April, 2012

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FEATURE O F ne ancient piece of wisdom for prop- erty investment has remained virtually undisputable throughout the history of American real estate: Choose your opportunity based on location, location, location. While the nation's oldest adage on housing is for- ever relevant, new ideas are emerging about how to utilize geography when investing in real estate. In the current market climate, some economists have been quick to cite location-focused factors as the catalysts behind recent housing prices, but other studies disagree, blaming home prices on the players, bankers, and lenders. The Role of Housing Supply ederal Reserve Economist Andrew D. Paciorek of- fered support for the traditional formula for house prices in a recently published study. "Although the volatility of house prices is often ascribed to demand-side factors, con- straints on housing supply have important and little-studied implications for housing dynam- ics," Paciorek wrote. "Supply constraints increase volatility through two channels: First, regulation lowers the elasticity of new housing supply by increas- ing lags in the permit process and adding to the cost of supply- ing new houses on the margin. Second, geographic limitations on the area available for build- ing houses, such as steep slopes and water bodies, lead to less investment on average relative to the size of the existing housing stock, leaving less scope for the supply response to attenuate the effects of a demand shock." Paciorek's argument echoed the two supply-side fac- tors former Federal Reserve Chairman Alan Greenspan offered in dismissing concerns about the housing bubble that burst in the middle of the last decade. (Greenspan, according to Center for Economic Policy and Research co-founder, economist Dean Baker, also cited demo- graphics and rising incomes as fueling demand—explanations that Baker discounted.) Indeed, according to Paciorek, "Understanding the factors that govern differences in [home price] volatility requires knowledge of both the demand and supply sides of the hous- ing market. Although we have learned a great deal about the importance of the supply side in recent years, much more research is needed. Crunching the Credit Numbers B ut as Paciorek took a tradi- tional approach, economists Manuel Adelino, Antoinette Schoar, and Felipe Severino looked at the supply of credit— in the form of underwriting standards and interest rates—in a paper for the National Bureau of Economic Research. Adelino is an assistant professor of business administration at the Tuck School of Business at Dartmouth, and Schoar is a professor of finance at the MIT Sloan School of Management, where Severino is a doctoral candidate. "Easier access to credit might reduce borrower financing constraints and increase total de- mand for housing, which in turn would lead to higher prices," they wrote but suggested credit conditions "might be respond- ing to expectations of stronger housing demand," not causing them. If banks reacted to market conditions, they said, "cheaper credit is not the driver of house price increases but a byproduct of increased demand for hous- ing, since housing as collateral becomes more valuable." Not necessarily so, suggested Eric Chen, an associate profes- sor of business administration at Saint Joseph College in West Hartford, Connecticut. "As economists, we deal in basic models that are funda- mentally unrealistic," he said. Economists construct models to "simplify the situation so that we can understand the direct rela- tionship between two variables. In doing so, we hold all other variables constant—this is the unrealistic part—while we dissect the relationship between the two factors that we're interested in." It might appear, he said, "that low interest rates mean easier ac- cess to capital and greater supply of dollars to lend. If you follow this line of reasoning, you might just conclude that home prices increase with low interest rates. A raise in interest rates, then, should produce lower home pric- es. This argues for a tension, or a tug-of-war, between interest rates and home prices. Yet the data suggests otherwise. Historically, home prices have increased with interest rates. This may suggest that there are more forces at play than just home prices and inter- est rates." Mortgage professionals offer their own view, suggesting the current trend of lower interest rates is indeed a market response. "Today's lower home prices are the backlash of easy money lending artificially stimulating demand, causing the run-up in prices through 2006," said Greg Cook of FirstTimeHomeBuyersNetwork. com in Temecula, California. "Low interest rates are good for the economy because they facilitate qualifying for home loans, and until we can reduce the inventory by putting families who can and want to make the payments into homes, our housing and the economy will continue to struggle." But according to Gloria Shulman of Centek Capital Group in Beverly Hills, "low interest rates are not moving the market." Instead, she suggested that "interest rates are not driv- ing down prices—bad appraisals are," which are delaying a hous- ing recovery. "The housing market will not recover when rates are artificially low because the core problems continue to be the job market and a backlog in foreclosures," she said. "And it's not like any job growth will solve the problem. You can't even get the best deal available—which is an FHA loan with 5 percent down—unless your household has at least $100,000 in income and good credit. And until foreclosures work their way THE M REPORT | 27

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