Issue: 78
Sent: 29-05-2007 11:01:09
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Irrational Exuberance Revisited - 6 - Lester Wills
Continuing with the review of the presentation given by Professor Robert Shiller entitled 'Irrational Exuberance Revisited', I am looking at some of his analysis of long-term returns from real estate.
Having found that house prices in the US had not really gone in the period between 1890 and 1997, he asked the question why? As he points out, the price of a house relates mostly to its structure and houses are getting cheaper to build, not more expensive, because of technical progress. Whilst land has been getting more expensive, if a person wants a house and does not care where it is, land can cost much less. As a result the population spreads out into formerly rural areas, taking the pressure off of prices in city centers. This is of course exactly what is happening in Australia, particularly to the west of Sydney I know because that is where I live)..
Shiller goes on to ask the question what to some may seem an obvious question, "Why do people believe home prices will do well in the long-term?"
He suggests that it is partly because of inflation confusion: As he says, homes cannot be split like shares when they become highly priced, and so the rise in nominal home prices caused by inflation is much more apparent than the rise in stock prices.
He also comes up with another possible explanation, that of the popular perceptions of the decline in real interest rates. He constructed a long-term real interest rate series back to 1890, and compared it with his home price series. He found that in reality, declining real interest rates cannot be used to justify the home price boom of today.
Whilst real interest rates have been declining since the early 1980s they do not match up well with home prices. He also separately tested the relationship between government expenditure and home prices and found no meaningful relationship.
Further, he found that the unemployment rate showed no correlation with real home prices. Shiller examined unemployment rates and found that the United States had two high periods of unemployment (the 1890s and the 1930s), yet neither of those periods experienced a decline in real home prices.
He points out that the latest explanation for the continuing boom in housing prices is because, there is no recession looming on the horizon (go figure!).
Any analysis of house prices must also realistically include the rental market, (especially in Australia). Shiller found that since 1913, real rents of primary residences, as reported by the U.S. Bureau of Labor Statistics (BLS), have actually declined. This means that whilst home prices have gone up in recent times, there has been no corresponding increase in real rents. I would hazard a guess and say that a similar situation has occurred in many parts of Australia.
However, as Shiller points out, rents are different from home prices as a renter does not have any speculative interest in the property whilst the buyer does. In order to make the analysis more realistic, Shiller examined the ratio of his home price index to the BLS rent index, suggesting it can be considered as the P/E for housing. He found that since 1913, this ratio has exhibited a strong uptrend. He admits that some have criticised the rent index as it does not account properly for quality change. Consequently, Shiller accepts that this may not be the most accurate measure, but, as he points out, at the very least, the available data does not show that recent home price increases are justified by rent increases.
So what is the deal? Do house prices go up over the long-term or not? Shiller calls on some amazing work looking at house price movements over a 350 year period. What's more it is in a very fashionable neighborhood in a major European city.
What he finds in terms of the real rate of return will be a shock to many. I will explain in the final edition in this series next time.
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