Nearly 11 million homeowners who bought at the peak of the real estate market before the economic downturn, or who took cash out of their homes through readily available refinancing, are now feeling the pain of owing more than their properties are worth. That population — roughly one-fifth of those who pay mortgages — is big enough to make even the most cavalier consumer think twice before buying a home, especially when key pricing indexes are showing continuing weakness in markets across the country. According to the Case-Shiller 10-city composite house price index, real house prices dropped by more than 31% between the end of 2005 and the end of 2008.

But potential home buyers’ fears may not be entirely justified. While the change in housing values might discourage homeownership, new Wharton research suggests that owning a home is less risky than might be expected and can effectively hedge against volatile prices for shelter, including rental rates, if a buyer does not take on excessive debt to make the purchase.

In a paper titled, “Can Owning a Home Hedge the Risk of Moving?” Wharton real estate professor Todd Sinai and co-author Nicholas S. Souleles, a Wharton finance professor, explore the risk of homeownership among consumers who move from one market to another. The authors use census data that tracks individual moves to study the volatility of housing prices between the markets where people live and the markets where they tend to migrate. When the correlation between housing prices in these corresponding housing markets is taken into account, price increases and declines track closer than they do in the market as a whole, reducing the amount of volatility, or risk, involved in buying a house.

In other words, by buying now, consumers can protect themselves from increases that could price them out of a housing market they might move into later, the authors find. Sinai notes that while homeowners often focus on the market value of their home, what really matters is the relative price — or how that figure compares to the price of finding shelter when they decide to move to a new market. Houses are different from other assets, such as stocks, he says, because the seller must replace the asset with someplace else to live. “If a house goes up by $10,000, it’s still the same house with the same kitchen. Just because it is worth more on paper doesn’t really change anything,” Sinai says. “And if a new house in a new city has also gone up in price by $10,000, a homeowner can cover that higher price with the capital gain. A renter would be out of luck.”

The research extends a notion that Sinai says local realtors seem to have always known: If a buyer thinks he or she would like to live in a certain community in the future, buying a small home in the area will help make a move up more possible later on, even if prices shoot up rapidly. If prices go down, the “upgrade” home will also have dropped in price. Sinai and Souleles found that the same idea often holds even if the buyer would like to live in a different community in the future. That’s because many homeowners move to a city similar to the one they left behind, according to the study.

Wandering MBAs

To better understand the true impact of housing price changes, Sinai and Souleles reviewed household data from the U.S. Census in 1980, 1990 and 2000. In all, they took into account 12 million data points, including housing prices, occupation statistics and rental prices in high-end apartment buildings in 44 major markets. Controlling for numerous variables, including education and marital status, the researchers found that the correlation in real house-price growth across those complementary metropolitan areas was higher than the median across all markets.

The paper shows that the median correlation in house-price growth across U.S. metropolitan statistical areas is 0.35. However, after accounting for where homeowners are actually likely to move, the median correlation rises substantially to 0.60. The top 75th percentile of correlated moves has an even higher rate of 0.89.

“We show that for such [correlated moves], home owning often hedges [homeowners’] net exposure to housing market risk, because their sale price [moves up and down] with house prices in their likely new market,” the authors write. That effect is more prevalent than previously recognized because, although prices can vary considerably from one market to another, “households tend to move between highly correlated housing markets.”

Sinai says the study was inspired by MBA students who often wonder whether they should buy a home in Philadelphia while studying at Wharton, or whether they should buy a house when they graduate and move to a new city where they may not remain more than a few years. “It got me thinking about how risky is it really for my students in Philadelphia to own a house for the couple years that they are here? Or if they go to New York and expect to stay for five or six years, should they buy a condo? How big is the risk?”

The research results are surprising because they show that housing markets are more closely correlated than previously believed, Sinai notes. When looking across housing markets overall, the gaps in house prices seem risky. However, upon a closer look at more detailed data, the research shows individuals tend to move to other regions where the difference in house prices between the two markets moves up and down less dramatically than house prices in the destination housing market alone. As a result, making an investment in a home is actually less risky than it might appear at first.

“The hitch is that people don’t just move to the rest of the country,” says Sinai. “People in Philadelphia don’t tend to move to lots of parts of the country. And in fact, the parts they do move to — New York, Boston, San Francisco — are different than where people in Cincinnati, Houston and Dallas tend to move. On average, people move between highly correlated housing markets. When you recognize that, it changes your view a lot.”

The Wrong Medicine

According to Sinai, the belief that housing markets are uncorrelated and that prices are highly volatile led to the development of products to protect against wide variations, including derivatives based on the Case-Shiller Home Price Indices and home equity insurance products that allowed households to pay a fee to guarantee that their house values would not fall below a certain point. Those financial products never took off, he says, perhaps in part because — as the research reveals — buying a home serves as natural protection against swings in housing prices.

Sinai adds that owners get the advantage of living in the house, which is similar to an added dividend. People also tend to build savings in the form of home equity. “Homeownership seems to induce saving on the part of households because they will pay down the mortgage, and by the time they are in their 70s they have no housing debt anymore. People are willing to put equity into a house, but wouldn’t be disciplined to put it into the stock markets.”

People tend to invest in homeownership because they have the ability to use debt to finance homes they might otherwise be unable to afford at times when it seems home prices are on the rise, Sinai notes. However, he adds, that the use of borrowed funds to increase purchasing power cuts both ways, and the role of debt in home buying is an important caveat to the research. “Owning a house with a lot of leverage is really, really risky and there are no two ways about that.” When a home’s price falls below the value of an existing mortgage, the homeowner cannot afford to move because there is no equity left to form a down payment on another home. “The real cost of house price declines come from leverage. That’s the real risk of owning a house.”

The use of innovative mortgage products with features such as teaser or adjustable rates, which helped spur the recent housing boom and bust, should not be abandoned but should be used with care, Sinai says. Improved regulations and more education could help homebuyers avoid the problems now weighing on residential markets. “Giving credit to people who can’t afford it is not innovative — it’s just a mistake. We don’t let people use any regulated medicine that they want. We make them get a prescription. Yet we let them use any financial medicine they want, whether it is good for them or not.”

On March 26, the Obama administration announced plans to help homeowners who are underwater with their mortgages. Lenders will be asked to reduce by 15% or more the principal owed on a loan that exceeds the current value of the home. The reduced amount would be forgiven by the lender over three years if the borrower continues to make monthly payments.

Sinai says that while he has not seen how the plan would work in detail, it is an attempt to stem the risk placed on the entire economy when housing markets contract. “It is abundantly clear that when people owe more on their houses than they are worth, it creates severe dislocation for households, the community and the banking sector,” he notes. “We’re in a situation where we have to adopt some very expensive policies to compensate for the fact that there was systemic easy credit. If we want to try and make housing a less risky sector, one would consider encouraging households to use less leverage. That would reduce the risk of a downturn like we have just seen and enhance the risk-management benefits of owning a house.”