The layman's theory of real estate goes something like this: The Pilgrims arrived. They started using the land. More Europeans came. The demand for land was so high that Native Americans were pushed out to make room for the newly-arriving settlers. More land can't be built, so demand and prices will always rise, making real estate a great investment.

Unfortunately, the formula isn't quite that simple. Here we take a look at real estate prices and the long-held theory that they will rise indefinitely.

Key Takeaways

  • Home prices last grew at a healthy rate in 2004 before the real estate market flattened.
  • Since then, home values have increased in some areas of the country because of strong demand and low supply, although most parts still haven't reached their pre-crisis levels.
  • Potential homebuyers shouldn't focus on national trends as prices vary between states and even neighboring cities.
  • Low mortgage rates have an indirect effect on home prices, as consumers are willing to take on more debt when credit is cheap.

Historical Prices

Prior to the well-publicized burst of the housing bubble and the resulting real estate crash that began in earnest in 2007, historical housing price data from the National Association of Realtors (NAR) seemed to support the theory of endlessly rising prices. The chart below tracks median home prices from 1968 to 2004, showing an average yearly increase of 6.4%, without a single decline during the 36-year period.

Figure 1: Medium home prices from 1968 to 2004

Source: National Association of Realtors

What the Data Doesn't Show

Unfortunately for homeowners, 2004 was the last year of healthy growth numbers before the market flattened. By 2006, NAR data showed just a 1% increase. After that, the markets experienced an unprecedented decline.

Prices began falling nationally in 2007. They fell again in 2008 and yet again in 2009. By mid-2010, housing prices fell back to 2004 levels in a stagnant market. What, for decades, seemed like a one-way ticket to growing profits had fallen by more than 30% in just a few years, according to data from Standard & Poor's.

Prices have gone up due to greater demand and a drop in supply in the market in many parts of the country, but a lot of areas still haven't reached the levels they were at before the crisis hit. Add to that the fact that lending standards have become more strict, and it's driving people out of the market.

Even before the numbers began to go the wrong way, the sales price trends data provided an incomplete picture. The National Association of Home Builders reported that the average home size in America was 983 square feet in 1950, 1,500 square feet in 1970, and 2,349 square feet in 2004. This trend continued in the first half of the 2000s, after which it began to decline somewhat.

With the size of homes getting bigger and inflation adding to the cost of building materials, it is only logical that home prices would rise. But what happens if inflation is factored out of the picture? The result is something completely unexpected. Even before the real estate crash of the late 2000s, home prices fell frequently and significantly. In fact, World War I, the Great Depression, World War II, the 1970s, and the 1980s, all saw periods of significant price decline. Lesser declines have occurred on a regular basis at other points as well.

Numbers and Trends

Even the national trend numbers tell only part of the picture. Housing price trends can vary widely between geographic regions. A boom in California can mask a bust in Detroit. Even within the same city, numbers can vary widely. Areas that experience new growth or gentrification can show significant price appreciation while areas across town can be in decline.

When looking at the national and regional statistics, be sure to account for the reality of the market in your local area. Rising prices at the national level may not help you if your city, state or neighborhood is in decline.

National trends may not give you the whole picture, as real estate values and prices vary between states and neighboring cities.

The Reality

Another important point to consider when looking at real estate as an investment is that it won't ever pay off unless you sell it. From a practical standpoint, even if your primary residence doubles in value since you bought it, it probably just means that your real estate taxes have gone up. All of the gains you experience is merely a gain on paper until you sell the property.

If you choose to sell and hope to purchase another home in the same area, remember that prices of other homes have risen too. To truly book a gain from your sale, you will likely need to move to smaller home in the same area, or move out of the area and find a less expensive place to live.

While it is possible to tap the equity in your home by taking out a loan against it, using your house as an automated teller machine (ATM) has been a foolish strategy in the past. Not only does the interest you pay eat into your profit, but the loan payment takes away from your financial stability. If real estate prices decline, you may find yourself in the unenviable position of owing more on the loan than the house is worth.

Mortgage Rates

Mortgage rates generally rise during periods of economic growth. When this happens, the job market is healthy and people's wages rise, too. Mortgage rates have been relatively low since the housing market crashed, making homeownership more attractive. The interest rate for a 30-year fixed-rate mortgage in May 2013 was 3.35%, and remains relatively unchanged as of June 2019 at 3.73%. According to Freddie Mac, low rates have propelled purchase applications, and the firm expects improvement in the housing market from higher sales activity and lower prices. Mortgage Reports predicts rates to be around the 4.4%-mark by the end of 2019, meaning increases may be muted.

So how does this play out for real estate prices? Lower mortgage rates don't necessarily have a direct relationship to home prices, even though we'd like to think they do. But they may have an indirect affect on them. When rates are low, consumers are more willing and can afford to take on more debt. That's because the cost of credit—i.e. interest—is cheap. Rising interest rates, though, tends to lead to weaker demand from buyers.

Is Real Estate a Bad Investment?

By now you may be thinking that there is no value in purchasing a home in the hope that it will gain in value over time. While it is true that you are unlikely to see any profits that you can spend if you plan to live in the same house all of your life, if you go into the purchase with an exit strategy, there is a much better chance of seeing a cash profit.

First, consider your motivation for buying a home. If you want to live in it, then you should stop thinking about profits and losses. If you're hoping to make money, then you need to enter the transaction with an exit strategy. This also means you should have a sell price in the back of your mind, all while keeping the purchase price of the property at the forefront.

When you reach your price point, you sell the property just as you would a stock that has appreciated. This may not be a practical approach for your primary residence, depending on your lifestyle, but it is exactly what many real estate investors do when they purchase properties—renovate and sell them. Just remember that prices don't always move up.

In the past, Japan has seen housing prices fall even more. That doesn't mean those prices won't bounce back into profitable territory, but keep in mind that in some cases it could take a very long time.

The Bottom Line

With history as a guide, most would-be homeowners would do well to buy a place they actually hope to inhabit, pay off the mortgage quickly, live there until retirement, then downsize and move to a less expensive home. It's not a sure bet, but this strategy does increase the likelihood of making a profit.