In the boom-and-bust economy of Silicon Valley, real estate agents have long known that when housing prices peak at outrageous new heights, first-time buyers recoil from the market. And once the youngest buyers sit out in anticipation of an economic slump, the whole housing pyramid starts to crumble.
       Until recently, one could call this little more than observation. But Stanford Business School economist Sven Rady and London School of Economics lecturer François Ortalo-Magné have developed a model that helps to explain the forces that drive housing markets up and down. Their theory shows that changes in housing prices depend on the current income of young households, which explains why housing prices are often more volatile than general income levels or a country's gross domestic product. Ortalo-Magné and Rady rest their theory on two important features of real-life behavior.
       First, most people follow a typical life-cycle pattern of climbing the real estate ladder. They rent, then purchase a small home, trade up to a larger home one or more times, and finally trade down to a smaller home or condominium when lifestyle changes or poor health warrant a move in old age. Using census and housing data collected between 1965 and 1996 in the United States and the United Kingdom, Rady and Ortalo-Magné found that both countries reflected similar trends. For example, the data showed that first-time American buyers tend to be in their early thirties (U.K. buyers were a couple of years younger) and their median purchase price totaled only about 75 percent of the prices that 40-something, repeat buyers paid for their homes. The U.S. data also provided evidence that some households reduce housing consumption in old age.
       Second, credit constraints in the form of down payment requirements significantly affect housing consumption for many buyers. For example, only a minority of first-time buyers get help from their families. In addition, for those trading up, capital gains play a big role: A gain of $5,000 on a property, for example, allows an owner to invest in another property worth an extra $50,000 if the down payment requirement is 10 percent. As a result, changes in bank lending policies can have a huge effect on young households' investment capacity and therefore on the whole market. Indeed, as banks in the United Kingdom loosened their lending requirements in the 1980s, young households were able to climb the property ladder much faster than before by taking advantage of rapidly rising housing prices until the market eventually went bust. "While economic recession ultimately sent the housing market into a tailspin, lending policies were clearly an important factor in the preceding housing boom," says Rady.
       The researchers' model indicates that the volume of real estate transactions appears to move in tandem with the larger economy as it undulates through booms and busts. "Transaction volume seems to anticipate the business cycle by four to five quarters. Looking at volume," he says, "we may be able to make some educated guesses about how the housing market will evolve in the near future." The researchers theorize that as an economic boom runs out of steam and housing prices flatten, young homeowners enjoy smaller capital gains. This slows their climb up the property ladder, and the transaction volume decreases immediately. That trend is reinforced as the economy slips into recession and housing prices start to fall. Toward the end of a recession, most buyers who own property have bought it at a low price. Having suffered small losses or none at all, they can afford the down payment on a house earlier than those who bought before them in the cycle. The volume of home sales picks up again, just as housing prices are about to rise. "Our model provides a framework where all these things fit together," says Rady.

--Barbara Buell

"Housing Market Fluctuations in a Life-Cycle Economy with Credit Constraints,"
François Ortalo-Magné and Sven Rady,
GSB Research Paper #1501,
June 1998