How Real Estate Impacts the US Economy

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Real estate, commonly known as the largest asset class in the world, would intuitively play an integral role in the US economy. Residential real estate properties provide a vital pillar of the “American Dream”: private housing for families. Separately, they can also be the greatest source of wealth and savings for many Americans. Commercial real estate (CRE) – including apartment buildings – creates jobs and rented spaces for retail stores, offices, and manufacturing warehouses. Real estate business and investment provides a source of revenue for millions of Americans.

In 2018, real estate construction contributed $1.15 trillion to the US national economy output (BEA.gov). That accounts for 6.2% of the US economy GDP over the same year, which is quite a significant proportion. For comparison’s sake, it’s more than the $1.13 trillion in 2017, however less than the 2006-peak of $1.19 trillion. Back in 2006, real estate construction was an even heftier 8.9% component of US GDP (Amadeo, The Balance).

While there’s some politicization over whether these qualify as “good” jobs, real estate construction is obviously labor-intensive. It plays a major force in job creation. The decline in housing construction was undoubtedly a major contribution to the COVID-19 Recession’s high unemployment rate.

The Ripple Effect in the US Economy of Real Estate

Construction is the only part of real estate that’s directly calculated into US GDP (Amadeo, The Balance). Nonetheless, real estate affects many other areas of the US economy, which aren’t captured by US GDP metrics. As an example, a decline in real estate sales inevitably leads to a decline in real estate prices. This effect lowers the value of all homes, irrespective of whether owners are actively selling or not. Furthermore, this causes a reduction in the overall number of home equity loans available to owners. Ultimately, the market impact is reduced consumer spending, as more homeowner cash is tied up in housing projects.

As many are aware, nearly 70% of the US economy is based on personal consumption (BEA.gov). Consequently, a reduction in consumer spending is directly linked to a downward spiral in the US economy. The downward spiral causality is easily witnessed. This macroeconomic phenomenon leads to further drops in employment, income, and consumer spending (Amadeo, The Balance). The primary concern about the US economy falling into a deep recession stems from concerns about Federal Reserve policy. The Federal Reserve received widespread accreditation for keeping rates very low throughout the COVID-19 pandemic. Many experts argue a further cut to interest rates are still necessary (Amadeo, The Balance). There is one positive takeaway regarding lower home prices. They lessen the chance of inflation.

Real Estate and the 2008 US (Global) Economy Recession

Of course, no better example exists of real estate’s impact on the US economy than the 2008 recession. While very few immediately realized it, falling home prices triggered the downturn and subsequent broad, ill effects. According to the National Association of Realtors (NAR), by July 2007, the median price of an existing single-family home in the US was down 4% since its peak in October 2005 (National Association of Realtors). Macroeconomists, risk analysts, credit analysts, and economists as a whole couldn’t reconcile how concerning this was. Clear definitions and numeric parameters of recession, bear market, and a stock market correction are well standardized. The same is still, not yet true for the housing market.

For perspective and comparison, many likened it to the 24% decline during the Great Depression of 1929. Others compared it to the decline ranging from 22% to 40% in US, oil-producing areas in the early 1980s. Incorrectly using these as benchmarks, the 2008 housing “slump” could appear barely newsworthy. To the contrary, the crash quickly gained steam. Economic studies have shown that even fairly small declines between 10% and 15% are enough to eliminate the homeowner’s equity. We saw this occur in early 2007 within communities in Florida, Nevada, and Louisiana.

Death by Derivatives

Staggeringly, nearly half the loans issued between 2005 and 2007 were subprime. Of course, this means homebuyers are much more likely to default. Far worse for the national economy, banks used these loans to finance trillions of dollars of derivatives. Banks infamously packaged these loans into mortgage-backed securities. They peddled them as “safe” investments to pension funds, corporations, and retirees. Moreover, they were thought of as “insured” from default by a new insurance product called a credit default swap. The biggest issuer was American International Group, Inc. (AIG).

Once borrowers defaulted, the mortgage-backed securities had very questionable value. A huge number of investors began to exercise their credit default swaps, such that AIG ran out of cash. They were ready to default themselves, until the Federal Reserve bailed them out.

Investment banks with a large number of mortgage-backed securities on their books – most notably Bear Stearns and Lehman Brothers – were rejected by other banks. Without cash to continue operations, they ran to the Fed for help. The Fed wound up finding a buyer for Bear Sterns, but not the latter, Lehman. The bankruptcy of Lehman Brothers kicked off the 2008 financial crisis, officially.

Are We on The Brink?

Studies show investors are seriously questioning whether another real estate market crash will happen in the next two years. Housing prices are more or less stagnant, while the Fed is beginning to drop interest rates. This is indicative of a bubble and historically we know that bubbles burst.

However, there are many structural differences to consider when evaluating today’s market with the housing market in 2005. Firstly, the volume of subprime loans makes up a smaller percentage of the mortgage market. Interestingly, however, these are growing under the “nonprime loans” name. In 2005, they contributed roughly 20% (Amadeo, The Balance). Additionally, banks have greatly increased lending standards. Investors, those who flip houses, have to provide between 20% to 45% of the cost of a home. Compared to during the subprime crisis, buyers needed to provide 20% or less.

Most importantly, homeowners are not taking as much equity out of their homes. Home equity skyrocketed at $85 billion in 2006. Subsequently, it collapsed to less than $10 billion in 2010 and remained around that level until 2015. By 2017, it had only risen to $14 billion (Amadeo, The Balance). A major reason behind that is fewer people are filing for bankruptcy (Allen, Consumer Reports). In 2016, only 770,846 filed for bankruptcy; by comparison in 2010, only 1.5 million people did (Allen, Consumer Reports). Many economists, quite surprisingly, attribute this to “Obamacare”.

The Bottom Line

Concisely, we’re very unlikely to see anything close to what we witnessed in 2008 for a number of reasons. Primarily, structural changes in the economy – such as volatility ratio mandates for investment and retail banks – would prevent a widespread financial epidemic, even if the housing market were to suffer a significant downturn. Equally important to the housing market, mandates for homeowners and active real estate investors are more stringent. Finally, cost-cutting measures, such as the ACA, make it less likely for homeowners to default on mortgage payments.

This is not even considering that while some reputable economists believe we may see prices decline in the next two years, we’ve yet to see it. In fact, as we continue to recover from COVID-19 economically, we’re seeing a housing market recovery. There’re multiple reasons we don’t need to worry about a repeat of 2008.