Real Estate and the Macroeconomy

In July 1987 Massachusetts governor Michael Dukakis began his run for the presidency in the midst of what was being called the Massachusetts Miracle, with employment growing rapidly and an unemployment rate of 2.4 percent. An economy that had experienced 12.8 percent unemployment and an employment base in secular decline in the mid-1970s had become the fastest-growing region in the country just over a decade later. That summer, however, state revenue began to shrink and real estate sales dropped sharply. By the time of the election in 1988, employment was falling, and it continued to fall until the end of 1991. In all, over 360,000 jobs were lost from a peak of 3.2 million, representing more than 11.5 percent of nonfarm payrolls. Employment declines in the other five New England states were comparable. In a development symptomatic of widespread troubles in the region's banking sector, Bank of New England Corporation, with $32 billion in assets, received a CAMEL 5 rating in March 1990 and was closed by the Federal Deposit Insurance Corporation in January 1991.¹ Its closure imposed net losses on the agency of $733 million.²

The extensive involvement of real estate in both the 1984-88 boom and the 1988-92 bust in New England has been well documented.³ A dramatic rise in housing prices fueled consumer spending, construction employment expanded more than 50 percent, and overall employment growth was concentrated in "population serving establishments."⁴ According to call reports (balance sheet reports that banks file each quarter with the Federal Reserve), 72 percent of all bank lending during the boom was collateralized with real estate, and real estate loans accounted for more than 90 percent of Bank of New England's losses.⁵ Mortgage default rates and foreclosure rates were high, and losses were severe.⁶ Higher vacancy rates, lower rents, and higher capitalization rates (defined below) led to sharp declines in commercial real estate values. Similar real estate involvement in the economic cycle had been documented earlier in Texas and was observed later in California, Alaska, and Hawaii.

Today the U.S. economy is in the tenth year of an economic expansion. Both residential and commercial real estate values have been rising steadily across the nation, and the volume of lending collateralized by real estate has grown sharply. This paper explores the involvement of both commercial and residential real estate in the national economic cycle. It considers the role of real estate in the expansion of aggregate demand, the risks to the financial sector from using real estate as collateral, and the distributional consequences of real estate inflation.

The Housing Market

Table 1 presents some very rough estimates of the size and value of the U.S. housing stock in 1999. The estimates are based on a variety of different but fairly consistent sources. In 1999 there were approximately 103 million housing units occupied year round. About two-thirds of these were owned by their occupants. In addition, 13.4 million units were seasonally occupied or vacant. Of those, 6.1 million were seasonal or for rent.

Table 2 presents national and regional data on housing price rises, based on weighted repeat sales indexes for single-family properties, from the Office of Federal Housing Enterprise Oversight (OFHEO). The table shows that home prices across the nation as a whole were up 6.5 percent year over year as of March 2000 and had risen 27.3 percent over five years, for a 4.9 percent compounded annual rate. That would suggest nominal capital gains of approximately $544 billion in the previous year and $1.9 trillion over five years. Although sizable, these gains are dwarfed by the increase in value of household financial assets over the last five years: the comparable increase in stock market capitalization is over $8 trillion. These aggregate figures mask a great deal of regional variation, however, which the rest of this section explores.

Table 1.

U.S. Housing Stock and Residential Mortgage Debt, End of 1999