The Real-Estate Deceleration
The news media have been featuring stories of the “slow down” in the real estate boom in the USA. Properties are on the market for sale longer, and prices are no longer rising, or rising at a smaller rate of increase. The data indicate that the real estate market, both in construction and in prices, peaked out in 2005.
by Fred E. Foldvary, Senior Editor
This deceleration does not imply that the real estate bubble will burst in 2006. The bubble metaphor should not be taken too far. The real estate market is not like a soap bubble that suddenly bursts, or like a speculative boom in a commodity, that can suddenly collapse. Real estate typically at first plateaus as prices stop rising. Many owners refuse to sell at lower prices, and so properties remain for sale for a longer time. Construction gradually slows as previous projects get completed but there are fewer housing starts.
The greatest real estate boom has been in California, and in January 2006 the news media there have been bursting with real estate stories. One headline says “Housing slows down across California” (Jan. 27, p. c1, Contra Costa Times). The California Building Industry Association has predicted that home buildings gains have come to an end. The number of housing starts in California has declined.
The January 11 headline in the business section of the Contra Costa Times exclaimed, “Economist warns of housing slump.” Christopher Thornberg, an economist with the UCLA Anderson Forecast, who previously described the real estate market as a bubble, warned that the real estate market is slowing down. He stated in a meeting with business leaders that the real estate market has peaked. “And beyond that is a downhill run.” He estimated that house prices in California are 30 to 40 percent overvalued. The fall of the housing domino will turn affect other industries.
The January 20 business section of the Contra Costa Times had a big article under the headline “Real estate slowdown.” It stated that many real estate analysis believe that December 2005 marked the end of the “historic home price run-up.” In the San Francisco Bay Area, the December 2005 median price fell 2.6 percent from the historic high on November 2005.
Economic investment drives the business cycle, and a third of investment is related to real estate. As construction declines, workers in that industry as well as complementary fields such as real estate finance lose their jobs. Homeowners will stop borrowing on the equity of their real estate. Their demand for goods declines, reducing profits in the rest of the economy. The reduction in investment and consumption eventually brings down total output, and the recession then strains the banking system as homeowners walk away from their loans.
The real estate boom was unsustainable because mortgage payments come out of wages. Productivity has been growing, but the extra income is not going to wages. A little of it goes to the high salaries of top executives, but most of it goes to land rent and land value.
Thornberg blamed California’s proposition 13 for causing some of the problem. That proposition, approved by the voters in 1978, capped real estate taxes at one percent of the market value, and capped increases in real estate taxes at two percent per year. Thornberg argues that the restriction on real estate tax revenue led California to enact worse taxes, on income and sales.
Thornberg is not predicting a recession this year. It takes time for the real estate slowdown to affect the rest of the economy. For the past 200 years, there has been a real estate cycle in the USA with an average duration of 18 years. The last cycle bottom was in 1990, indicating a coming recession around the year 2008. But it could come a year sooner or later.
The smart money invested in Real Estate Investment Trusts (REITs) and real estate partnerships in the late 1990s. REITs trade in the financial markets and can be bought and sold like stocks or mutual funds. While those who invested in the technology boom and held on after 2000 had large losses, those who invested in real estate sailed through the recession of 2001 and had large gains by 2005. Smart cats have now been selling such real estate investments.
The real estate boom is not caused by the non-existent free market. Governments induce people to speculate in real estate with artificially low interest rates and with tax advantages. Those who sell their homes escape much of the capital gains tax, while property taxes and mortgage interest are tax deductible. Low-income housing yields tax credits, and those who own rental properties can depreciate them and then swap them with no tax. Speculators get rewarded, while the ordinary worker who is not already a landowner gets increasingly shut out of home ownership. Those who did buy a house with risky adjustable-mortgage loans could lose their homes if they get laid off or when interest rates rise and they can’t afford the higher payments.
The dysfunctional policies that drive the real estate boom and will lead to the coming bust are so ingrained in our political culture that they will not be dislodged any time soon. Fundamental reforms in taxation and the financial system will only come about after a crisis.
Real estate cycles world-wide have not been moving together. Japan, for example, has been rising out of its 15-year slump as banking reforms have finally cleaned out bad loans. But once the USA sinks into a deep depression, all the countries exporting to Americans will suffer a loss of business. We can’t stop the momentum, but at least smart cats who understand real economics can prepare themselves for the coming depression, which will be world-wide.
-- Fred Foldvary
Copyright 2006 by Fred E. Foldvary. All rights reserved. No part of this material may be reproduced or transmitted in any form or by any means, electronic or mechanical, which includes but is not limited to facsimile transmission, photocopying, recording, rekeying, or using any information storage or retrieval system, without giving full credit to Fred Foldvary and The Progress Report.
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