FRBSF Economic Letter
2005-21; August 26, 2005
Housing Markets and Demographics
Fifteen years ago, like today, there
were concerns that house prices might collapse. One big
difference between
then and now, however, is the basis for those concerns.
Today, people are worried that a house price bubble (if
one exists) might burst, while 15 years ago, people were
worried about demographic effects, specifically, the inevitable
aging of the baby boomers.
The earlier concern was sparked
by a paper by Mankiw and Weil (1989), in which the authors
famously predicted that
between 1987 and 2007, real house prices could fall by
3% per year. In fact, real house prices grew by an average
of 3-1/2% per year from 1987 to 2004. Of course, the
Mankiw-Weil prediction may yet come to pass; or it may
have already
occurred and simply been masked by the surge in demand
over the last seven years that is due to other factors.
But the relationship between demographics and house prices
remains interesting both because housing constitutes
such a large component of the typical household's wealth,
and
because much remains to be understood about the consequences
of the baby boomers liquidating their housing and financial
assets. In this Economic Letter, I revisit the economics
of the housing market and demographics.
A simple model of
the housing market
Prices and quantities in housing markets are determined
by the interaction of the construction sector (the supply
side) with households (the demand side). Key variables
governing the supply of new housing include prices, the
costs of construction materials and land, the cost of
financing, and the amount of undepreciated housing stock.
Similarly,
key variables governing the quantity of housing include
prices, the level of mortgage rates, expectations of
permanent income or wealth, rates of return on other
investments,
and demographic factors that influence the decision to
buy a house.
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One demographic factor that is particularly
significant is the age distribution. A baby boom, or
a temporary increase in the birth rate, shifts the age
distribution
(Figure 1). This is important because, as Figure 2 shows, homeownership rates
vary considerably by age, increasing from an average of less than 40% for households
in their twenties to almost 70% by the time they reach ages 35-44. Evidently,
the initial decision to buy a house is closely related to life-cycle events,
such as having a family. Importantly, homeownership rates for households 65
and older are even higher; apparently, they are reluctant
to leave homeownership,
even as their household size shrinks and the need for space declines.
The effects
of the postwar baby boom on the age distribution of the U.S. population suggest
that the share of younger households will rise over time. If ownership
rates follow historical patterns, this larger share of young households will
lead to a decline in the demand for housing and downward pressure on prices.
To assess the timing and magnitude of this downward pressure, it is useful
to consider two extreme cases. In the first case, households
and builders are forward-looking,
and demand and supply are "price-elastic," meaning quantities are
responsive to changes in prices. In this market, in anticipation of weaker
demand for housing
as boomers age and exit, prices would tend to decline, because young households
would be unwilling to pay high prices now for houses that will be cheaper in
the future. However, this does not imply that house prices would collapse.
With lower prices, price-elastic households may decide the time is ripe to
invest
more in housing—either a bigger house or a second house. In addition, builders
would observe the lower prices and reduce new construction. So, in this market,
the effect of the exiting baby boomers on house prices would be gradual, and
the overall magnitude of price changes would not be great.
At the other end of the spectrum is a housing market with
myopic participants whose behavior is not responsive to
price changes. Even though relatively large
numbers of baby boomer houses are expected to be for sale in the future, myopic
households would not "see" this and would not force prices down.
Builders would keep building straight into the downturn in demand. Once boomers
actually
start to exit, there would be relatively more houses for sale, and households
would require large discounts in order to increase their consumption. In this
market, house prices would be much more volatile, and the overall magnitude
of price changes would be great. The question, then, is: Which of these two
extremes
comes closer to describing the U.S. housing market today? Demand-side factors
and expectations
As Figure 2 showed, despite significant variation in house prices and interest
rates over time, homeownership rates by age of household are not very different
now from any time in the last 25 years. This is consistent with other research
suggesting that, compared with the demand for other consumer goods, housing
demand is relatively price-inelastic. Such a finding is not surprising, because
housing
is special in a couple of ways. First, like food, it is a basic need, and all
households consume it in some fashion. Second, housing comes in hard-to-break-up
packages; therefore, while households may be expected to buy more house if
prices decline, they are less likely to buy more houses.
So will demand for the houses
of exiting baby boomers be weak? If the houses come onto the market suddenly,
then prices are bound to fall. This is the essence
of demand inelasticity. For example, rural areas and cities that have suffered
population loss have not enjoyed the large increases in house prices that the
rest of the nation has recently experienced but saw price declines instead.
But
the aging of a baby boom need not imply population loss. In fact, the U.S.
population is projected to grow over the next 50 years,
though the average household
age will decline. Therefore, apart from the issue of homeownership rates, there
should be enough potential demand to meet the supply of baby boomer houses
for sale, thus providing some support for prices.
There is also a question of how
imminent a sale of baby boomer assets is. While homeownership rates stay high
as households age, there is a debate on whether
real housing expenditures decline with age. This was a prominent assumption
in the Mankiw and Weil analysis that has not been fully
resolved. On the one hand,
baby boomers have more financial assets and generally better health than their
parents, which would tend to support housing consumption. On the other hand,
changes in the tax code now make it easier to trade down, which reduces housing
consumption. This debate, however, matters only for the timing of the baby
boomer impact. At some point, death or illness will cause
baby boomers' houses to come
onto the market.
It would appear, then, that the most important question
as far as demand is concerned
is how "expected" the sale of baby boomer housing assets will be. Unfortunately,
the empirical literature on house prices provides conflicting evidence on this
question. House prices tend to appreciate over long periods of time, and then
flatten out over long periods of time. Therefore, in general, one can form reliable
expectations of future price appreciation by extrapolating from the recent past.
At the same time, for extreme events, there is evidence that market prices adjust
before the events actually take place; for example, real estate values tend to
fall immediately upon the announcement of plans to close a local military base.
Furthermore, Krainer and Wei (2004) show that the volatility of house prices,
though perhaps excessive, is essentially pinned down by volatility in future
prices and rents, as asset pricing theory would suggest. How elastic is supply?
The analysis in Mankiw and Weil assumed a very inelastic
supply response—for every 1% increase in house price
the construction sector would increase the stock
of housing by 1%. Other researchers (e.g., Topel and Rosen 1988) estimate the
supply response to be more elastic—for every 1% increase in house price, new
construction increases by 1.5-3%.
During the 1990s, however, the link between
house prices and new residential construction shifted dramatically. Even though
house prices shot up at the end
of the decade, the response from the construction sector was unusually subdued.
At first blush, this suggests that supply has become less price elastic. But
there is good reason to think the supply response reflects developments particular
to that period. A well-established literature in urban economics on supply
constraints, such as regulation and physical geography,
shows how these constraints affect
price dynamics. Glaeser, Gyourko, and Saks (2004) argue that these constraints
have become more binding, particularly in markets that experienced productivity
shocks over the past 20 years. While this may partly explain why prices have
risen so quickly in certain regions without a matching supply response, it
is unlikely to imply that developers would ignore falling
prices and rising vacancies
and keep on building. Additionally, the subdued supply response during the
recent upswing in prices has apparently not led to overbuilding,
implying less likelihood
of excess supply once the baby boomers leave their houses. Conclusion
Even as discussion of the current run-up in house prices
points to the extremely favorable demographic conditions
for demand, little has been said (lately) about
what will happen once these demand conditions ebb. The worst-case scenario
for house price declines depends on three factors:
an inelastic demand for housing,
a fair degree of myopia when forming expectations, and an inelastic supply
function. However, recent research in urban economics
suggests that two of these factors—expectations
formation and the supply response—are probably more flexible than once thought.
Furthermore, a negative demand shock like the aging and exiting of baby boomers
is only one of many factors to consider in anticipating the future of house
prices. The productivity gains in the 1990s can be
viewed as a positive demand shock.
To the extent that younger generations now expect higher permanent income,
this increase in expected wealth should help support
house prices. John Krainer
Economist References
Glaeser, E., J. Gyourko, and R. Saks. 2004. "Why Have
House Prices Gone Up?" Harvard University working
paper.
Krainer, J., and C. Wei. 2004. "House
Prices and Fundamental Value." FRBSF Economic Letter. .
Mankiw,
N.G., and D. Weil. 1989. "The Baby Boom, the
Baby Bust, and the Housing Market." Regional Science
and Urban Economics 19, pp. 235-258.
Topel, R., and S. Rosen. 1988. "Housing Investment
in the United States." Journal of Political Economy
96(4) pp. 718-740.
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do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
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