Will the Roof Cave In?
By Nick Ravo
worth.com
After sifting through supply, demand, and
demographics, one economist sees the real-estate
market slipping downhill into the next century
Your home soon will be worth less than it is now.
And in a few years, it will be worth even less. And in a few decades, it will be worth a lot less.
That's right-less. Forget what real-estate brokers
tell you. Forget what you read In the real-estate
section of your local newspaper. Forget your dream
about cashing out of that new split-level on
steroids when you retire and taking off for some
sunny and cheaper clime. Forget it. You're doomed
because of demographics. You're doomed because of
disinflation. You're doomed because home builders
will keep building homes.
In fact, your home-unless you're one of the lucky
few-might be losing value right now, as you sleep,
as you mow the lawn, as you fix the roof, as you
write the mortgage check. You thought the
real-estate recession was over? Just wait until the Real Estate Crash of 2010.
And this is not a Paul Erdman novel.
In the gray world of housing economics, it is known simply as McFadden's chart, although adjectives and analogies to Mount Everest or the Matterhorn are
sometimes attached-and they are certainly apt. The
chart is the centerpiece of a report written in
1994 by Professor Daniel McFadden, an economist.
Simply put, McFadden posited that home prices would peak in the mid-1990s and slowly fall to their
inflation-adjusted 1911 level (no, that's no
typo-1911) through the first half of the 21st
century, affecting not only baby boomers but
Generations X, Y, and Z, too.
This work, "Demographics, the Housing Market, and
the Welfare of the Elderly," is no dumbed-down
press release, either. McFadden, a professor at the University of California at Berkeley, wrote it
under the aegis of the National Bureau of Economic
Research for a book, Studies in the Economics of
Aging, which was published by the University of
Chicago Press. His work, much of it indecipherable
to anyone without a knowledge of advanced
mathematics, is based on decades of information,
and it attempts to balance an obvious demographic
problem (the wave of baby boomers entering
retirement) with housing demand (which he believes
will increase in retirement locales but decrease In work locations) and housing supply (which he
believes will increase in capacity, despite limited land in desirable areas). And in the time since his study appeared, he hasn't backed off any of its
conclusions.
The apex, coincidentally, in McFadden's chart is
right about now, but he adds that short-term
predictions of income and prices are less accurate
than forecasts of long-term trends, so the high
point could be off by a few years. "There are three major factors influencing the housing market-
demographics, income growth, and
construction-Industry capacity and costs," he says. "Through the 1980s and early '90s, all three
factors were pushing prices up. in the future, at
least demographics and possibly construction
factors are going to be pushing the other way.
"The movement of baby boomers out of the
large-family-house category and the projected
flattening out of the U.S. population over the next 50 years create a demographic imperative that would cause housing prices to fall over the long run if
there were no other changes going on," McFadden
says. "Superimposed on this Is increasing demand
for square footage with growing household incomes,
which puts upward pressure on prices, and the
growing capacity of the construction industry,
which puts downward pressure on prices....The study predicts that all these effects taken together will put in net downward pressure on prices."
The results, McFadden adds, are sensitive not just
to demographic changes but also to how fast
household income and construction costs increase.
"Another caveat is that housing markets are local
and heterogeneous," he says. "So that even if one
believed the long-run forecast of national trends,
these could be overwhelmed by local conditions in
Phoenix, Seattle, or Cleveland."
Indeed, Phoenix is a good example of how supply can tweak McFadden's predicted demographic and
population changes, says Karl E. Case, a professor
at Wellseley College and one of the nation's
leading experts in real-estate economics. "If you
look across metropolitan areas, the ones with the
greatest price appreciation have not been the ones
with the best demographics," he says. "Why? Because supply plays a role. When they build faster than
people go to Phoenix, for example, house prices
don't do much."
The chart, and its thesis, though downplayed or
dismissed by some economists, has its believers.
John Tuccillo, the former chief economist for the
National Association of Realtors, shares some of
McFadden's pessimism. "There are a number of layers at which this can be attacked," he says, "but the
bottom line is the same: After about 2022, the
housing market begins to tail off badly, and values probably suffer badly. You will notice my date is
later than McFadden's, and there are several
reasons why. Older boomers, those born between 1945 and 1956, will be more long-lived, more active, and more interested in the housing market than their
forebears. it's not until the younger boomers start to retire that the numbers begin to turn against
the real-estate market."
McFadden's thesis is also one of the central
focuses of the book Boomernomics: The Future of
Your Money in the Upcoming Generational Warfare,
written by William Sterling and Stephen Waite, an
investment strategist and a portfolio manager,
respectively, at Credit Suisse, and published in
1998 by the Library of Contemporary Thought.
"Barring war, pestilence, famine, or-more likely,
perhaps-massive waves of immigration, the imbalance in size between the baby boomers and the baby-bust
generation suggests a buyers' market for real
estate ahead," says Sterling. "That should be
especially true in many Northern suburban
residential markets when the baby boomers begin to
retire in large numbers beginning around 2010."
He cautions, too, that demographic shifts occur
gradually, so it's not as if a bear market in real
estate can be predicted with pinpoint accuracy. And the vagaries of the business cycle also make a big
difference. "What is more predictable," Sterling
says, "Is that the underlying trend in real estate
prices will be generally unfavorable, and that home prices may have trouble keeping up with inflation
after the boomers begin to retire in large
numbers."
In other words, the crash will come like a man
going bald: slowly, surely, painfully. "It is not
necessary for home prices to decline in nominal
dollars in coming years for homes to represent a
terrible investment for baby boomers," Sterling
says. "The McFadden chart implies, between 1995 and 2020, an annual inflation-adjusted depreciation of
about 0.8 percent per year, which sounds rather
harmless. But compounded over 25 years, that
results in an inflation-adjusted loss of 19
percent."
Assume a rate of inflation that approximates recent experience-say, 2 percent annually. in that case,
McFadden's projections imply that home prices rise
modestly but fail to keep pace with inflation.
Using McFadden's profile for real home prices,
today's $150,000 home would be worth $172,000 in
2010, $193,000 in 2020, and $216,000 in 2030. "That doesn't sound bad," Sterling says, "until one
realizes that, to keep up with inflation of 2
percent annually, today's $150,000 home would have
to be worth $190,000 in 2010, $232,000 in 2020, and $283,000 in 2030."
That loss of value on an after-Inflation basis will get worse as more boomers move into retirement age.
"McFadden projects an average annual real
depreciation per year of about 1 percent over the
1995-to-2030 period, which would imply a 30 percent decline in real values by 2030 from their 1995
level," Sterling says. "In other words, a home that cost $150,000 in 1995 will have a value of $136,000 in 2010, if inflation is zero, and $121,500 in 2020 and $105,000 in 2030. if inflation settles in at
about 1 percent per annum, then today's $150,000
home can be expected to remain at around $150,000
into the 2010, 2020, and 2030 horizon. Even
modest-sounding rates of inflation, like 1 percent
per annum, imply a substantial loss in the
purchasing power of the dollar over long periods."
The detractors to the McFadden chart are many, of
course. Ken Lusht, a professor of real-estate
economics and associate dean for research at Smeal
College of Business at Pennsylvania State
University, says even the demographics-usually the
wobbliest leg of the real-estate table in any
future scenario-don't look that bad.
"Beginning in the mid-90s, the starter-home
group-26 to 34 is the typical buying range-began to decline and will continue to decline until around
2010," Lusht says. "The trade-up group-those 35 to
45-will peak around 2005, then decline for about
ten years. The second-home or vacation-home
group-those in the 45-to-55 range-has increased
since 1990 and should increase rapidly through
around 2010. The retirement-home group-those 60 to
90-began to decline slightly in the mid-90s, will
continue to do so through about 2005, then increase rapidly through 2020. Finally, the apartment-renter group-In the 18-to-28 range-has declined rapidly
from 1990 until right about now. it begins to
increase again in 2003.
"I'm not sure all of that adds up to a crash," he
says. "Starter homes will lag for a while. Around
2005, starter homes will pick up, while move-ups
begin to lag. Apartments will do well for the
foreseeable future, as will vacation and retirement homes. The latter two groups will, in my view, do
even better than the current demographics suggest,
as life spans and quality of life increase."
Richard K. Green, an associate professor at the
University of Wisconsin School of Business, notes
that a study of McFadden-level gloominess-
published in 1989 in Regional Science and Urban
Economics by esteemed economist N. Gregory Mankiw
of Harvard-predicted that real house prices would
fall by 47 percent between 1987 and 2007. "My
calculations have the CPI [consumer price index]
rising by about 39 percent between 1987 and 1997,
while the Freddie Mac Repeat Sale index has house
prices rising by 43 percent over that time period," Green says. That's an inflation- adjusted increase
of 4 percent in the value of homes over those ten
years. it's a measly figure, to be sure, but it's a far cry from a 47 percent decline.
Green, who also published his 1996 report on
housing prices in Regional Science and Urban
Economics, says the evidence suggests that there is not much to worry about with respect to a big
boomer sell-off. He agrees with McFadden that the
supply of housing will increase but differs on what the effect will be on the cost of housing. And
demographics, he says, are also not the
800-pound-gorilla predictor many believe them to
be. "The big wild cards are the cost of capital and tax policy-substantial changes in either of these
could cause house prices to either rise or fall
substantially," he says.
Green also says that predicting a sustained
collapse in the price of a financial asset implies
that markets are incredibly ineffcient-which may,
he says, be the case sometimes during the short
term but isn't for sustained periods. "Information
about demographics is freely available," he says.
"It is hard to believe that if the aging of the
population mattered so much, people would not be
rushing away from ownership and toward rental,
unless we really believe that people are
financially stupid."
Even McFadden has his doubts about the collapse of
real estate, noting the dIffculty and the track
record of long-range forecasting. "Personally, I'm
not shorting real estate," he says. Still, the
evidence is strong that the inflation-fueled
real-estate heyday that many boomers and, in
particular, their parents witnessed in the 1970s
and 1980s isn't going to be seen again. Ever.
"Senior boomers will be forced to accept the
unpleasant choice of selling at unattractive price
levels or rethinking their plans to move south or
buy smaller homes," Sterling says, adding that this could forestall a retirement real-estate boom in
places like Florida and Arizona.
"The typical characteristic of real-estate markets
under distress is that transactions simply dry up,"
Sterling says. "Would-be sellers, when confronted
with poor market conditions, often just take their
homes off the market, hoping to re-list later on
when things improve. But if demographic analysis is
correct, boomers who are waiting for things to
improve may have a long wait indeed."
Nick Ravo is a reporter for The New York Times. He
wrote about Florida's housing market in the April
1998 issue of Worth.
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