The most widely discussed real estate issue in the United States today boils down to a two-part question: Does a housing bubble in America exist? And if so, will it burst? This column will present my current thoughts on the subject.

Fear of a housing bubble is based on the following facts:

  • Housing prices in many regions have risen at record speed. From 1996 to 2004, while the U.S. median home price in current dollars rose 56.7%, the same measure rose 156% in California, 144% in Miami, 127% in the New York region, 124% in Las Vegas, and 105% in the Boston region.

  • The total number of homes of all types sold also has soared. Before 1993, it rarely exceeded 4 million units. But then it rose from 4.3 million units in 1993 to 6.8 million in 2004, and may exceed 7 million in 2005.

  • More homebuyers are using mortgage loans that require low or no down payments. Many loans are based on initial interest-only payments for five to 10 years. That keeps initial payments low, but will then shock buyers with big increases.



“Flippers,” or speculators who buy residences with no intention of occupying them, are buying a higher percentage of housing units sold — especially high-rise condo units, and to a much lesser extent, detached single-family homes. If home prices were to fall, many of these speculators would walk away from their deals, causing prices to fall farther.

All real estate markets are being flooded by capital from investors avoiding the volatility of stocks and the low yields and rising interest-rate vulnerability of bonds. This trend has caused mortgage lenders to loosen their credit standards, raising the risk of many housing investments.

What is a bubble exactly?

A market bubble is an inflated pricing of some asset far beyond its true reproduction cost. It is caused by excessive demand for that asset. That demand is usually stimulated by past rapid increases in the asset's price that generate widespread expectations of further increases. The bursting of such a bubble occurs when demand for the asset suddenly collapses, causing the asset's price to plummet. An example is what happened to the Nasdaq stock index in 2000, when it plunged from 5049 to 1429.

Could the demand for housing collapse, causing a catastrophic fall in prices? I doubt if this could occur in the single-family home market in all but the most speculation-dominated markets. The main protection against such a collapse is that nearly every single-family housing unit is already occupied by members of a household. Unlike the users of office space — the demand for which can fall precipitously overnight if firms disappear or go bankrupt, as many Internet firms did in 2000 — all those households still have to live somewhere.

History lesson

If housing prices start to decline, most owner-occupants who were considering selling would withdraw their homes from the market and wait for prices to recover. Thus, the supply of units for sale will fall almost as fast as demand, placing a floor under prices.

Most past declines in home prices have occurred as a result of regional or national recessions in which many workers lost their jobs, as in Texas in the mid-1980s. When such a recession becomes prolonged, as in Japan in the 1990s, home prices can decline greatly over a long period. But that has not happened in the U.S. since World War II.

Moreover, the U.S. economy is expanding, not contracting, so jobs are rising. Therefore, the demand for single-family homes is unlikely to fall sharply, if at all.However, demand for certain other types of housing units can collapse suddenly because so many of the buyers are not occupying the units, but rather hoping to sell them quickly. This trend is particularly true of high-rise condominiums in which large proportions of the units have been sold to speculators.

Such purchasers might “walk” if the re-sale prices of their units suddenly decline. That seems most likely in Miami, where the condo market is being flooded with new units by developers trying to cash in on the housing price boom.

Demand for rental apartments can also fall suddenly, but mainly as a result of a recession that cuts employment. When times are tough, many renters double up, or move back with their parents. Hence, during recessions rental vacancies typically rise and apartment rents stabilize or fall.

Potential threats

The recent rapid run-up in housing prices cannot last forever because people's incomes are not rising nearly as fast. The biggest threat to housing prices is probably any type of recession, or even a drastic slowdown in the nation's or a region's current economic expansion. In several past regional recessions, housing prices have notably fallen. In California in the early 1990s, the median price of homes sold dropped 11.7% from 1991 to 1996.

It is true that the national annual median price has never declined since 1968. But that fact disguises many significant regional or local housing price declines. Any big slowdown in a region's economy could cause similar price declines. But a total collapse on a national scale associated with a housing bubble is unlikely.

The real threat of a sharp slowdown, or a modest decline, in home prices is not the direct impact upon housing markets as much as related effects on other economic sectors. If housing prices stopped rising, the desire to buy a home to capture further appreciation would fall, so sales of new homes would probably decline. But high-level homebuilding activity has been a key element in the current economic expansion. A slowdown in new housing construction and all the related demands for items like new furniture and building supplies would cut job growth notably.

Moreover, consumers have been motivated to maintain high-level spending on many non-housing goods and services by the huge equity gains in their homes that they count as increased personal wealth. If home equities were to start shrinking as a result of even slightly lower prices, this could notably dampen consumer spending, further slowing economic growth.

These negative effects would surely aggravate any slowdown in economic activity because of factors other than housing market conditions. Thus, if a recession were to start for other reasons, job losses would slow the demand for housing, setting off these adverse reactions in housing markets. So the housing price situation, while not a true bubble, could significantly exacerbate such a recession.

Ripple effects of Katrina

This picture is further complicated by the impact of Hurricane Katrina. The immense loss of housing inventory in the Gulf Coast will create a need for many thousands of new units or repairs to damaged units — but it is not clear who will pay to meet that need. If a combination of insurance payments and federal aid comes to the rescue, the housing construction industry will benefit.

Yet the positive impact of this rebuilding is so regionally constrained that it would not fully offset the overall negative impact described above, if a recession were to occur. And Katrina itself might slow overall economic growth enough to cause at least a notable pause in the economic expansion.

Thus, the recent rapid run-up in housing prices in many metropolitan areas is probably not a true market bubble. But it could have notably adverse effects on the U.S. economy, if a recession or a large-scale slowdown occurs. Sooner or later, that is quite likely to happen.

Anthony Downs is a senior fellow at the Brookings Institution and a visiting fellow at the Public Policy Institute of California. He can be reached at anthonydowns@csi.com.