth will drop to 3% but homes will still grow at 5%-7%, but that is what's happening. Investors are conditioned to say home prices go up 5% per year no matter what. That is simply wrong, misleading and dangerous.

A few exercises will make the fundamental shift in the housing market clear.

The housing market has gone from a stable investable asset that preserved wealth over time to a speculative, highly leveraged asset that doesn't have much to do with wages. The growth in housing has to do with sentiment, speculation and greed. Since 2000, there have been many years where the national average of home prices grew above 10%, sometimes as high as 15%. That growth came with wage growth of 4%. How does that make sense?

Let's take a look at how things have changed...

Income is the ultimate driver of all consumption and major asset purchases so it makes sense to take a look at income growth first.

Income Growth:

The first chart to look at is aggregate income/population growth.

This chart takes into account the number of employed people * the average weekly earnings of employed people / total population.

What we are trying to see is the total earned dollars in the economy divided by the number of people those dollars need to support. If population grows faster than wages then those dollars need to be spread more thin leaving less dollars for large items, specifically homes.

Aggregate Income / Population (Year-over-Year Growth): (BLS, Census Bureau)

This is all in nominal dollars (not adjusted for inflation since homes aren't adjusted for inflation there is no reason to adjust it).

What's interesting in the chart above is the difference between this economic cycle and each one prior. In all previous economic cycles, wage growth moved cyclically, showing growth, peaking, and slowly declining. This cycle, wages growth has been nearly exactly flat. I'm quite sure it will decline into the next recession as it did in the past but it is interesting how this economic cycle brought wage growth that was stagnant.

There is wage growth, it is just flat. You may think any wage growth is good, and it is. If asset growth was flat, at the same pace as wages, there would be no issue with the chart above.

The issue is that nearly all asset prices, specifically homes for this analysis, have been experiencing very rapidly accelerating growth rates. Growth rates that are far and above the rate of wages. This causes a problem because it is proof that the housing market is not driven by the fundamentals of the economy. Another factor is bidding home prices out of line with the wages the economy produces.

Home prices never outpaced wages from 1970-2000. There was never a housing crisis (of course, there were corrections but no collapses). Starting in 2000, home prices grew out of line with wages, the peak spread between wages and home price growth coming in 2005, and a crisis was the result.

Today, the same trend continues as it did in 2000 where home prices once again are on a different trajectory from wages.

Each year home prices grow faster than wages, the more unaffordable homes become. Year after year can compound to reach home price levels that are far out of reach from most Americans and make a mean reversion very painful.

Home Prices And Wages:

The chart below shows the year-over-year growth of the national home price index and the year-over-year growth of aggregate wages.

As I mentioned, look at the shift that occurred in 2000. Prior to 2000, wages tracked home price growth very closely. After 2000, that changed dramatically.

To make the distinction more clear. I broke the above chart into two separate time frames.

1977-2000 Wage Growth And Home Price Growth:

The correlation is very clear and the relationship is sustainable. Graphing the same data from 2000-today is different.

2000-2017 Wage Growth and Home Price Growth:

For nearly 10 years straight, home prices grew at a faster pace than wages. In 2005, home prices were going up 13% annually and wage growth was 4%. How could anyone have looked at this data and thought it could continue?

The same thing is occurring today since the housing market recovered in 2012. For the past five years, home prices have grown at a much faster rate than wages. There was a massive gap in 2013. Again we have an unsustainable dynamic between home price appreciation and wage growth.

Compounded over time, even a 1% difference in wages and home prices can result in home prices that are 20%-40% more unaffordable.

Using the growth rates above, below is a chart that shows the compounded growth rate of housing and wages.

You can see that until 2000, home prices and wages compounded to the same level, therefore housing was equally affordable on a relative basis for 30 years.

Since then, nearly each year, home prices compounded at rates higher than wages and each year, homes get more unaffordable.

I did as above and broke the chart into two time frames.

1977-1999:

2000-2017:

It is not a stretch to say that this is not sustainable. At some point, it is hard to say when home prices have to revert back to the same level as wages. This means that home prices could fall 30% to revert back to the trend of wages.

Below is a chart of the compounded growth rate between home prices and wages in different time frames.

During the housing bubble from 1990-2006, home prices grew at 5.4% vs. wages at 3.3%. Today, over the past five years, we are at the same dangerous spread with home prices growing at 5.5% and wages growing at 3.2% on an annual basis.

When wages and housing grow at different rates, home prices are subject to more booms and busts.

Homes used to be stable assets with low volatility. Today, home values change quite dramatically. Below I calculated the annual volatility of home price changes. The volatility of the housing market today is nearly as high as the current volatility of the S&P 500! (NYSEARCA:SPY)

The volatility of home prices has nearly doubled in the 21st century. This is devastating for consumption. If you are twice as uncertain about the value of your home, likely your largest asset, you are much less likely to consume big ticket goods and services.

This is empirically true if you look at inflation-adjusted consumption over time. Each cycle makes a lower high in growth. I used rent inflation to show the effect high housing inflation has on consumption.

Takeaway:

There was a paradigm shift in the housing market that took place after 2000. Housing should no longer be considered a safe, stable investment. It is a boom-bust asset. One should be highly cautious investing in real estate at the top of the cycle (where we are today). Real estate is typically a long-term investment and while I want to be very clear in stating that I do not know if home prices will fall this year, or the next, it is nearly a mathematical certainty that home prices will have to revert to the growth rate of wages. This makes a large correction in home prices inevitable.

Lastly, unless the dynamic between home prices and wages changes and returns to a stable relationship, consumption and growth in the economy will remain weak. A house is too large of an asset to have stock price level volatility.

With the Federal Reserve as involved as they are today, it seems unlikely this new phenomenon will change.

At least understand this relationship before someone tells you home prices will go up 5% a year every year.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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