How Rare are Housing Bubbles?
Understanding the Case-Shiller Index and its Counterparts
September 9, 2014
by Cesar A. Orosco and Laurence B. Siegel
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Do house prices experience periodic bull and bear markets like the stock market? Or are they stable in real (inflation-adjusted) terms most of the time, with big disruptions once or twice in a century? Two popular house price series tell these very different stories. Knowing which is better will lead to superior investment outcomes and improved policy decisions.
Karl (Chip) Case, of Wellesley College, and the Nobel Prize-winning Yale professor Robert Shiller, have constructed the most widely-known suite of indices, which are now part of the S&P index family. Here is the Case-Shiller national house price index in real terms from 1890 through December 2013:
Case-Shiller National House Price Index in Constant Dollars, 1890-2013
And here is a house price series distributed by the data firm of Crandall, Pierce & Co., consisting of the median new home sales price in constant dollars collected by the U.S. Department of Housing and Urban Development. (For brevity, we call this the “Crandall” series.)
Crandall, Pierce Median New Home Sale Prices in Constant Dollars, March 1963-March 2014.03
Source: Crandall, Pierce & Co., Libertyville, IL. Reprinted with permission.
Could any two charts describing the same underlying phenomenon look more different? In the Case-Shiller chart, there was one great bear market in the last 50 years, from late 2006 to early 2012, following a massive price expansion or bubble.1
In the Crandall chart, however, bull and bear markets have alternated in a remarkably regular pattern. All of the bear markets represent losses of roughly 20%, with the crash of 2008-2011 only a little worse than the three other housing bear markets that occurred in 1968-1970, 1979-1982, and 1988-1992. The Crandall chart also shows real prices rising pretty smartly – 1.35% per year – while the Case-Shiller chart shows a much slower rise.
Note that the two price series do not purport to measure the same thing. The Crandall data are for new houses only; the Case-Shiller data are intended to reflect the entire stock of housing capital.2 The Crandall data are for a median house, the size and quality of which are constantly changing; Case and Shiller explicitly adjust for changes in the size and quality of a house. There are many other differences, so it’s understandable that the two series disagree somewhat – but they’re both intended to track house prices, so the contrast between them is striking and troubling.
Which chart provides a more reliable picture of housing-market returns as experienced by the typical investor?
We should care because the return and volatility of individually owned real estate has profound investment and public policy implications.
Investment implications of house price return and volatility
Paul Samuelson said we are born short a roof over our heads. Thus, if we buy a house – one house – it’s a hedge, not a speculation. The value of the liability (the need to have a house) moves with the value of the asset (the house). For this investment we do not care much about the return and volatility characteristics; we are just prepaying a liability.
But if we speculate in real estate by buying houses or other properties to rent out, they become a portfolio asset like any other. We need to know the expected returns, volatility and correlations with other assets. The Crandall data make housing look like a normal capital asset, one that fluctuates with expected cash flows and discount rates, and that has a standard deviation typical of assets having similar expected returns.
The Case-Shiller data, however, make housing look like a magical asset until it crashes; it has a decent return with almost no volatility. The return is decent because of the receipt of rent. Both the Case-Shiller and Crandall series are price-only, leaving out income from rent net of expenses, which is the primary source of profit for real estate investors. Independent studies have shown that total returns on unleveraged real estate are between those of stocks and bonds.3
The Case-Shiller and Crandall charts, then, present two very different investment profiles and would cause you to behave very differently as a real estate investor depending on which chart is accurate.
Public policy toward real estate
If the Crandall data are correct, the housing crash of 2006-2012 was a normal bear market, a little more severe than the others but not qualitatively different. If so, then the policies preceding the crash were not so bad. Subprime mortgages, loose appraisal practices, and so forth are part of the ordinary workings of a competitive market where people try different things to sell houses and lend money.
But if the Case-Shiller data are correct, we would want to avoid repeating the policies that led up to the crash at all costs. Homeowners who bought (or took out new mortgages) at the top may never recover. If the bubble and subsequent crash in the Case-Shiller data are due to policy errors, these errors are unconscionable.
We came into this investigation with some biases, and it’s healthy to disclose what they are. On one hand, we believed at some level that there is nothing new under the sun. Every capital market phenomenon has an antecedent, or many of them. Real estate values, hence prices, have been fluctuating since expected cash flows and discount rates have been fluctuating – that is, forever. There is no fundamental reason why real estate should not look like any other asset, and in the Crandall chart – which is a pretty picture – it looks very much like one, with bull and bear markets and short-term volatility.
But we were also pretty sure that real estate in the 2000s experienced a crash that was qualitatively more severe than a normal bear market. The pain was far worse and extended far more widely than in previous episodes. Was this just a matter of too much lending to buyers who were poorly positioned to take such risk? Probably not. The percentage decline in real estate prices, we believed, was at least partly to blame for the feeling that there had been a real estate depression.
Comparing the two series
Let’s compare the two series across a number of dimensions.
Long-run rate of return
Before delving into the differences between the Crandall and Case-Shiller series, let’s note the similarities. The long-term rates of return do not seem radically different: 1.5% per year for Crandall and 0.5% for Case-Shiller (both are real, and price-only). But this 1% per year “spread” is economically significant when compounded over long periods of time.
Houses have grown substantially in size and quality over the period studied, so part of the 1.5% annual increase in the Crandall series – which is just a median real new-house sale price – is obviously due to that increase. The Case-Shiller series explicitly adjusts for quality changes and still shows a 0.5% real capital gain, so we accept that lower rate as correct.
- The Case-Shiller chart goes back further in history, so we can see whether there were bear markets in the pre-World War II period. There was only one, and it was a big one, involving a 50% loss over 1894-1919.
- In technical terms, the Crandall series is a median; that is, at each point in time it reflects the price of a single house that divides the population of all houses into two equal-sized subsets, half of the houses cheaper and half more expensive. The median house is a different house in each period. The Case-Shiller series is a true index, like the S&P 500 – it’s designed to capture changes in the value of the whole single-family residential real estate asset class.
- An early study showing this result is Ibbotson, Roger G., and Laurence B. Siegel. “Real estate returns: a comparison with other investments.” Real Estate Economics 12.3 (1984): 219-242. (At the time, Real Estate Economics was called AREUEA Journal.) Later work confirms the result.
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