The dream of owning a home has become more elusive than ever. Over the past decade, U.S. house prices have increased by nearly 4.7% per year above the rate of inflation while the median household income in the U.S. has only grown by 1.5% per year (above inflation) over the same time period. Coupled with the highest mortgage rates since 2008, we might be in one of the most unaffordable housing markets ever. Given this rapid increase in home prices, it raises the question: “Why are houses so expensive?”
Though the answer is complex and multi-faceted, in this blog post I will examine the many factors that contribute to the high cost of housing and provide a comprehensive overview of the expensive housing market we find ourselves in today. But, before we can determine “why are houses so expensive?”, let’s take a brief look at the history of house prices in the United States.
A Short History of U.S. Housing Prices
If I had to summarize the history of U.S. housing prices in a single line it would be:
There are decades where nothing happens and there are weeks where decades happen.
You can see this clearly in the chart below which shows the change in real U.S. home prices since 1890:
As you can see, U.S. homes tend to experience long periods of relatively little growth followed by short periods of dramatic change.
For example, from the end of WWII until the year 2000, U.S. home prices appreciated by 0.32% per year after inflation. However, in the seven years that followed, U.S. homes rose by 6.3% per year after inflation, a growth rate around 20x faster than the prior five and a half decades. Of course, this was during the now infamous mid-2000s housing bubble, but it illustrates the fits and starts of the U.S. housing market.
In fact, before the 2000s, the most extreme changes in U.S. house prices occurred in the late 1910s and in the 1940s. During the late 1910s, U.S. home prices declined (in real terms) as supply shortages from WWI led to double-digit inflation throughout the U.S. And during the 1940s, U.S. home prices rose rapidly with increased household formation and higher homeownership rates following the end of WWII. As DQYDJ plotted here, the home ownership rate in the U.S. rose from 44% in 1940 to 62% by 1960:
This was the most significant rise in homeownership in U.S. history and explains a lot about why housing looks like the way it does today. Why did homeownership go up so much over this time period? Don Schlagenhauf, a researcher at the St. Louis Fed, attributed the increase to changes in mortgage financing, demographics, and rising incomes.
When it came to mortgage financing, homebuyers didn’t have the 30-year fixed rate mortgage as an option until the late 1940s. Instead they had to use something known as a “balloon contract,” where they made a large down payment upfront (i.e. up to 50%) with the remainder of the balance to be paid off over the next 10 years. More importantly, these balloon contracts didn’t allow borrowers to build any equity in their home until the balance was paid off in full.
This structure made it more difficult for borrowers to buy homes than the fixed rate mortgage options that came afterwards. Schlagenhauf estimated that this change in mortgage financing “probably accounted for between 5 and 7% of the increase in home ownership rate between ’40 and ’60.”
On the demographics front, as people returned from WWII they began starting families. This created the post-WWII baby boom and led to a rapid increase in household formation and homeownership across the United States. Schlagenhauf estimated that these demographic changes “account for 5 to 8% of the increase in home ownership.”
But, the biggest impact on the home ownership rate in the U.S. came from rising incomes. As people returned to work following the end of WWII, incomes more than doubled from 1940 to 1960. This made it possible for many Americans to afford their first home. Schlagenhauf estimates that anywhere from “12% to 57%” of the change in homeownership from 1940 to 1960 can be attributed to this income growth.
Nevertheless, while these three factors had a large impact on the homeownership rate, Schlagenhauf’s research suggests that each of these only had a minor impact on housing prices themselves. So what led to higher housing prices? According to Schlagenhauf, it was the relatively higher productivity growth in the goods sector (vs. the construction sector) that enabled those working in the goods sector to afford homes and bid up prices.
I emphasize the changes that occurred in the post-WWII housing market because this period (and the increase in homeownership that came along with it) sets the stage for the modern U.S. housing market. Now that we have done a brief review of the history of U.S. housing, let’s dive into the factors that are driving today’s high home prices.
Why Are Houses So Expensive?
Though there are many components that can influence housing prices, ultimately, everything comes back to supply and demand. Prices tend to rise when supply drops (without changes in demand), when demand rises (without changes in supply), or a combination of the two. With that in mind, let’s dig into what leads to low housing supply, what leads to high housing demand, and how these conditions led to the most expensive housing market in U.S. history.
What Contributes to Low Housing Supply?
Though the factors affecting housing supply vary within each local housing market, generally the two biggest determinants of housing supply are construction (i.e. how many houses are we building?) and regulation (i.e. where are we allowed to build houses?). Housing supply stays low when we are unwilling (lack of construction) or unable (lack of freedom) to build more houses.
Lack of Construction
On the construction front, we can see that the number of housing starts (i.e. new residential houses being built) fell precipitously with the onset of COVID in 2020:
And while housing starts recovered shortly thereafter, they were below their long-term average for most of the last decade:
You might see this and think, “Well, we didn’t need to build a lot of houses after 2010 because we built too many during the 2000s housing boom.” While this would have been a correct statement in 2010, by the beginning of 2020 U.S. housing inventory had dwindled to one of its lowest levels ever. You can see this by examining the US Existing Home Months’ Supply from the late 1990s through the end of 2019:
Remember, our housing supply was the lowest in recent history right before COVID hit. And though the COVID crisis did temporarily increase housing supply, the mass influx to buy homes that occurred in the years after took housing supply to even lower levels.
I’ve highlighted both of these periods in the chart below which shows US Existing Home Months’ Supply through March 2023:
While lack of construction and inventory is partially to blame for the low supply of housing in the U.S., so is regulation. For this, we turn to our next section.
Regulatory Constraints
Zoning regulations (or regulations related to how land can be used) are a key determinant of housing supply. In many areas, such regulations (and not the lack of construction) are to blame for the shortage of affordable housing. One of the most popular examples of this is the city of San Francisco, where apartment buildings are illegal to build in over 75% of the city:
As you can see, most of the city is zoned for single-family homes, duplexes, triplexes, and fourplexes. When you combine these restrictive zoning policies with the surge in demand to live in the city (due to increased job opportunities), you get higher home prices and higher rents.
But, this phenomenon isn’t just exclusive to the United States. Arguably, the impact of zoning regulations has been even more extreme for our neighbor to the north—Canada. As you can see in the chart below, the percentage change in U.S. home prices pale in comparison to what has happened in Canada over the past few decades:
While some of this is due to Canada incentivizing foreign real estate investment, zoning is also partially to blame. As the blogger Jesse Livermore (pseudonym) recently pointed out, zoning regulations are what prevent homes from being built around some of Canada’s biggest cities:
While I understand the motivation to protect green spaces (e.g. I don’t think we should replace Central Park with affordable housing), this also partially seems like an environmental veil to hide the true motivation of NIMBYs (“Not In My Back Yard”).
For the uninitiated, NIMBYs are home owners who group together to prevent certain kinds of housing developments from being built in their neighborhoods. Their collective power influences zoning regulations that can keep housing supply restricted.
My favorite example of this comes from the famed venture capitalist Marc Andreessen. In April 2020, Andreessen wrote a post titled It’s Time to Build where he critiqued America for its complacency and inability to build new things including housing. As Andreessen stated:
You see it in housing and the physical footprint of our cities. We can’t build nearly enough housing in our cities with surging economic potential — which results in crazily skyrocketing housing prices in places like San Francisco, making it nearly impossible for regular people to move in and take the jobs of the future. We also can’t build the cities themselves anymore.
Funny enough, a few years later Andreessen wrote something else to his local housing board after a multifamily development was proposed in Atherton, CA where he resides:
Subject line: IMMENSELY AGAINST multifamily development!
I am writing this letter to communicate our IMMENSE objection to the creation of multifamily overlay zones in Atherton … Please IMMEDIATELY REMOVE all multifamily overlay zoning projects from the Housing Element which will be submitted to the state in July. They will MASSIVELY decrease our home values, the quality of life of ourselves and our neighbors and IMMENSELY increase the noise pollution and traffic.
Andreessen comments (and those of his fellow neighbors) worked and the multifamily development was removed from the proposal.
I tell this story because it illustrates a fundamental truth about why housing supply can remain low even in areas with growing demand. The economist Steve Randy Waldman summarized this idea beautifully in his blog post titled, “Home is where the cartel is.” It’s arguably the best blog post I’ve ever read on the housing market and explains a lot of the reason why “build more houses” is much easier said than done.
Now that we have looked at what contributes to low housing supply, let’s turn our attention to the other side of the equation and evaluate what contributes to high housing demand.
What Contributes to High Housing Demand?
Though there are many factors that can contribute to high housing demand, the ones that have been most important in the U.S. in recent years include:
- Demographic changes/migration: Though there were many stories written in the pre-COVID era about Millennials not being able to buy homes, this all changed once COVID hit. As Opendoor reported, in 2022 Millennials were the largest generation of homebuyers, representing 43% of all buyers. More importantly, the data suggests that these Millennials were moving to the suburbs in record numbers, thus increasing the demand for single-family homes. We can see this in the data as well as the number of buyers exceeded the number of sellers in most housing market throughout the U.S. for much of 2021 and 2022 (h/t John Burns):
- Low-interest rates: In addition to the shift toward the suburbs, the low interest rates that were prevalent in 2020 and 2021 incentivized people to take out debt and buy homes. With the rapid rise in interest rates over the last 18 months, we have seen the pendulum swing in the other direction as nearly all borrowers have a mortgage below the current market rate and home sales have since dropped by over 30%. With higher interest rates, demand to buy a home has declined and it has reduced the supply of homes on the market (since some homeowners are unwilling to move and give up their low rate mortgages). Some factors (such as interest rates) impact both housing demand and supply.
- Economic growth: As local economies grow, there tends to be more demand to work (and live) nearby these areas. This can explain the rise in home prices in large cities like San Francisco and New York over the past decade as economic growth has led to more opportunities (and more demand to live near those opportunities).
- Population growth (including immigration): If an area sees a rising population without an increase in housing supply to match it, home prices (or rents) should rise as a result. While population growth in the U.S. is still positive (mostly due to immigration), I don’t think this has been a larger driver of U.S. home price increases (in aggregate).
- Government policies: Much like interest rate policy, other government policies can incentivize individuals to borrow more and purchase homes. For example, the home mortgage interest deduction is a tax policy that motivates home ownership in the U.S.
- Investment opportunities: In addition to owner-occupied housing, the demand for housing can increase if individuals or institutions think it will be a good investment. Though institutions have been buying more houses in the U.S. over the last few years, they still only represent about 3% of the overall housing market in the United States:
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- This implies that nearly all the homes sold in the U.S. are sold to individuals, not institutions. So while institutional buyers can impact demand and prices, they seem to only do so on the margin for now.
Of the factors listed above, demographic shifts, low interest rates, and economic growth seem to have had the largest impact on housing prices in the U.S. since the beginning of 2020.
Now that we have looked at what factors can influence demand in the housing market, let’s look at how these factors (coupled with low supply) led to higher housing prices in the U.S.
Low Supply + High Demand = Higher Prices
When we combine the lack of housing supply going into 2020 with the surge in housing demand that occurred afterward, we get the perfect storm for higher housing prices. In fact, from January 2020 to mid-2022, the median sales price on U.S. existing homes rose by over 50%:
Though housing prices have since come down a bit, they are still 42% above their January 2020 prices.
More importantly, because of these higher prices (and increased interest rates), the monthly mortgage payment required to purchase the median priced home in the U.S. has increased by 93% since the beginning of 2020:
In other words, the monthly mortgage payment needed to buy the median priced home in the U.S. was around $1,000 in January 2020 and is around $1,934 today.
Now that we’ve answered, “Why are houses so expensive?” in today’s housing market, let’s wrap things up by discussing whether they are likely to stay expensive in the future.
Where Do Prices Go From Here?
With home prices still quite elevated today relative to recent years, some have wondered whether U.S. home prices will fall in the coming months. Cullen Roche put together this great graphic showing the relative change in home prices and rents since 2000 that suggests that house prices may have some way to fall:
While I do find this graphic and the long-term convergence between rents and home prices compelling, another part of me can’t shake the fundamental lesson I learned from Steve Randy Waldman—home is where the cartel is.
Because of this post it’s difficult for me to imagine a housing crash anytime soon. Why? Because people are so incentivized to prevent the housing market from crashing. This is true at both the local and national level. No one wants to see their housing wealth evaporate. This is why we have seen an uptick in concessions from sellers to buyers in recent months. People would rather cover the buyer’s closing costs (or something similar) than lower their price.
You have to remember that housing still represents the primary way in which most Americans build and store wealth. As the National Association of Realtors once stated:
Homeownership is the largest source of wealth among families, with the median value of a primary residence worth about ten times the median value of financial assets held by families.
With such a concentration of wealth trapped in this illiquid asset, there are too many motivations to keep housing prices from falling in a dramatic fashion.
Therefore, instead of a housing crash, I could imagine a housing fizzle, where prices either stagnate or slowly decrease (in real terms) over a long period of time. I’m not really worried about a housing crash because the housing market today is very different from the one of 2005-2007. We don’t have hundreds of thousands of borrowers in homes they can’t afford. We don’t have rampant speculation in the housing market. We don’t have banks incentivizing homeownership at the same level as they used to. Of course, I could be wrong, but this is my best guess given the structure and culture of housing in the U.S. today.
But, regardless of what I think, the answer to the question “why are houses so expensive?” won’t be any different in the future than it is today. Home prices will always be based on the same thing—supply and demand. So if we want less expensive homes, we either have to increase supply, decrease demand, or do both. Unfortunately, finding effective ways to do this (without negative consequences) is the hard part.
Thank you for reading.
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This is post 352. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data
