WHAT prices will today’s home buyers get if they sell a decade from now?

Most people live in their home for many years. They don’t need to view it as an investment at all, but if they do, they surely need a long forecasting horizon.

The problem is that modern economics has a poor understanding of past movements in home prices. And that makes the task of predicting the state of the market in 2023 challenging, at the very least. Still, we can learn something by analyzing the factors that affect home prices in general.

There has been some good news lately: home prices have risen over the last year, and with those gains there has been a renewed sense of optimism. But do these price increases mean that homes are now good investments for the long haul?

Unfortunately, no. We do know one thing from economic research: one-year home price increases, after correcting for inflation, have had almost no statistical relationship to increases 10 years down the road. Thus, the upturn last year is irrelevant to long-run forecasting. Booms are typically followed by busts, usually in far less than 10 years. In a decade, an entire housing boom, if there is one in inflation-corrected terms, is likely to have been reversed and completely washed away.

Inflation has a major impact on long-term home prices. So do the costs of construction. We’ll examine these factors now, and turn to other important influences like speculative pressures and cultural and demographic trends in subsequent columns.

Home prices look remarkably stable when corrected for inflation. Over the 100 years ending in 1990 — before the recent housing boom — real home prices rose only 0.2 percent a year, on average. The smallness of that increase seems best explained by rising productivity in construction, which offset increasing costs of land and labor.

Of course, home prices are likely to be much higher in 2023 when measured in nominal dollars — those that aren’t inflation-adjusted. Inflation is the deliberate policy of the Federal Reserve, with a target rate now of 2 percent a year as measured by the personal consumption expenditure deflator, or about 2.4 percent on the Consumer Price Index. At those rates, nominal prices will be roughly 25 percent higher, over all, in a decade.

All else equal, the current Fed policy would have this effect: a home selling for $200,000 today will sell for around $250,000 in 2023, though the real price — corrected for inflation — would be unchanged. But because people often forget to correct for inflation, they may have the illusion that the market is improving.

In an ideal world, steady and uniform inflation would have no effect on rational decision-making because it affects incomes as well as prices. But in the real world, inflation does affect our psychology. People feel more optimistic when their nominal pay rises or when a neighbor’s house sold for more than they paid for theirs. But in thinking about investments for the long term, we should focus on fundamentals — on real, inflation-corrected values and on the economics behind them.

Here is a harsh truth about homeownership: Over the long haul, it’s hard for homes to compete with the stock market in real appreciation. That’s because companies whose shares are traded on a stock exchange retain a good share of their earnings to plow back into the business. The business should grow and its real stock price should also grow through time — unless the company makes poor decisions, as some certainly do.

By contrast, real home prices should decline with time, except to the extent that households shell out some money and plow back some of their incomes into maintenance and improvements, because homes wear out and go out of style.

Housing is an ambiguous investment to evaluate, because a good part of its real return typically comes in its providing a place to live, not in providing dividends paid in cash. For example, a homeowner may gradually realize that she doesn’t need all of the space in her house, but may not be emotionally prepared to start recapturing some of its economic value. The owner may not want to take in roomers, to use the old phrase, just as a modern renter may not want to live in a room in someone else’s home (though new markets like airbnb.com are aiming to change that mind-set).

Next week, a look at real estate bubbles. Robert J. Shiller is the Sterling Professor of Economics at Yale.

Article source: http://www.nytimes.com/2013/04/14/business/why-home-prices-change-or-dont.html?partner=rss&emc=rss