Home prices have gone through a severe bear market for the past five years, after experiencing a strong rising market for several years before that. While some have become discouraged about residential real estate, the time for discouragement is past. Today’s combination of low prices and low mortgage rates makes home buying very attractive. More than that, the real estate cycle itself is now far over-depressed, well below its long-term trend. The natural-and powerful-turn of that cyclic wheel in itself creates a major force driving appreciation of home prices over the next several years. To see this, we’ll look at one of the most cyclic areas of all: California.
The graph above shows median California home prices from 1972 to 2012, as reported by the California Association of Realtors®. There was a tremendous increase from $28,000 in 1972 to $560,000 at the height of the boom in 2006, followed by the recent bear market. Note the short-term recovery from 2009 to 2010 due to the tax credit. This was followed by a decline in 2011 and an increase in 2012. The case is very strong that the bottom is essentially defined and there is a great deal of room for recovery.
California, the most populous of the fifty states, is not one single market. The Central Valley is not the Silicon Valley. However, the great majority of California metros experienced a major housing boom in the last decade followed by a corresponding decline. Accordingly, it is appropriate to look at this large coastal-and cyclic-state as a whole on a high macroeconomic level.
The next graph presents a synthetic variable that gives a measure of the underlying real estate cycle in California. It represents the amount that the market (after correcting for inflation and mortgage rates) is above or below its forty-year trend.
This graph reveals the sheer magnitude of the business cycle itself after inflation and mortgage rates have been factored out. This cycle can have peaks and troughs that are more than 50% above and below the trend. At present the indicator is more than 50% below trend, suggesting that a substantial recovery is not only possible but likely.
Notice that the real estate business cycle went well over trend in the late 1970s, with prices rising very rapidly even after inflation, and even in the face of high (and rising) mortgage rates. This shows the inherent momentum and cyclic swing of the business cycle in action. Remember that a home is a hedge against inflation for the average person. Thus, inflation does not kill a real estate market if the cycle is in its positive phase. True, mortgage rates go up, but not enough to stop it; there is a rise even after allowing for higher rates and inflation.
There was a settling back in the early 1980s, which was indeed partly due to the Volcker increases in interest rates to combat inflation, thus causing a recession, but even more because the business cycle itself went into a bear phase. California real estate has been inherently cyclic even after other factors are allowed for. Here the business cycle is a fundamental of economics, just as is the law of supply and demand. There was a cyclic boom in the late 1980s followed by a cyclic bear in the 1990s, even though interest rates were going down during the nineties, enabling many refinances. The market simply had moved from bull to bear.
What has been shown for California, of course, suggests similar conclusions for other cyclic markets and for most of the country in general. One can expect a basic cyclic bull market for several years, cleaning out the distressed inventory as it rises, then crossing its trend about 2017-and quite possibly overshooting on the other side. Barring an external catastrophe such as a major war or another event on that level, this new bull market seems almost unstoppable.
