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Faculty
Research:
April 2006
What Real Estate Bubble?
New research from Pomona economics professors Gary Smith and Margaret
H. Smith shows homes actually are undervalued in most of the 10 U.S.
markets they studied.
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Fears of a real estate bubble are overblown and homes remain undervalued
in many markets, according to new research from a pair of Pomona College
professors who came up with a fresh methodology for gauging bubble
trouble.
 By
comparing the cash flow generated by owning a home to the cost of
renting a comparable house, economics professors Gary Smith and Margaret
H. Smith found bubble conditions in only one of the 10 metropolitan U.S.
housing markets they evaluated. In a
paper presented March 31 at the
Brookings Institution in Washington, D.C., the husband-and-wife team
concluded that buying a home generally remains an attractive long-term
investment – even if buyers are conservative in their assumptions about
how much home prices will rise in the future.
“Most of the country is certainly not in a bubble if you define a bubble
as prices far above fundamentals,” said Gary Smith, who is the Fletcher
Jones Professor of Economics at Pomona College. “The average person in
the U.S. is still better off buying than renting.”
San Mateo County in the San Francisco Bay area was the only region
studied where homes were overvalued, by 54 percent. Elsewhere in
California, Orange County prices were about right, while homes in Los
Angeles (11 percent under) and San Bernardino (20 percent under)
counties still were somewhat undervalued. Beyond California, homes also
were undervalued in Boston (12 percent under) and Chicago (17 percent
under). Undervaluation was dramatic in Dallas (40 percent), Atlanta (53
percent), Indianapolis (65 percent) and pre-Hurricane Katrina New
Orleans (46 percent).
The Smiths’ methodology consisted of evaluating housing as a long-term
investment, similar to stocks and bonds. In each market they studied,
the Smiths matched up similar homes, comparing the cost of buying versus
renting, using Multiple Listing Service data from summer 2005. They
projected homeowners’ net savings on rent over time, discounted by a
required after-tax rate of return of 6 percent (included because
the money sunk into the home purchase could presumable be invested
elsewhere, for example, in stocks and bonds.) Their analysis factored in
expenses such as one-time closing costs, taxes, maintenance and
insurance. On the other side of the ledger, they also factored in tax
benefits from ownership and the fact that rents will rise over time,
while payments on a fixed-rate mortgage will not.
 They
assumed a 20 percent down payment, with a 30-year mortgage at a 5.7
percent fixed rate. Under the Smiths’ model, in many cases, the home
purchase initially generates negative cash flow, as the expenses of
owning exceed the rental value and tax benefits. But over time cash flow
becomes positive. And in some of the more dramatically undervalued
markets, such as Indianapolis, owning a home generated an immediate
positive cash flow.
So why all the talk about a housing bubble? The Smiths note in their
paper that as housing prices have risen dramatically in recent years,
some researchers have concluded that homes are now priced well beyond
their fundamental values. But the Pomona College professors question the
implicit assumption that market prices previously matched fundamental
values but now have exceeded them. “Perhaps housing prices were too low
in the past and recent prices have brought market prices more in line
with fundamentals,” they write.
Beyond that, the Smiths question the methodology by which some
researchers have concluded that the housing market is “bubbly.” The
report notes that “housing-bubble discussions generally rely on indirect
barometers such as rapidly increasing prices, unrealistic expectations
of future price increases, and rising ratios of housing price indexes to
household income indexes. These indirect measures cannot answer the key
question of whether housing prices are justified by the anticipated cash
flow.”
Gary Smith says their model also can be adapted to calculate the
likelihood of housing being a good investment under different scenarios,
such as an adjustable rate mortgage instead of a fixed. However, the
Smiths’ model assumes buyers will hold on to the house for the long
haul, not selling in a couple of years.
He advises against trying to predict which direction home prices are
headed, telling the cautionary tale of a Claremont, Calif., professor
who in 2003 decided against buying because he had read in the newspaper
that home prices were 20 percent too high. It turns out home prices rose
dramatically in the area. “You’ve got to run your own
numbers,” Smith said.
Gary Smith is the author of more than 50 articles and several economics
textbooks He earned his B.A. in mathematics at Harvey Mudd College and
his Ph.D. in economics at Yale University. Margaret H. Smith, an
assistant professor of economics at Pomona College, earned her B.A. at
Yale University and her Ph.D. at Harvard University (both in economics).
She also is a Certified Financial Planner and has been published in
journals such as the Journal of Financial Planning, Applied
Financial Economics and Industrial Relations.
Read the full paper.
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