Wealth Effect of Real Estate

Buying the American DreamIt’s as American as apple pie, Chevrolet and baseball. You may not know what it’s called, but if you live in the great U.S.A. it’s had a hold on you. The “Wealth Effect” of real estate can be addictive.

It’s why so many of us go to the classified ads and the computer to check real estate listings just to see what the neighbors home down the street was listed for… and then after a SOLD sign gets posted why we check to see how much it sold for. Curiosity may have killed the cat, but cats have 9 lives. Real estate cycles don’t.

It’s been heavily studied by scholars, debated by psychologists, theorized by sociologists, and explained by economists. But little has been clearly understood about its effect on society perhaps until now. The Wealth Effect is clearly an American phenomenon and it’s beginning to show its other side. Equity lines of credit and second mortgages are going bad at an over-heated pace. Foreclosures are picking up.

Nobel Prize winner Franco Modigliani postulated the Wealth Effect in the 1950s. His idea was that if wealth increases, people buy more. If it decreases, they buy less. If they buy a lot less a recession develops or worse. Modigliani’s research showed that for every $1 of new wealth, people spend about five cents more and vice-versa.

The problem, say psychologists, is it can make people feel like they’re getting rich, but it can back-fire and good people can turn out to be dead-beat losers in bankers eyes forced out of their homes because of foreclosure as a result.

It grabs its members by our own societal norms. As Americans we like to think we’re getting rich in real estate when we hear the prices are going up because when we sell our homes, for most of us our biggest investment, we’ll profit. But it doesn’t always work out that way. The Wealth Effect has side effects worse than a bad Sunday morning hangover.

Ben Bernanke, the new Fed chief even mentioned it in passing during his last session with the Congressional economic panel. “Something called the Wealth Effect allows people to feel…and spend more…”

The Wealth Effect may not be talked about much, but it’s alive and well in America, and it may hurt us more than help us for a country that has the lowest savings rate of any developed nation in the world.

The home owner spends borrowed money much faster than the typical stock investor who takes funds out of their stock account – in about one year compared to several years for stock market investors. Maybe there’s something to be said for respecting the good old American green back.

Typically housing leads the economy into recession. The nation is already in a housing recession.

In 2004 when the real estate frenzy was so intense America seemed to suddenly have a new religion. Instead of going to Sunday services we went to open houses. But now a more subtle kind of nervousness has taken its place. Consumer confidence is down. The Wealth Effect is becoming all too tough for many people to handle, and it’s relationship to the housing market melt down in America is taking a mammoth grip on the U.S. consumer.

Scholars who have studied the Wealth Effect are now saying that the real estate boom would have probably been only about half its size had lenders not developed a new breed of mortgages, and loosely offered second lines of credit and refinances up to 150% on primary residences.

The liberal lending practices fed a nearly insatiable desire of many people, but the back-fire has led to record foreclosures, which are certain to increase over at least the next two years. The consequence has been devastating for millions of American home owners and real estate investors. It is reshaping the mortgage business, and threatens to produce the worst economic disaster since the Great Depression.

Housing has a unique role in the U.S. economy. The Wealth Effect has everything to do with the way people feel about their own economic confidence. But the feeling of financial strength has given way to a nation uncertain about its economic future, despite a growing global economy.

Depending upon which study you consider credible, real estate related industries provide from 20 to 35% of the national economy. Until 2001 home equity constituted roughly one-fifth of total household wealth. But the figures have been drastically redrawn, and total home equity is being reduced as a result of falling home prices in most of the country.

At least real housing wealth is far more broadly distributed across income levels than stock wealth, providing a greater Wealth Effect for those that still have equity in their homes at least for now.