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Feb 11 2015


Sergio Rebelo, the Tokai Bank Chair in International Management at Kellogg, kicked off the 2014 Kellogg Real Estate Conference with an informative lecture about boom and bust cycles in international residential real estate markets. During the talk, he explained the sources of the market crash during the Great Recession and shared insights on potential forward trajectories for the United States.

According to Professor Rebelo, residential booms historically have tended to follow one of two paths. About half the time, a real estate boom is followed by a period where market values plateau before rising again. Professor Rebelo referred to this as a “boom-boom” cycle. In the other half, booms are followed by downward swings (“boom-bust”). The real estate market in the mid-2000s clearly followed the latter of these two trajectories.

Some leading market indicators that a boom will be followed by a bust include high price-to-rent ratios, high prices relative to construction costs, and an influx of new buyers into the market. In particular, Professor Rebelo noted that a significant influx of young buyers into the for-sale residential real estate market, ostensibly chasing quick capital gains from house flipping, is a key sign that the market will transition from a boom to a bust. These measures were all on display during the years leading up to the recession.

There were additional warning signs that the housing market was headed for trouble. One was the United States’ low household savings rate, which had dropped from 10% in the 1980s to 2% by 2006. This also compared unfavorably to other nations, like China, where households save almost 50% of their incomes. Second, corporate profits in the U.S. financial sector were disproportionately outpacing those in other sectors of the economy. In 2007, 40% of corporate profits were derived from the financial sector, which only represented 6% of economy-wide employment. A significant chunk of these profits were related to real estate, which should have raised a flag. Third, new housing starts typically track with the pace of new household formation, but in the years leading up to the recession, there was a surplus of new housing relative to new household formation. In all cases, the signs were missed until too late.

So who should be blamed for not noticing the United States’ runaway housing prices? Bankers, according to Professor Rebelo, who were too relaxed about underlying fundamentals of the housing market rather than worrying about whether a boom-bust cycle was on the horizon. “I like bankers who have twitches,” said Professor Rebelo, in one of the more memorable quotes of the conference.

One reason why bankers were more relaxed than they should have been was that mortgage delinquency rates remained low throughout the boom. Home prices were rising year after year, which gave people access to further debt via home equity loans that were backed by their newly-increased housing values. Once prices reached their inflection point and stopped rising, however, access to additional home equity borrowing subsided, and it wasn’t worth it for a lot of people to continue stretching to make their debt payments. As a result, delinquency rates skyrocketed and homeowners started selling, causing prices to drop and delinquency rates to increase further.

Looking forward, Professor Rebelo acknowledged that it’s impossible to project when the economy will fully recover but offered some insights. In general, he said, financial recessions take longer to recover from than recessions caused by other factors. Even for a financial recession, though, this latest one has lasted far longer than other similar downturns.

As a best case scenario for the U.S., he compared the United States’ situation to that of Sweden in the early 1990s and projected that it would take 5 years from the trough of the recession to reach pre-crash levels and 10 years for the market to catch back up with its long-term trend line. For a worst case scenario, he compared the U.S. to Japan, which has yet to fully recover from its recession in the 1990s. However, Professor Rebelo thinks it is unlikely that the U.S. will follow Japan’s path, as the U.S. is more structurally sound. Where Japan’s overall population, and young professionals in particular, is not growing fast enough to make up for its aging population, the U.S. is faring much better in terms of population growth. It will be interesting to look back in ten years and see which path turned out to be more accurate.

About the Author

This article was written by Ryan Zampardo '16.