Median Incomes and Economic Obsolescence of Large Homes

One thing that has led me to believe that the housing market in Southern California is largely at bottom is the fact that many houses are selling at less than replacement cost. While such a discrepancy can exist for a long time in places with declining population, replacement cost is a pretty sound fundamental for determining the minimum sustainable house price in areas with growth.

The report on median incomes released yesterday, though, suggests to me a flaw with my line of reasoning. While the average new house has grown about 20 percent in size over the past ten years, median household incomes have actually fallen a bit. If house size is a proxy for house quality (and we have good statistical evidence to think that it is), then house quality has outstripped the ability of people to pay for it.

When comparing market prices to replacement cost, we really need to think about depreciated replacement cost. Depreciation comes in three flavors: physical, functional and economic. Physical depreciation happens because things wear out as they age–it is what Congress is thinking of when it allows depreciation deductions for investment property and plant and equipment.

Functional depreciation happens when a component of a capital asset does not perform its function well by current standards. Think of a furnace that uses lots of energy, and could be replaced by something more efficient. It is possible that it could work as a furnace for years, but it still would be best replaced by something more efficient.

Finally, there is economic depreciation, which happens when the demand for something (like Detroit real estate) disappears. It is possible that large houses have incurred economic depreciation because people lack sufficient income to afford them. If this is true, values can fall below original construction cost and stay there for some time.

Such considerations do not, of course, apply to reasonably well located, modest homes–I continue to believe that 1500 square foot houses in the San Fernando Valley and the central part of the San Gabriel Valley are reasonably priced now. But the market for larger houses may be troubled for some time yet to come.

One other implication: builders should construct smaller houses in the years to come. This vindicates a prediction I once made. Unfortunately, I made it in 1990.

Disclaimer: This page contains affiliate links. If you choose to make a purchase after clicking a link, we may receive a commission at no additional cost to you. Thank you for your support!

About Richard K. Green 103 Articles

Affiliation: University of Southern California

Richard K. Green, Ph.D., is the Director of the USC Lusk Center for Real Estate. He holds the Lusk Chair in Real Estate and is Professor in the School of Policy, Planning, and Development and the Marshall School of Business at the University of Southern California.

Prior to joining the USC faculty, Dr. Green spent four years as the Oliver T. Carr, Jr., Chair of Real Estate Finance at The George Washington University School of Business. He was Director of the Center for Washington Area Studies and the Center for Real Estate and Urban Studies at that institution. Dr. Green also taught real estate finance and economics courses for 12 years at the University of Wisconsin-Madison, where he was Wangard Faculty Scholar and Chair of Real Estate and Urban Land Economics. He also has been principal economist and director of financial strategy and policy analysis at Freddie Mac.

His research addresses housing markets, housing policy, tax policy, transportation, mortgage finance and urban growth. He is a member of two academic journal editorial boards, and a reviewer for several others.

His work is published in a number of journals including the American Economic Review, Journal of Economic Perspectives, Journal of Real Estate Finance and Economics, Journal of Urban Economics, Land Economics, Regional Science and Urban Economics, Real Estate Economics, Housing Policy Debate, Journal of Housing Economics, and Urban Studies.

His book with Stephen Malpezzi, A Primer on U.S. Housing Markets and Housing Policy, is used at universities throughout the country. His work has been cited or he has been quoted in the New York Times, The Wall Street Journal, The Washington Post, the Christian Science Monitor, the Los Angeles Times, Newsweek and the Economist, as well as other outlets.

Dr. Green earned his Ph.D. and M.S. in economics from the University of Wisconsin-Madison. He earned his A.B. in economics from Harvard University.

Visit: Real Estate and Urban Economics Blog

Be the first to comment

Leave a Reply

Your email address will not be published.


*

This site uses Akismet to reduce spam. Learn how your comment data is processed.