Overinvestment in Residential Real Estate: An Analysis of the Impact across Levels of Economic Diversification

Article excerpt

Executive Summary

This paper examines county-level data within metropolitan statistical areas in two east coast states, to explain variation in the magnitude of the boom and bust in residential real estate from 2001 to 2010. Evidence of past housing cycles demonstrates that real estate is not immune to volatility or devaluation. It responds to changes in supply and demand. Wheaton's (2005) analysis of ski resort real estate prices in Loon Mountain, New Hampshire, suggests that resort areas are especially vulnerable to boom and bust episodes, particularly due to additional demand forces from secondary or recreational home ownership.

An important result from the present study concerns the effect in resort destination areas and areas where income growth was less than average over the decade. The findings are consistent with those from Wheaton (2005), and show that building activity and home prices are more elastic in areas considered to be vacation-type destinations as compared with activity and price changes in non-vacation destination counties. These findings have implications for policy makers, and suggest the need for reconsideration of decades of federal housing policies that were, among other things, intended to stabilize the workforce in the U.S.

Introduction

Federal incentives have been a growing factor in the residential real estate market for decades. These incentives, combined with historically low interest rates, created an unprecedented expansion in housing construction in the last decade, and by the peak of the expansion in 2006, the annual volume of new home sales was 156% greater than the level in 1992. The potential for overinvestment was rarely viewed as a serious risk for the long list of stakeholders including homeowners, builders, investors, real estate and finance professionals, government officials and others. Yet, by 2010 the annual volume of new home sales stood 73% below the 2006 peak.

There are many reasons to be concerned about instability in real estate and construction. These sectors combined averaged 16 percent of the value-added to GDP from 1998 to 2009. This does not include direct banking services supporting real estate and construction transactions, nor does it consider the key role mortgage lending played in the overall financial sector and the many consumer and business activities that benefitted from bank credit. Another concern is the impact on worker mobility when home prices drop significantly below their mortgage balance. The decreased liquidity in residential real estate has a dragging effect on the recovery in employment.

Casual observation of various markets in North and South Carolina suggests the magnitude of the latest housing cycle varied considerably across different locations within regions. These states comprise a mix of coastal, mountain, and major metropolitan regions, with varying degrees of government and private sector activity Certain cities in the major resort areas of these states appear to have suffered much greater in the last housing recession. Researchers have noted this tendency in past studies. Gallin (2006) reports that many large coastal cities suffered dramatic price swings in the 1980s and 1990s. Wheaton (2005) tries to explain why real prices actually fell over a 25-year period in the resort area of Loon Mountain, Hew Hampshire.

These studies and others highlight the importance of the supply response to changes in the lending environment, inflation expectations, and other expected economic outcomes. In the latest building and real estate boom, the opportunity for small and/or novice investors to join the supply side of the market became widely recognizable, with some television networks devoting entire shows to "flipping" properties. This phenomenon may have been greater in areas where the cost of undertaking a new entrepreneurial risk might have been lower or the rewards greater.

Smaller resort communities in the Southeast are one type of area where the economic conditions might have induced such undertakings. …