In this episode of the REconomy podcast from First American, Chief Economist Mark Fleming and Deputy Chief Economist Odeta Kushi unpack the ‘wealth effect’ economic theory and explain why, despite soaring house prices, the wealth effect’s influence on the housing market may be limited.

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“If I'm a homeowner looking to buy a bigger and better home, it may seem that I have a lot more purchasing power because my home has appreciated, but so has the bigger and better home I'm interested in. Of course, there is an exception here and that is moving from a more expensive area to a less expensive area is one way for an existing homeowner to take advantage of their equity gains. In this scenario, the wealth effect can incentivize an existing owner to move out and move up to a more affordable area. But, generally speaking, this wealth effect may not be enough to encourage existing homeowners to sell.” – Odeta Kushi, deputy chief economist at First American

Odeta: Hello, and welcome back to another episode of the REconomy podcast where we discuss economic issues that impact real estate, housing and affordability. I am Odeta Kushi, deputy chief economist at First American. And here with me is Mark Fleming, chief economist at First American. Hey, Mark, I think we're getting into some behavioral economics today.

Mark: Hi, Odeta. Indeed, we are. We're tackling a theory that's commonly called ‘the wealth effect.’ The theory basically is homeowners are more likely to sell their homes because they feel wealthier when the value of their home goes up. That would make sense. You feel richer when your investment portfolio rises, so you spend more. So, if you feel richer because your home value has risen, wouldn't you want to spend more and buy a bigger house? That makes sense, right? Or does it?

Odeta: Right, and newsflash, as you may have heard, house prices have gone up, way up. Roughly two-thirds of Americans are homeowners and, according to the latest S&P Case-Shiller House Price Index, reflecting February data, annual nominal house price appreciation increased to 12%. That is the biggest gain in 15 years, which really makes me wonder, if two-thirds of American households are homeowners, and their houses have grown in value, aren't they then feeling wealthier?

Mark: Well, yeah, this is the kind of house price appreciation from before the housing boom, so they must be feeling a whole lot wealthier right now. Right?

Odeta: Right. And wouldn't they want to take advantage of all of that newly acquired equity by selling and therefore adding housing supply to this very parched market? I mean, the wealth effect that you mentioned implies that homeowners should be more likely to move if they feel wealthier because their home has appreciated. Yet, at the end of March, existing-home inventory was down 28% year over year. And we know that that inventory measure isn't capturing all of the existing-home sale inventory in a given month. By the way, see episode eight of the REconomy podcast for more on that. But we also know that the existing supply is low because average tenure length is at a historic high of over 10-and-a-half years, as potential sellers continue to keep their homes off the market. So, why aren't all of these wealthier homeowners buying up?

Mark: That's a great question Odeta. We can start with the obvious that a homeowners house may have appreciated by 12% compared with a year ago. But, so have of all the other homes that they may be thinking about buying. Remember, unlike most other economic markets, in the housing market the seller is almost always also a buyer. So, the homeowner is wealthier as a seller, but would be entering the housing market as a buyer at a time when all other homes in the area have likely appreciated by the same amount. While the homeowner’s equity gains boost wealth, those gains only allow the homeowner to buy the proverbial same home, I'm err quoting here, as the one they're selling, rather than a bigger one. So much for feeling any wealthier.

Odeta: Well, that makes a lot of sense. If I'm a homeowner looking to buy a bigger and better home, it may seem that I have a lot more purchasing power because my home has appreciated, but so has the bigger and better home I'm interested in. Of course, there is an exception here and that is moving from a more expensive area to a less expensive area is one way for an existing homeowner to take advantage of their equity gains. In this scenario, the wealth effect can incentivize an existing owner to move out and move up to a more affordable area. But, generally speaking, this wealth effect may not be enough to encourage existing homeowners to sell. But is there something that will encourage them to sell?

Mark: Sure, falling mortgage rates. We seem to be talking about rates all the time. Yeah, this is so important in the housing market. When rates fall, a potential home buyer can buy the same amount of home for a lower monthly payment or buy more home for the same monthly payment. The 30-year tailwind that we've had of declining mortgage rates has allowed homeowners to buy a home at one mortgage rate and then later sell and move into a more expensive home when rates are lower. This is what's really driven what we refer to as housing turnover. People moving and buying homes and buying up. This long-run decline in mortgage rates has encouraged existing homeowners to move out and move up, and I just can't help but think right here of the Jeffersons and their theme music. I'm not gonna sing it. I don't want to subject our listeners to my attempt to sing anything, but you know what I'm talking about. Moving on. Oh, I gotta stop.

Odeta: Oh, you did it, didn't you? I thought you're gonna spare us, but there it is, the Jeffersons theme music Well, if mortgage rates encouraged people to move, and rates have inched up in recent months, isn't that a problem?

Mark: Possibly. But, while existing homeowners are sitting on historically high levels of equity and, as we said, not feeling so much wealthier, many of them have also secured historically low fixed-rate mortgages. Everyone has gone out and refinanced at three-and-a-half, three-and-a-quarter or even below 3%. So, there's this lock-in effect that increases as mortgage rates rise. Remember, all those existing homeowners are sellers and buyers. And so, as they look at the market and say, well, if I want to become a buyer, I have to compare what it would cost. That tailwind of now rising mortgage rates is increasing the monthly cost of borrowing for the same amount. So why move out if you have to move down or pay more to move up? The higher the prevailing rate relative to their existing mortgage rate, the stronger that effect. So, even as house prices are rising right now, rising rates could actually make homeowners that are thinking about buying actually feel less wealthy. It's not home equity that makes you wealthier in the housing market, it is declining mortgage rates, and by association, rising mortgage rates make you feel less wealthy.

Odeta: And that's really a problem from a supply perspective because, as we mentioned, about two-thirds of all home buyers are existing homeowners. In other words, most buyers are sellers first. So, if existing homeowners are staying put, that limits the available inventory of homes for sale for potential first-time home buyers because they can't buy what's not for sale. The other issue, of course, is that the record low level of homes for sale makes it difficult to find the next house to buy. So, sellers who are also prospective buyers don't sell for the fear of not finding something to buy. We actually refer to this as the housing ‘Prisoner's Dilemma,’ a reference to a paradox in game theory that shows why two completely rational individuals might not cooperate, even if it seems that it's in their best interest to do so. Think about it. If all sellers choose to sell, they will benefit as buyers because they would increase the inventory of homes and alleviate the supply shortage. However, the risk of selling if others don't in a market with a shortage of inventory prevents many existing homeowners from selling. The result is prices are further bid up by competition for the increasingly short supply. That's exactly what we're seeing in the market today. So, in short, existing homeowners are increasingly locked into their current home, especially as rates rise.

Mark: And feeling no wealth effect at all as a buyer.

Odeta: But what about first-time home buyers?

Mark: While existing homeowners may feel locked-in to their existing homes, first-time home buyers do have a better situation, at least in the sense that they are not feeling any financial lock-in effect. But, first-time home buyers have the same challenge as existing homeowners that are trying to find something to buy. That doesn't change. And they don’t benefit from the wealth caused by rising house prices. Remember, they're not homeowners, so they're not even keeping up. And, even as rates are rising, still, we seen tons of first-time home buyers out there. In fact, as of the January 2021 numbers released by Fannie and Freddie, over 50%, or just under, sorry, just under 50% of all purchase mortgages were to first-time home buyers. So, somehow or another, they're making it work.

Odeta: And as we've discussed in episode 10 of the REconomy, buying a home is often prompted by lifestyle decisions, sometimes even more so than financial considerations. So, despite a likely increase in the lock-in effect as rates continue to rise, we actually still expect home sales to continue to remain robust, but not because of any economic theory of a homeowner's wealth effect. Homeowners may not be moving out and moving up, but there's a lot of millennials who still want to move in. Thank you for joining us on this episode of the REconomy podcast. Be sure to subscribe on Apple, Google Spotify or your favorite podcast platform. You can also sign up for our blog at Firstam.com/economics. And if you can't wait for the next episode, follow us on Twitter @OdetaKushi for me and @MFlemingEcon for Mark. Until next time.